“This is a testing time for investors. Over the past year the market has been driven forward by strong fundamental trends underpinned by changes in the real world – but over the last month a more animalistic sentiment has sent shares plunging.
“As we consider the remainder of the year we must ask ourselves whether these fundamental forces will reassert themselves and allow stock prices to progress? The first and most vital fundamental force that was driving shares forward before this correction was the strength of the US economy, accompanied by a strong dollar. This has not changed. Even as she heralded a delay in the lift-off of rates, the US Federal Reserve chairman, Janet Yellen, reasserted this emphatically.
The US economy
“Yellen continues to predict improvements in US employment. She also asserts that sooner or later an employment environment this tight does generate inflation as the Phillips Curve reasserts itself.
“Of course, what has so shaken the market in recent days is that Yellen placed so much emphasis not on the US domestic economy but on the slowdown in China.
The Chinese market
“Does Yellen know more than we do? Perhaps the shrill voices on business news channels who claim that under the surface China really has ‘no growth’ are on to something? Has China’s central bank been whispering desperately in her ear? These fears have shaken the second force that enabled markets to make real progress in the early part of this year: a belief that China’s slowdown would be managed and would not jeopardise aggregate global growth to a troubling extent.
“We believe this is still the case and the market has capitulated to a level of fear on China that is unlikely to be reflected in forthcoming data.
“How did we reach this conclusion? By agreeing with the scaremongers that Chinese official data probably flatters the overall picture, yet also by asserting that this does not mean that it is impossible to make reasonable assumptions about the Chinese economy. It is possible to build a real-time economic indicator for China using the many dozens of independent data sources that now exist.
“An analysis on this basis suggests that in the real world Chinese GDP is running at somewhere around 5.5%. Yes, this is lower than the 7.1% still forecast by the World Bank but it is also the growth rate of a reasonably healthy economy, and well above the current consensus of doomsayers.
“China’s long-term problems remain real but we believe the latest panic about its economic strength owes more to timing than to economic fundamentals.
“Investors have frayed nerves awaiting a US rate hike and this has amplified Chinese economic fears to a terrific volume. It is also true to say that Beijing made a significant error as it attempted to intervene and control its frothy and unrepresentative stock market – a largely pointless exercise that sapped confidence. Yet, to believe China’s economy has precipitously worsened in recent months is unreasonable based on the evidence.
So what could drive stock prices upwards from here?
“Firstly, a re-adjustment to the reality that Chinese economic growth is weaker than the past but only moderately so.
“Secondly, consumers in the United States and other petroleum importers finally deciding to spend the savings they are seeing at the petrol pump – as they surely will when they realise that low oil prices are here to stay.
“Thirdly, the US Federal Reserve moving to get the rate rise out of the way – a vote of confidence in the US economy. We should remember that the period preceding US rate hikes has been volatile in all of the past five economic cycles over the past forty years. However, on average over the course of the tightening cycle, stock prices have risen by just less than 20%.
“Our conviction is that this is the wrong moment to capitulate to market falls, the wrong moment to listen to ill-informed bears on China and the wrong moment to run to close out positions that back the fundamental real-world trends underway.
“We continue to believe the dollar will strengthen and that the cost of money in the United States will rise faster than in other developed markets. We also retain our sanguine view on global stock markets and, in particular, favour those sectors and economies where we see independent real world forces driving earnings growth.”