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What China's troubles mean for investors

You may not realise it, but however you are invested you can't ignore what's happening in China, argues Mike Deverell.


by Mike Deverell on Aug 20, 2015 at 08:00

What China's troubles mean for investors

Apart from being the world’s second biggest economy, its largest trading nation and accounting for 40% of 2014 economic growth, what does China have to do with my portfolio?

Ok so it’s not quite 'what have the Romans ever done for us?' but hopefully you get the point! You may not always realise it, but however you are invested you can’t ignore what’s happening in China.

China is one of the principal reasons why the FTSE 100 is around 6,500 right now rather than 7,100 as it was just a few months ago. If you are invested in a FTSE tracker then the main driver behind your recent investment performance is China’s economy and not the robust UK economy as you might expect.

In the FTSE 100, only around 20% of earnings are made in the UK. Emerging markets is not far behind at perhaps 15% of profits.

Energy and materials make up around 20% of the FTSE. As China slows and reduces infrastructure spending it has less demand for commodities which adds pressure on world prices to drop. As I write, Brent crude oil is around $49 a barrel, down more than 50% in the last year. This is partly due to over-supply but also reduced demand.

Copper, often seen as a bellwether for global economic health, is down more than 25% in 12 months. This means the energy companies and miners which are such a big chunk of the FTSE have dropped off a cliff.

Other emerging market economies which have previously benefited from exporting their commodities to China are suffering for the same reasons, and stock markets in those countries have fallen badly as profits slide in response.

Shanghai crash

Of course many of the headlines have been about the recent crash in the Chinese stock market.

This doesn’t directly affect most UK investors. Even if you have a specific China fund in your portfolio, the chances are most of the stocks within it are actually listed in Hong Kong rather than Shanghai.

For most international investors it is very difficult to invest in the China mainland. Hong Kong listed 'H' shares have not seen anything like the same falls as mainland listed 'A' shares, as they are known. Of course, they did not see such a great surge upwards either!

It is worth noting that, despite the recent drop, over 12 months Shanghai stocks are still up around 80%. Given this and the small allocation of international investors to the Shanghai or Shenzhen markets, the knock on effect of the China market crash is relatively limited.

More worrying was the panicked response from the Chinese authorities in attempting to prop up the markets, which has caused nervousness that things are worse in China than they seem.

Not just stocks

However, the Chinese economic slowdown affects more than just shares.

The slumping commodity prices have contributed to very low inflation, just 0.1% in July after being zero in June. This is one reason why interest rates are unlikely to go up until at least next year. Whilst the UK economy is performing strongly, the Bank of England is meant to target inflation of around 2% a year.

There is little chance of inflation returning to 2% any time soon. If the Bank puts up rates this could drive the pound higher, making imports cheaper and compounding this disinflation. In this worst case scenario this could turn low inflation into destructive deflation.

The recent Chinese devaluation of its currency has exacerbated this disinflation as their exports become cheaper to the outside world. This has also pushed down stock markets in countries seen as competitors of China.

The low inflation and reduced likelihood of rate rises has also supported bonds, which tend to do poorly when rates go up. Low inflation also makes bonds more attractive as the “real yield” of a bond – the yield minus inflation – is higher.

Meanwhile, those with big cash savings may have to wait a while longer to see any decent levels of interest.

You’re not buying the economy

It is worth pointing out that economic growth and stock market returns do not necessarily go hand in hand.

If economic growth is poor you would expect earnings growth to be poor. However, as markets are forward looking then expected drops in future profits are reflected in prices now.

The principal determinant of the return on an investment is the price you pay. You tend to see a much better return from equities when the price/earnings ratio is low and a poorer return when it is high.

The Chinese market (or at least those Chinese companies listed in Hong Kong) actually trades on a very low price/earnings ratio relative to other markets and to its own long term average. The fears around the economy are already reflected in prices and as a result we quite like Chinese equities.

Turning back to the UK, the FTSE 100 remains quite expensive in our view and is very exposed to the Chinese economy. However, in smaller companies within the UK there is a lot more value and much more exposure to the robust UK economy. As a result, profits are growing strongly in many small cap stocks.

UK commercial property is another way to play the strong domestic economy, whilst limiting exposure to international risks.

We live in an increasingly globalised world and you can’t ignore such large economies like China or the US. Events in those countries have an impact on a lot of things that you might not expect. If, for example, the US presses ahead and increases interest rates next month as many believe they will, the impact on pretty much every asset class could be much bigger than that caused by recent events in China.

Mike Deverell is a partner at Equilibrium Asset Management in Cheshire. The views expressed in this article are his and do not constitute investment advice.

1 comment so far. Why not have your say?

kenneth douglas

Dec 11, 2015 at 15:45

How old is this story?, the market as not seen 6500 for some time..

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