08th June 2015
Bernard Doyle, JBWere NZ Strategist, shares his views on Greece and China.
* The combination of the Greek 'No' vote with signs of panic in the Chinese equity market investors have begun to contemplate the twin threat of Grexit combined with a Chinese hard landing. We are watchful, and have suggested investors may want to hold a little extra cash while markets endure heightened volatility (the Vix volatility indicator has popped to the 15-20 range, below). However both the Chinese equity market and the Greek rear-guard referendum look more Cooked Goose than Black Swan to us. Looking at each event in turn:
* First, to Greece where the risks of an exit from the Euro Area (Grexit) have risen, exacerbated by the landslide “No” vote in the weekend referendum. According to newswires the new Finance Minister (Euclid Tsakalotos) made a good impression at the EU Finance Ministers summit overnight (despite arriving without a written proposal). However, against that, Greece faces two hurdles: 1. a greatly compressed timeline, thanks to a lack of Euro in the Greek banking system that may soon force the Government into issuing its own people with IOU's in lieu of cash. Even if the banks limp on for the next couple of weeks, by July 20 the Greek government must pay the ECB €3.5bn or default and face a loss of ECB support; and 2. growing signs of resistance to a deal from the EU. Notwithstanding the likely support of Germany, for geopolitical reasons, and almost certainly France, there is a growing rump of countries that have begun to voice reservations about retaining Greece in the Euro.
* Our base case is that Greece remains in the Euro Area. However, if against all parties interests, Grexit were to occur Greece’s economy would be the Cooked Goose. With no access to a hard currency, Greece could become a humanitarian disaster, and would take at least 5 years to return to something resembling normalcy. European financial markets would suffer a temporary setback (possibly a fall of ~10%) from today’s levels, but the ECB would be back to a “whatever it takes” response to any signs of trouble in countries such as Portugal and Spain. Accordingly scope for a serious contagion is limited in our view.
* The medium term investment case for the Euro Area continues to look reasonable to us – and we’d expect dip buying to kick-in early on in the event of a severe Grexit-sell-off. Two things that have caught our eye: 1. The broader European political backdrop is actually benefitting from Greece. Spain is the poster child here, where the downward spiral of Greece has served to cap the popularity of Podemos, the Spanish equivalent of Syriza (below). 2. Leading indicators remain in good health. Business confidence in core Europe is close to pre-GFC levels (below, right).
* The second Cooked Goose is the Chinese equity bull market, which looks to have suffered a terminal blow to sentiment. In the year to 31 May, Chinese A shares rose 126%. Stunningly, this performance came as economic growth slowed and industrial earnings stagnated. So what drove the bull market? Margin lending into the share market that was, in the words of one of our research partners, “easily the highest in the history of global equity markets”. However the leverage fuelled rally has turned decisively, with Chinese A-shares falling 32% since June 12.
* The Chinese leadership has handled the equity market naively. After remaining largely silent while the Shanghai and Shenzen bubbles inflated, authorities have looked panicked in their response to the inevitable messy conclusion. Measures such as a voluntary commitment from local brokers not to sell stocks below an index level of 4,500 (already well out of the money at 3,550) have had little impact as animal spirits and margin calls dominate.
* We are starting to see some signs of market concern that the equity slowdown will impact the Chinese real economy. Copper prices, for example, have fallen 6% over the past 48 hours. While not dismissing a headwind, we would be surprised if the equity sell-off caused a Chinese hard landing, for three reasons:
- Chinese equities are not the Chinese economy. Chinese economic growth has slowed steadily for the past year, and has shown little evidence of benefitting from the roaring equity market. This is not surprising, as the equity market is not yet deeply integrated into the economy. Accordingly, we don’t expect any ensuing bear market to automatically drive an economic downturn. That said, there is no doubt a well-functioning equity market is an important plank in China’s economic reforms. A truly catastrophic decline (say >50%) would deal a blow to both Government credibility and the prospect of limited spillovers.
- Chinese equities are not a key component of household assets. This has been a retail driven bull market, and consequently there is the potential for a negative wealth effect as investors nurse losses. However even with the latest sell-off, A-share equities are still +10% year to date. Accordingly it is only the unfortunate investors that came to the party late that are hurting. Additionally, while statistics are thin, it is estimated that direct and indirect equities are unlikely to be much more than 10% of household assets (source: Goldman Sachs), again limiting scope for a deep consumer downturn.
- More stimulus. While the Chinese authorities have not managed the equity sell-off well, they are more adept, and experienced, at managing the economy. While economic growth has slowed, signs of stabilisation are emerging, with the property market one such example (below). The equity market sell-off is likely to lead to an extension of stimulus measures aimed at shoring up the real economy.
Soufun 100-city house price Index
* The combination of Greek and Chinese stresses may continue to weigh on global equities. Our Industrial share price indicator, for example, has slipped in recent days (below). However we struggle to see much evidence that either event could change the shape of the global economic cycle. Accordingly we continue to advise against medium term investors feeling the need to drastically re-engineer portfolios.
* We also remain sceptical that these events yield much new information for New Zealand’s prospects. Yes, our milk powder prices have felt the impact of the Chinese slowdown – but as discussed earlier, this has played out independently of the Chinese sharemarket. We would be surprised if the A-share sell-off were going to meaningfully impact demand for dairy in China. Interestingly, the milk & diary component of the Chinese CPI posted its deepest declines in March, and have since shown signs that the worst is past (below).
* Greece and China are also taking attention away from another important development in the world economy – the re-emergence of oil price weakness (below). Goldman Sachs cite production growth in the US, Iraq, and Russia as reasons for expecting this weakness to extend. A wildcard here is Iranian nuclear negotiations which look close to a breakthrough, and would signal an end to sanctions on one of the world’s biggest oil producers if successfully concluded.
* The combination of rising oil prices and falling dairy prices were directly cited as one of the key reasons for the RBNZ’s June rate cut. It would complicate the 2015/16 easing cycle if this rationale were to unravel over coming months. Accordingly, while we acknowledge the likelihood of further RBNZ easing, we believe the consensus is overstating the certainty with which rate cuts are delivered.