If any evidence was needed of how much China means to the world’s markets, then the first trading day of this year was the smoking gun.
A loose conjunction of technical factors drove the Chinese market down 7 per cent, and the whole world was dragged down with it. Nowhere was this true more than in Germany, under the assumption that a Chinese meltdown is bad news for capital goods exporters.
Although some market observers have tried to draw a distinction between Chinese policy confusion and economic data, most did not. The onset of a new arm of Middle East tension added to market fears, but it is interesting to note that oil prices rose for only one day and resumed their slide shortly afterwards.
Cutting through the market fog, we can look at the year ahead in the global economy and markets. In a nutshell, this year should bear a lot of resemblance to last year, with perhaps a couple of vital exceptions: oil prices cannot continue to fall at the same pace and the US dollar may well have its best bull days behind it. Both of these factors damaged corporate earnings and market sentiment last year and should start to fade away during the first half of this year.
Once you strip away the hit to energy and commodity earnings, other sectors in the United States and Europe should show healthy earnings growth. We do not quite buy the double-digit expectation, but high single-digit corporate earnings are definitely possible without the need for a major acceleration in economic growth. The US economy should show better growth, however, as consumers should eventually spend most of their oil price windfall compared to the 40 per cent or so they are spending now.
The global economy should grow at a rate at least equal to last year’s without inflation overshooting and forcing the Fed’s hand. In fact, 70 per cent of the world’s countries by GDP have core inflation below 2 per cent (which does not take the low oil price into account).
Although the pass-through of higher wages into retail prices is something worth watching carefully, we notice that few companies have sufficient pricing power to raise prices in line with wage growth, leaving them with the choice of investing in labour-saving technology or eating into their margins.
It has often been mentioned that US corporate margins have peaked, but once you remove the energy sector, US margins are still at an all-time high. The sectors with the highest historical margins are information technology and financials, areas where we do not see foreign competition undercutting US companies.
We are therefore constructive on equities despite the horrible start to the year. We will make a special mention of Europe, where the cyclical rally is underpinned by improved credit and plentiful money supply, and Japan, with idiosyncratic opportunities based on a sea change in corporate governance and pension fund investment.
Concerns will still linger about emerging markets, although clear distinctions have to be made between countries. China has yet to learn not to interfere with financial markets, and this will continue to create wobbles. Although China’s economy is not melting, just slowing down, it is now clear that it will no longer lead world growth by importing capital goods for its infrastructure development.
We are thus now more dependent on consumers in advanced and emerging markets for global expansion. Emerging countries that rely on commodities or foreign capital may still suffer for some time, though, but contagion to the rest of the world is likely to be limited.
Michel Perera is the chief investment strategist for Emea at JP Morgan Private Bank
