A tale of two markets
Noticeably absent from this year’s soaring stock market have been emerging market equities and those companies which deal in commodities. Stoked by unprecedented money-printing and massive global “ring-fencing” of the world’s most serious credit problems, developed country equity markets including those representing the US and Europe have posted record gains so far this year. “Easy money” federal banking policies have propelled both the S&P 500 and Dow Jones Industrial Average up to new all-time highs over the past few weeks.
But while the S&P 500 has registered gains exceeding 16% this year, the MSCI emerging markets index is barely breaking even. China, by far the largest emerging market, has actually declined by about 2% year-to-date as of this writing. Closely related to the limping Chinese dragon, a basket of commodities as represented by the Goldman Sachs commodity index has fallen by over 3% this year putting downward pricing pressure on most companies which find, extract and sell basic materials such as copper, gold and aluminium.
China’s Growth ‘Slowdown’
China, the world’s second largest economy, plays an important part in the global economy. Just a few years ago, the large, developing nation played a leadership role in pulling the world out the Great Recession through its massive infrastructure investment programme rapidly deployed during the economic depths of 2009. Unlike most of the developed world, China’s centrally controlled, one-party government had the unique advantage of making extreme policy moves without the need for long, drawn out debate. And while the country’s earlier programme pushed commodities prices to new highs, in recent months the economic growth engine has begun to slow, taking commodities prices down in tandem.
China’s growth rate slowed to 7.7% in the first quarter of 2013, below the 7.9% reported for the prior period and less than the 8.0% consensus estimate. Economists quickly panned the number after its release in mid-April sending Chinese stock markets tumbling. Signs of weakness appeared again in the headlines last Thursday when an independent Purchasing Managers’ Index gauge was released indicating that China’s manufacturing slowed in May.
Markets tend to react vehemently to bad news as they did on Thursday. But taking a step back, even at 7%, China’s growth rate should be the envy of just about any other nation on the planet. By comparison, the US is expected to grow 2.0% this year while Germany may see just 0.5% GDP growth. The International Monetary Fund (IMF) forecasts the world economy as a whole to grow at a rate of 3.3% in 2013.
Ostensibly, Chinese economic “slowdown” is relevant only to its highly prolific past. From 1979 until 2010, China's average annual GDP growth exceeded almost all other countries with an impressive 9.91% average increase. Over those years, China's GDP surpassed that of the United Kingdom in 2006, Germany in 2007 and Japan in 2009, making China the world's second largest economy after the United States.
Besides having an impact on the emerging market sector as a whole, many analysts consider the world’s second largest economy to be the marginal buyer of most commodities. Spikes and plunges in commodities prices are often directly related to China’s anticipated growth trajectory at various points in time. If the sleeping giant can manage to reaccelerate its growth, lagging markets have a chance to catch up again. Clearly, a resurgent China has the potential to put a better bid on commodity prices and give a welcome boost to other emerging markets including Russia and Brazil, which rely heavily on selling basic materials to China and the surrounding other emerging ‘Asian tiger’ nations such as South Korea and Taiwan.
In the meantime, commodity prices remain volatile with pressure on the downside. In fact, this year’s sharp sell-off has been accentuated by growing retail investor participation. A recent article in the Financial Times quoted Ruchir Sharma, head of emerging markets for Morgan Stanley as saying “The commodity mania (over the past decade) spawned a new industry of investment funds that allow even lay people to trade in commodities. The total invested in commodity funds has more than doubled over the past five years to more than $400bn in 2011“.
Dissecting the DragonChina changed leadership at the beginning of this year creating some uncertainty about government policy. Shortly after his appointment, newly elected Prime Minister, Li Keqiang declared that the economy would have to “climb hills and cross ridges”. Li left no doubt that one key initiative will be China’s economic growth, but he is also committed to rebalancing the system. Runaway credit growth, a surge in the off-balance sheet “shadow banking” system and excessive real estate speculation have been cited as other areas for concern.
Hindered by the recession in Europe, China’s largest export market, much of the growth slowdown has been out of government’s control. On the other hand, a fair portion may also be intentional as the government seeks to curb property speculation and reduce fixed asset investment. According to the National Bureau of Statistics (NBS), the new government is intent on “improving the quality and efficiency of growth” and this appears to be happening. China’s industrial output in March rose 8.9%, while consumer-related retail sales grew 12.6%, matching the median forecast. Fixed-asset investment was also below expectations and looks to be decelerating.
If the NBS is committed to a higher quality growth composition, then that might justify some reduction in the quantity. To that point, China’s first quarter’s growth was led by consumer spending, which contributed over 55% of the total and this year services have the potential to become the largest part of the economy. Services are fine for rebalancing but do not support a theme for rising commodity demand.
Playing with Dragon Fire
At LOM, our equities strategies have happily benefited from a long and successful run in US stocks over-represented against a global equity index. While this has been the right call so far, in recent weeks we have begun to move back into select non-US markets. Those investments have included emerging market countries which appear to be showing better relative value. For example, after underweighting developing markets earlier in the year, our equity strategy has lately increased its exposure to markets including China, Taiwan, Malaysia and Turkey.
As China rebalances its growth profile, investors should think about rebalancing their own portfolio. A rising consumer class achieving greater levels of buying power is highly constructive for a number of consumer companies providing products and services to the developing world. As well, commodities companies and those markets exposed to basic materials are likely to see further bumpiness; but nevertheless, heightened volatility in the commodities space will likely provide many attractive opportunities for the patient investors as the lumbering dragon climbs hills and crosses ridges.
Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.