For all the talk during the summer that China’s ‘Black Monday’ (24 August 2015) could be about to trigger the next global recession, by October markets appeared to have largely shrugged the issue off. This despite the fact there is no evidence that China’s economy today is in any better or worse shape than it was on 24 August, or indeed during the months preceding the People’s Bank of China’s (“PBoC”) surprise currency devaluation on 11 August – when investors appeared equally unconcerned by signs of slowing Chinese growth.
Amidst an almost continuous loop of market ‘noise’, it seems a long time ago now, though it was just a few months, that Greece was the focus of attention and pointed to as the most likely perpetrator of the derailing of global recovery. As is often the case, since July we have seen market attention shift suddenly from one issue to another, sometimes over a matter of days.
This highlights the importance of carefully assessing what is really going on rather than being lured by the neatness of distilling complex issues into easily digestible stories. Drawing comparisons with historic financial crisis based on selective representations of certain market movements may make a ‘good’ story, but it ignores the myriad factors underlying these previous crashes.
Logic over instinct
Crucially, this more considered assessment needs to be carried out during the market volatility ‘episode’ and not with hindsight once it’s all over, when it may too late to make the right decisions in terms of the real risks and opportunities.
This is easier said than done as it often requires fighting one of our most basic human instincts – that of fight or flight in the face of apparent danger. In many situations, flee first and assess how genuine the danger is later might be key to survival. In investing, it can be lethal.
In the cold light of day, being greedy when others are fearful sounds perfectly logical. However, in the heat of the sort of dramatic volatility that gripped markets during late summer, most of us are vulnerable to our human instincts overwhelming logic.
Today, we might feel some satisfaction in pointing out that we identified the indiscriminate selling leading up to ‘Black Monday’ as noisy and a potential opportunity in developed market equities at the time. However, we have to remind ourselves of two things: firstly, it did not feel comfortable at the time and, secondly, we did not know more than anyone else and were no better equipped to time the market. Our views at the time were not based on predicting that markets would bounce back so sharply and so quickly, but on an assessment of current valuation in the context of the facts.
What really happened
It was the PBoC’s surprise decision to devalue their currency (on 11 August) that suddenly drew market attention to broader Chinese economic conditions. We had been observing China’s slowdown for some months, but the consensus seemed distracted by other factors, such as concerns over a potential ‘Grexit’. As a result the Chinese equity market had been building to bubble-like territory, encouraged by Chinese policy-makers who then found themselves helpless when the bubble burst in June/July/August. Quite why remains unclear, but this was the source of much fretful speculation in the weeks that followed.
The Chinese currency move itself was modest. We have highlighted before that we feel the CNY is significantly overvalued, possibly by as much as 30%, so a 3% devaluation does not feel meaningful in that context. Chinese policy makers may have an eye on competitiveness but a massive devaluation is not necessarily in their interests as they do not want to encourage a currency war with their Asian competitors. In addition, they have ample foreign exchange reserves at their disposal for infrastructure spending and to intervene in the currency market to manage an orderly, rather than sharp currency decline. So they still have plenty of scope for further measures to try and achieve economic stability, indeed they have now cut rates six times this year.
So perhaps August’s devaluation was simply an attempt to convince the IMF that they are willing to allow ‘market forces’ more influence in an effort to become an SDR reserve currency. Given that the Chinese economy had already been slowing, the devaluation seems less likely to be an urgent response to any ‘growth shock’ than a somewhat clumsy move by the PBoC. Chinese policy makers have spoken for some time of their desire to move from an investment-led economy to a consumption-driven economy. This is quite a shift for any economy, and perhaps mistakes along the way are to be expected.
Whatever the reason, while the move itself was not shocking, it did surprise markets. As figure one shows, in a short-term context it would have felt meaningful, after a broadly flat 12 months for the currency.
As we see time and time again, when investors are surprised, they are initially more inclined towards knee-jerk responses rather than considered analysis. As figure 2 shows, this happened not only in terms of Chinese and emerging equity markets, but also in equity markets in developed regions, where the fundamental growth picture still looked robust (see figure 3) and, thus, such a dramatic sell-off something of an inconsistent response to the news.
For example, there were days during August when I would be watching the German DAX index fall 3% on no news relevant to the German market at all. Indeed, several developed equity markets saw double digit losses in the course of a couple of weeks. This sort of price action, in the absence of any real evidence that China’s problems were about to derail deep-seated recovery in the West, looked likely to be driven by factors other than fundamentals.
When we see markets gapping down in this fashion, we look for signs that people are behaving illogically – either because their own emotional responses or their risk budgets are pushing them to reduce risk. Headlines like “Investors Race to Escape Risk” and Bloomberg commentary along the lines of “If things don’t settle down in China, we could have another ugly open tomorrow and you wouldn’t want to be caught holding positions you bought this morning” makes little sense to us as long-term investors. And given our belief that volatility does not equal risk, we are always watchful for signs that ‘price insensitive’ sellers – who operate investment processes based on strategies like volatility targeting, gamma hedging, stop-losses and risk parity – create a fertile investment environment for behaviourally-biased investors. It is music to our ears when we read articles about investors who “basically need to rebalance at the end of the day” or feel that “If we don’t cut holdings ourselves, the fund faces risk of forced closure”, or who are forced to sell assets they do not want to, simply because they are the most liquid and therefore quickest way to reduce exposure during short-term volatility.
The final piece of the jigsaw that pointed to Black Monday being a buying opportunity was the fact that developed equity markets (FTSE 100, TOPIX, DAX 30, S&P 500) moved from being relatively neutrally priced to observably cheap, based on most measures of value. For example, the German DAX moved to an earnings yield of 8.72% on 24 August (see figure 4), a level at which it is possible to argue investors were paid ample compensation for risk.
The easy part
It is easy to look back now that the ‘Black Monday’ episode has unwound and point out how logical it was to keep calm and take advantage. The reality is, many such phases are not as short-lived and when investors are in the middle of these episodes, it is impossible to know where the bottom is or how long recovery will take. So the hard part is having the discipline and emotional fortitude to withstand volatility so long as your fundamental convictions have not changed. Nonetheless, the process of reflecting after the event is an important one.
The driver of the market rebound in recent weeks has not been fundamental improvement in China, but a rerating based on relatively stable fundamentals and the role of policy makers in reassuring investors – for now at least. Given the speed of this snapback (the DAX went up around 14% from the bottom in late August to the peak in the first week of November) this particular short-term behavioural episode looks to have ‘unwound’ and the opportunity to take advantage has passed. However, with policy action still the dominant topic, we can expect more episodes in which investors are distracted from fundamentals. Therefore it is likely that market volatility will persist for some time yet. Remembering the lessons of previous episodes will be key to navigating that.