Investors who regularly follow international financial developments or who have exposure to international equities must be well aware of the significant declines across the major equity markets over recent weeks.

The sell-off intensified at the beginning of last week. In fact, on August 24, the Chinese Shanghai composite index dropped by 8.5 per cent – the steepest daily decline since 2007. This sent other global equity markets into a tailspin. European indices dropped by around five per cent on the day and the Dow Jones Industrial Average in the US declined by 1,000 points in the first few minutes after the market opened. The US equity market partly recovered by the close of Monday’s trading session but still ended the day around 3.6 per cent lower. Monday’s events were widely labelled ‘The great fall of China’ or ‘China’s Black Monday’ – a reference to the crash of October 1987.

The wild gyrations continued throughout the week, although many European and US indices recovered most of the losses while the Shanghai composite index ended the week down 11 per cent.

Following the extreme volatility on a daily basis last week amid the steepest stockmarket sell-off in several years, many would rightly question the reason behind the contagion across the globe from China’s stockmarket downturn.

At the outset, it is worth mentioning that the overheating of the Chinese equity market had been rather evident for many months as the Shanghai composite index had climbed by 150 per cent during a 12-month period between June 2014 and mid-June 2015 despite clear indications for quite some time of a slowdown in Chinese economic growth following double-digit growth on an annual basis in earlier years.

Statistics indicate that most of the trading activity across the Shanghai equity market was taking place from a growing retail investor base, who were borrowing increasing amounts of money to purchase additional shares and grow their investment portfolios.

The Shanghai composite index tumbled by 24 per cent between June 15 and August 11 as a series of interest rate cuts by the People’s Bank of China and other intervening measures failed to stem the sudden reversal of the debt-fuelled equity market bubble. These measures included a reduction in the stamp duty on share transactions and liberalising pension fund rules, allowing an allocation of up to 30 per cent in domestic equities.

In recent weeks, although many news channels and internet portals were giving increasing prominence to the developments across China on a regular basis, the event that possibly prompted the slump was the devaluation of the yuan on August 11.

The decision by the People’s Bank of China to intervene in the market, leading to a two per cent devaluation of the yuan (or remnimbi) against the dollar, was another stark warning that the economic slowdown was indeed gathering momentum. In fact, Chinese exports declined by 8.3 per cent in July, their largest drop in four months. The yuan, which until recently was loosely pegged to the US dollar, had been strengthening against other currencies in line with the US dollar over recent months – making Chinese exports relatively more expensive. The devaluation was intended to increase the attractiveness of exports giving the economy a much needed pick-up.

On the other hand, a weaker yuan makes European and US exports to China more expensive for the Chinese consumer, leading to a reduction in demand for US and European products.

Moreover, a few days after the surprise devaluation, data on the manufacturing sector indicated weak growth once again while the market was also disappointed by the lack of further measures by the People’s Bank of China over the weekend of August 22 to 23 in response to the weak manufacturing data.

It is very hard to say what the long-term repercussions will be

However, the People’s Bank of China did lower interest rates by a further 25 basis points the day after the significant sell-off of August 24.

Interest rates have now dropped to 4.86 per cent compared to an average of 6.4 per cent between 1996 and 2014. This was the fifth interest rate reduction since November 2014. The reduction in rates in recent months was intended to increase bank lending and curb the decline in share prices which alarmed several investors around the globe.

China’s central bank also reduced its reserve requirement ratio by 0.5 per cent, effective from September 6, and injected approximately the equivalent of €19.4 billion into the country’s financial system through a short-term liquidity adjustment operation.

These latest measures, together with the comments from William Dudley, the head of the Federal Reserve Bank of New York, helped stem the decline across European and US equity markets last week although intra-day volatility was significant and widely compared by analysts to the reaction in the stockmarket in the midst of the eurozone crisis in 2011 and in the aftermath of the Lehman bankruptcy in September 2008.

Dudley dampened expectations of a September interest rate hike by the Federal Reserve as he commented that the case for an increase had become “less compelling”.

Although by the end of last week the major European and US equity markets managed to recover most of the losses sustained during the day on Monday, the sell-off in recent weeks was pretty significant and many markets entered into correction territory after the worst monthly declines for several years.

In Europe, the DAX fell by 9.3 per cent during August, the CAC40 shed 8.5 per cent and the UK’s FTSE 100 fell by 6.7 per cent, whereas the S&P 500 in the US fell by 6.3 per cent. Meanwhile, the Shanghai composite index slumped by 12.5 per cent and the near 23 per cent fall in the index during last week is the largest weekly decline since 1996.

Last week’s events not only impacted equity markets but also led to increased levels of volatility across currency markets. Many were probably surprised at the sudden appreciation of the euro against the US dollar at the start of the week. Normally, the US dollar strengthens during periods of risk-aversion. However, it weakened significantly against the euro, exceeding the rate of USD1.16 as the possibility of a September rate hike initially faded. However, the greenback rebounded to below the $1.13 level against the euro following the upward revision in the US GDP growth rate to an annualised 3.7 per cent during the second quarter of 2015.

Following the extreme levels of volatility across the equity and currency markets, many investors are questioning whether the developments in China were merely an overdue correction across the market or whether this could represent the start of a more prolonged downturn. While the growing impact of the Chinese economy cannot be underestimated, it is very hard to say what the long-term repercussions will be.

It is safe to say that the global growth outlook is at a difficult juncture with growth in many regions remaining anaemic despite support from the major central banks over several years. Moreover, with the prospect of an interest rate hike by two of the major central banks (the US Federal Reserve and the Bank of England), the outlook is more challenging.

What is probably more certain is increased volatility with occasional bouts of turbulence based on newsflow from China, the timing and speed of interest rate hikes by the US Federal Reserve and, to a lesser extent, the Bank of England, as well as developments from the Greek political crisis in the run-up to the upcoming election.

Investors should adequately position themselves for this heightened volatility and to be on the lookout to possibly increase exposures to certain companies that may seem to have been oversold during recent times of panic selling.

Errata corrige

In last week’s article ‘Profitability at RS2 more than doubles during first half of 2015’, it was stated that “During the 2014 financial year, RS2 registered a surge in service fee income to almost €8 million (+84 per cent) largely due to the implementation and consultancy services provided to the two new major clients, namely Barclays Bank plc and the unnamed global processing company signed up in 2014”. The sentence should read: “During the 2014 financial year, RS2 registered an increase in revenue of almost €8 million (+84 per cent) largely due to the booking of licences and additional implementation and consultancy services provided to various clients, which included services over and above what RS2 used to offer in the past. These new services, related to infrastructure design, implementation and consultancy, are being offered based on the knowledge RS2 has gained from implementing these services for its own managed services subsidiary which is now offering outsourced services to large clients in the financial industry”.

Edward Rizzo is a director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd (RFC) is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

© 2015 Rizzo, Farrugia & Co. (Stockbrokers)Ltd. All rights reserved.

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