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China: A long flight is rarely without turbulence

By: Mat Lystra, Sr. Research Analyst

Are we in the midst of some great unraveling for China, the inevitable breakup on re-entry after a historic rise to become the largest FTSE Russell emerging market? Or, is it more likely that this is a patch of turbulence on China’s long flight towards becoming a more mature, consumer driven economy that is more globally influential than at any time since perhaps the days of Marco Polo? 

Investors have been struggling with these questions as the recent turmoil in Chinese stocks has left some doubting whether they are worth the risks.  Beginning in late June, the volatility of mainland China equities began to rise and daily index moves of 5-10% were common. To calm the markets, the Chinese government intervened with new downside restrictions and directed a tranche of bailout funds to the China Securities Finance Corporation.[1]

Most recently, China decided to devalue their currency, the Renminbi, and allow it to float within a widened band against the U.S. dollar. Some interpreted the currency move as a signal of further weakness in China’s already slowing economy.

We believe providing some historical perspective can be beneficial in determining whether China’s recent volatility is fleeting or portends a long-term decline. As seen below, volatility has spiked in recent months to levels not seen since the 2007-2009 financial crisis. Over the 10-year period evaluated, the 30-day rolling volatility (red line) hit a new high on July 29th, 2015. However, the “downside deviation”, which only registers the magnitude of daily returns when they are less than zero (negative), remained below the high reached on June 11, 2007 (green line).[2]

The recent volatility can make it hard to remember that just a few months ago China was the best performing country in the FTSE Emerging Index.  So it’s surely even harder to remember that when China became a member of the FTSE Emerging Index it was a mere 3.5% of the index.  Now, even after period of correction that suggests the market is responsive to global investor concerns about valuations and future growth prospects ; China is still up more than 80% over the last 12 months and remains the largest emerging market country with a weight of approximately 28%.[3] 

China’s rise to become the largest FTSE emerging market happened over a period of decades, not weeks or months. At the same time, the Chinese government has been committed to further opening its domestic equity markets to foreign investors. 

The August 2015 currency devaluation, while having the added benefit of boosting exports, is another step in the overall integration of China into global capital markets and may have boosted the Renminbi’s chance of being included the IMF’s “special drawing rights” basket of currencies[4]. Any long flight is bound to come with some turbulence before the destination is reached. For China the destination is a more balanced and competitive economy with fewer restrictions on foreign investment in Chinese stocks, the latter carrying with it the likelihood of inclusion into FTSE standard benchmarks.

 

[1] http://www.bloomberg.com/news/articles/2015-08-09/here-s-what-china-s-re...  

[2] Our downside deviation minimum acceptable return assumption was zero and was calculated on a rolling basis after 30 observations.

[3] Returns sourced from Bloomberg as of 8/21/2014 – 8/20/2014.

[4] http://www.bloomberg.com/news/articles/2015-08-19/imf-board-sets-sept-20...

 

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