The turmoil we have experienced in the financial markets over the past few months has been explained in many ways. Distinctive nervousness and sometimes panic have contributed to the major fluctuations, but basically, there are two factors that have been crucial to the development in 2016.
In 1983, former Minister of Taxation and Taxation Mogens Lykketoft made a special note when he called the actors in the Danish financial world for a bunch of hysterical treasures. It is not certain that he had left a similar comment in 2016, but no matter what, the wording has been used again and again when the financial markets have experienced large price fluctuations.
Developments in the global equity markets have been unusually tough in 2016, and violent fluctuations during very short periods have led to panic conditions and speculation as to whether we were on the brink of a new financial crisis.
Basically, we have to get used to larger fluctuations. The increased regulation of the financial sector after the financial crisis combined with algorithm-based computer trading are contributing causes of the market reacting with greater fluctuations when data comes which the hysterical stock counts can perceive as positive or negative. Property management estimates that there are two factors that have resulted in the large turbulence in 2016.
There is no doubt that China has been one of the key pivotal points in relation to the fall in share prices in 2016. The market has responded in particular to the slowdown in growth that the country is currently experiencing, although developments as such should not be behind investors.
For a long time, China has undergone a transformation from an investment-driven manufacturing economy to a more consumption-driven service economy. The reason why the market is still worried is that more key ratios have confirmed the slowdown in growth and that the country began to devalue its currency (yuan) last August.
The growth slowdown in China has, as I said, been underway for several years, but with the devaluation last year the situation changed markedly. China has previously pursued a fixed-exchange-rate policy against the US dollar, but by suddenly weakening the yuan against the US dollar, it made it cheaper for the outside world to buy Chinese goods and more expensive for the Chinese to import foreign goods.
In itself, it is not a landmark act, since the central banks’ monetary policy stimulus programs in the primary economies have also largely intended to weaken the respective currencies. On the other hand, the decisive factor in relation to China was the signal that the Chinese wanted to break with the fixed-exchange-rate policy and the bond with the dollar. The entire communication about the devaluation in August and the subsequent minor devaluations proved to be a challenge for the financial markets. China stated that the yuan should be a stable currency and that, as part of its entry into the IMF’s reserve currency basket, the Special Drawing Rights, SDR, would also be more market-based. That message, however, was in sharp contrast to what the markets experienced: A number of minor devaluations and a general depreciation from December going into January.
The financial markets, therefore, started 2016 in a vicious spiral, where a number of poorer than expected key figures increased the fear that there was a hard landing on the way in China, and that to a greater extent than before, it was willing to use the currency as a possible means of restarting Chinese exports in particular.
The word currency war has rarely been used in recent years. However, repetitive monetary stimulus programs first in the US and later in Japan and Europe have largely been aimed at weakening domestic currencies against trading partners so that export goods became cheaper abroad. For example, recent European Central Bank (ECB) stimulus programs have provided significant downwind to European and Danish export companies because it has simply become cheaper for the US to buy European and Danish goods.
In this perspective, it is not surprising that China’s entry into the global currency war has shaken the markets. After all, the challenge is that not everyone can weaken their currency in order to export since there are naturally one or more who are forced to import.
The problem is intensified as many of China’s trading partners in Emerging Markets have locked their own currencies firmly against the Chinese. Thus, the problem is not only isolated to China, but also to large parts of Emerging Markets.
In addition to the direct effect through trade between East and West, another and the more significant element is the direct and indirect financial link between China and the rest of the world. China’s desire to liberalize its currency has implications for external trade. However, the financial impact is far more important.
Overall, there are three factors that push the Chinese currency:
An all-natural consequence of China’s new currency policy, the expectation of growth slowdown and the lack of communication have contributed to speculation as to whether the Chinese currency would continue its decline. Sales pressure from currency speculation reinforces the pressure on the currency unless action is taken. Therefore, China has among other things raised the offshore banks’ reserve requirements for domestic accounts in connection with foreign exchange trading and at the same time limited the short liquidity, so that very short interest rates have increased significantly. It has made it much more expensive to speculate on the Chinese central bank.
2. Pull on deposits
When China, as in the autumn and early 2016, lets its currency weaken primarily to US dollars, a natural interest arises from Chinese and Chinese companies pulling money out of the country and placing them in hard currency that is not relatively weakened. This means that the fear of further weakening causes the Chinese to swap the yuan to the dollar, putting additional pressure on the Chinese currency and foreign exchange reserves, with the central bank buying the yuan. China currently has a $ 50,000 limit that can be used to exchange Chinese foreign currency deposits with ordinary Chinese. The limit has been introduced in an attempt to control the flow from the deposit side, but one must expect that the framework has largely been exploited by those who have been interested in it.
3. Conversion of dollar debt
The amount of dollar debt in China and Emerging Markets is the third major cause of the Chinese currency’s pressure and pressure. Since the financial crisis in 2008 and 2009, the US central bank has tried to boost the economy by lowering interest rates and pumping liquidity into the market. Part of this abundant liquidity has flowed towards China and Emerging Markets in the form of borrowing (see figure on next page). The advantage for borrowers in this regard was, among other things, that the interest rate on the debt was falling and close to zero, while the US dollar generally weakened due to the monetary policy measures in the US – overall a favorable situation for the borrower, as the cost of debt servicing was low and falling.
Bank for International Settlement (BIS) published in its quarterly analysis from December 6, 2015, the volume of dollar-denominated debt in Emerging Markets. Since 2008, the dollar debt in Emerging Markets is estimated to have increased by up to 83 percent (see note 1) to a total of DKK 3,300 billion. dollar (see note 2)). Of the total estimated dollar debt in Emerging Markets, BIS estimates that China represents 31 percent. So, in addition to China already has a very high total debt of approximately 247 percent of GDP (see note 3), part of this debt is also in dollars.
With an American economy recovering and an increasing expectation of interest rate hikes in the US (first interest rate rise came in December 2015), this has led to a strengthening of the US dollar against a wide range of currencies over a long period. China has seen the slowdown in growth over the same period, and has repeatedly lowered interest rates or made other monetary maneuvers in an attempt to increase Chinese growth. An increasing US interest rate and a number of devaluations of the Chinese currency (see notes 4 and 5) have, all things being equal, caused the cost of servicing the dollar debt to rise.
This is why, over the autumn and early 2016, a conversion of dollar debt into debt in Chinese currency has been seen. Chinese companies thus settle their debt by buying dollars and borrowing in local currency, which some feared would put pressure on the currency. However, wealth management does not expect the Chinese foreign exchange reserve to be seriously challenged, as the Chinese currency is still subject to significant currency restrictions for Chinese individuals – and companies – and there is ample opportunity for further tightening of restrictions by the Chinese government.
As described above, the uncertainty surrounding the Chinese currency policy and the forward-looking level of Chinese growth has been significant reasons for the nervousness in 2016. In an attempt to control the movements in the Chinese stock market to a greater extent, China introduced a so-called Circuit Breaker at the beginning of the year. say a kind of pause mechanism that goes in and stops all trading in the stock market when falling over a short period of time becomes too big.
It gives investors and traders the opportunity to stop and assess the situation, and the expectation was that in this way, to a large extent could avoid panic in the market. A pause mechanism in a stock market is not unusual, but in China’s case, the construction was inappropriate. At a price drop of 5 percent, a 15-minute stock exchange break would automatically be introduced, after which the deal would be resumed. If the market fell subsequently by a total of 7 percent, it would close the rest of the day.
The challenge in a stock market such as the Chinese is that fluctuations are considerably greater than in the more established markets. This is due to the risk in general, but also to the speculative culture that prevails among private Chinese investors. If the pause level reaches 5 percent and the market opens again after 15 minutes, there is not far to the total of 7 percent where the market closes completely.
In China, after the break period, investors used the window to sell stocks to get out of speculative positions before the market closed. Thus, the effect of the pause mechanism against the intention became greater fluctuations and frequent market closures. It created considerable volatility, and on January 8, 2016, the pause mechanism was settled after only having been active for four trading days.
Another important area in relation to the explanation of the turmoil in the stock market in 2016 is the development of the oil price.
Since June 2014, the oil price has fallen from around $ 90 a dollar. Barrels to now about $ 35, which can largely be explained by the supply situation of crude oil more than changes in demand. Increased supply of shale gas and oil from, among others, the United States has contributed to the supply level generally rising massively. Combined with OPEC’s ambition to maintain and periodically increase the supply of crude oil from the member countries, this has resulted in a sharp fall in oil prices.
The speed with which the oil price has fallen and the low of the oil price have supported the share price fall and the panic that has sometimes appeared in the stock market in 2016. This is because the credit risk has increased significantly. Many oil companies and companies that service or otherwise support the oil industry have come under severe economic pressure due to the fall in oil prices. Projects have been canceled, the investment activity in the oil sector is at zero and at the same time several energy companies have difficulty in settling their debt.
The focus on the credit risk from the energy sector and the potential economic consequences has pushed the entire stock market. The energy sector has naturally been hit by the very low oil price, but the market fear has increasingly been directed towards the financial sector (including the banks), which risked being hit by rising loan losses. Certain parts of the industrial sector whose operation is dependent on the oil price have also been affected by the increasing credit risk.
All of this is due to the fact that these sectors have a significantly greater weight in the stock market, but this is also the reason why, in 2016, it was possible to see a conspicuous covariation between the oil price and the stock market. When the oil price has fallen, the stock market has also fallen, which immediately seems wrong, as a lower oil price acts as tax relief for the global consumer. Cheaper oil increases everything else equal to the consumer’s purchasing power and should support consumer desire. As a result, this would generally be positive for the stock market, as most economies are consumer-driven.
The reason why we have experienced the opposite is to a large extent that the credit risk runs faster to the stock markets than the positive consumption effects at a low oil price. In other words, the fear of bankruptcy in the energy sector and any negative consequences in other selected sectors has been weighted higher in investor awareness than the positive consumer effects we expect to see in the coming quarters. However, wealth management believes that the market’s fear of significant credit losses in the banking sector is overvalued.
Growth concern combined with a new currency regime for the Chinese currency was one of the main reasons why China has played a key role in global stock market developments in 2016. Also, the communication from the Chinese central bank and an erroneous attempt to control the fluctuations in the Chinese stock market reinforced global nervousness and pushed the financial markets.
In addition, a significant drop in oil prices combined with an accelerating credit fear were also factors that pushed the stock market as the oil price set new base orders. A development that also contributed to the triggering of a number of classic recession signals in especially the credit market and the manufacturing sector.
Add to that the regulation of banks over the last few years, which has significantly reduced their stock market holdings, thereby removing the buffer that could previously dampen troubled periods and a marked increase in computer trading, responding and amplifying the market movements within milliseconds. there is going on. The question is whether it was just the hysterical compilations of 1983 that were at stake again, or whether the development is based on real concerns. The answer is probably that it is a mixture of fundamental concerns that have been reinforced by a sometimes frantic mood.
Over the past month, markets have seen a gradual stabilization in the Chinese currency and a relatively stable oil price around $ 35-40 per dollar. barrel. Precisely the stabilization of these conditions, which were among the triggering factors for the nervousness at the beginning of the year, has created a positive mood in a stock market, where much of the lost by mid-March was regained.
Although stock market quotations in 2016 have contributed to nervousness and sometimes panic conditions, as an investor, one must not ignore the challenges facing the stock markets in the longer term. China and other countries are undergoing structural developments in their economies from export-driven to more driven by domestic demand. However, Formuepleje expects that it is still the United States that drives the classic operational recovery.
However, one must have in mind that this is done at the same time as a normalization of the risk profile of equities and an expected gradual normalization in the US monetary policy, so that as an investor one should also have a more normalized expectation of the future equity return.