China’s economic judders bring questions – and opportunity

By Marion Dakers, Financial Services Editor

The collapse in Chinese markets has brought into focus a question that Western nations have been grappling with since the 2008 financial crisis: how much, if anything, stock markets have to do with the real economy.

Warning signs that Chinese stocks were overheating have been clear for months, and the scenes of distraught retail investors losing their life savings as prices began to snap back in June barely made a ripple in global markets, until last week.

The Shanghai and Shenzhen brokerages were viewed as one step above casinos, with 80pc of the daily trading volumes coming from ordinary retail investors allowed to leverage up to the hilt on a state-sponsored bull run.

Peter Fitzgerald, Aviva Investors’ head of multi-assets investments, said: “There’s a big difference between the Chinese economy and the Chinese stock market. The economy, for example, has been doing well over the past 10 years, while the stock market really hasn’t until recently.”

How China’s market panic spread to the rest of the world, creating a global meltdown last week, with the biggest one-day gains and losses since the eurozone crisis, is still unclear. The uncertainty is partly why market players stayed on edge for so long.

Some City insiders have pointed to Beijing’s decision to devalue the yuan on August 11 as a warning that China’s economy was indeed slowing; others suggested disappointing data on manufacturing growth a week later was the trigger.

Others still have said it was the People’s Bank of China’s failure to intervene to prop up the market over the weekend of August 22-23, as it had done during previous wobbles, that finally unnerved traders. Theories that hedge funds were forced to sell to cover heavy losses in Asia earlier in the summer were also spreading.

Belated moves in Beijing to cut interest rates and the amount of reserves the banks must hold on Tuesday were viewed as “too little, too late” by market participants who had grown accustomed to regular, spectacular support for prices from Beijing in the past year, according to Catherine Yeung, investment director at the fund manager Fidelity.

The PBOC was throwing “everything but the kitchen sink” at the crisis, with interventions in both equities and currencies, according to Andrew Polk, senior economist at The Conference Board, as the central bank seemingly tried to get out in front of the expectations of increasingly frazzled markets.

But last week the efforts simply served to spook investors. The New York Stock Exchange used its circuit breakers, installed after the 1989 crash, to pause stocks on 1,278 occasions on what was immediately dubbed Black Monday. A normal day sees fewer than 10 stocks halted.

The FTSE 100 lost 4.7pc on Monday, followed swiftly by the biggest sell-off in four years for the Dow Jones index in New York. The global markets spent the week chasing each others’ tails, often taking cues from the Shanghai Composite – the index that six months ago was widely seen as a rampaging bull market, driven by the rising popularity of loan-fuelled trading rather than real economic growth.

The Vix, a measure of trading volatility among US markets, spiked last week to its highest level since the eurozone crisis in 2011. For brief periods, the flight to protect against losses was so rapid that the CBOE, which produces the index, was unable to come up with a reading.

Mr Fitzgerald said: “What’s made it worse is the state’s extraordinary measures to contain this. While there’s a history of authorities intervening in the markets, it’s tended to happen when values are very low and it was needed to support confidence. It’s created considerable mistrust for foreign investors.”

There is a stark contrast between the PBOC and the US Federal Reserve’s approach to managing markets. The Fed tends to treat investors like the recently burgled: reassurance at every stage, no loud noises during the night. American central bankers have been signalling for two years that the crisis-era programme of vacuuming up bonds from the market, known as quantitative easing, would be wound up as the economy improved.

Even this approach wasn’t enough to prevent the “taper tantrum” of 2013, when the markets took umbrage at the suggestion that the Fed would begin to tighten monetary policy. The work to drop repeated hints about an interest rate rise is ongoing.

China’s abrupt interventions have therefore come as a surprise to investors who have only recently gained direct access to the country’s A-share market.

Lucy O’Carroll, chief economist at Aberdeen Asset Management, said: “The role of China in the world economy is growing, and events have more of an impact than they did 15 years ago.” Markets were learning what China did and how it did it, she said, and China was learning how markets reacted to its actions. “They don’t want to be seen to be reacting to every little twist and turn in the markets.”

By Friday night, after five days of frenetic trading, the world’s biggest markets ended up more or less back where they started overall, despite an 11pc drop in the Shanghai Composite.

The longer-term significance of the crash remains up for debate. The more optimistic watchers point out that the US markets have just been through the third-longest period in the past 90 years without a major market fall of at least 10pc. China was simply the spark for an overdue correction.

Some also sound a note of caution about the timing of the rout, during what is normally the height of the summer slowdown on trading floors around the world. The lack of trades magnifies the effect of the deals that take place, particularly if the only players left making bids and offers are computer programmes designed to seek out and exploit any liquidity.

Nigel Brahams, a partner in financial services and markets at the law firm Fox Williams, said: “High-frequency trading doesn’t ultimately change the direction of the market but it accelerates and exaggerates it. With less people in the market in August, it takes fewer of them to move the market; there’s relatively little volume driving the markets other than HFT.”

Mark Haefele, global chief investment officer at UBS, also suggested that the sell-off was partly driven by risk controls within hedge funds triggering automatic sales, accelerating the pressure to sell. However, UBS also has deeper concerns about China’s health. “We take the sell-off very seriously, as this unfamiliar mix of emerging market uncertainty, deflationary pressure, central bank interference, and extreme volatility is hard for global markets to digest,” he said.

UBS has crunched the numbers on a possible Chinese slowdown and has estimated that a 1pc drop in economic growth would knock up to 0.4pc from Europe’s output. Even though China buys relatively little from European trading partners, equating to about 3.1pc of overall exports, a slowing consumption of fuel, commodities and consumer goods might spiral into deflation further afield.

On Tuesday the European Central Bank’s vice-president, Vitor Constancio, tried to dampen anxiety over an economic slowdown in China, saying that the economy did not show signs of major deceleration and that Europe’s central bank stood ready to intervene if deflation reared its head.

For countries with greater reliance on China, the effects could be more pronounced. The currencies in Turkey, South Africa and Malaysia all hit their lowest levels in over a decade after China’s move to devalue the yuan. This makes their exports more attractive but could spur an exodus of capital and exacerbate other economic weaknesses within these countries.

But without the central banking might of Beijing, or its $3.65 trillion capital reserves, they are consigned to wait for signs of progress from within China.

The annual Jackson Hole get-together this weekend has allowed the US authorities to drop more hints about what the China shudders might mean, with every morsel on inflation and interest rates carefully watched.

The Communist government’s next five-year plan will be aired in October, with Premier Wen Jiabao’s desire to move more people into urban centres likely to continue unabated.

Data on China’s third-quarter economic growth will fall due at around the same time, and while the figures are notoriously beholden to the state target of 7pc expansion, the ugly stock market performance seems almost certain to have dampened activity in financial services, which were growing 17.4pc in the first six months of the year.

Signs of interruption in the long-term goal to rebalance the economy from manufacturing to services would hinder Beijing’s other goal of further opening up its economy to the world.

The MSCI has already deferred putting the Chinese stock market into its benchmark world indices, and the International Monetary Fund has delayed placing the yuan into its influential basket of world currencies.

Meanwhile, China seems likely to continue tinkering in the markets until it stops crashing. Margin trading since the onset of the crash has fallen back to 1.25 trillion yuan, the level seen at the start of the year, suggesting that burned retail investors are waking up to the dangers of leveraged bets. “That’s something of a relief, as the liquidity surge has been taken out of the market,” said Ms Yeung at Fidelity.

Stocks that have strong companies underpinning them should retain their value, which will become clearer if and when the authorities pull back from intervening in the market. However, Ms Yeung added, “you can’t lose sight of the fact that China needs to deleverage and the reform agenda still needs to be implemented.”

Stock-pickers within the City investment firms Aviva, Aberdeen, Fidelity, Numis and St James’s Place were among those who bought into the declines during last week’s dizzying trading sessions. They faced an uncomfortable reminder of China’s increasingly key role in the world’s financial machinery, but they also saw bargains.

Chris Ralph, chief investment officer at St James’s Place, said: “I think it’s very difficult to conclude what the underlying trigger was. But some of our managers were buying in because they were seeing the indiscriminate market falls lowering the price of what they see as quality companies.” At Aviva, Mr Fitzgerald said: “I think if you’re an investor who is taking a medium-term view, three years rather than three days, it was a good opportunity to put some capital to work.”/Telegraph