Equity markets trying to digest China shock
Global equity markets were hit hard following the Chinese devaluation and, despite some
bounce off the lows, the major markets are still down between 7-11% over the past
month. The sell-off has impacted investor confidence and, although many BofAML
strategy indicators are now indicating oversold conditions, we suspect any recovery will
take time and be choppy in nature. Risks remain - notably the Fed next week, where our
economists still expect a hike, and in China where our FX strategists see the CNY policy
as unsustainable, even if the authorities did reaffirm it at G20 over the weekend.
Uncertainty over the impact of weaker EM growth
Investors appear uncertain about the how big an impact the deflationary shock emanating
out of China and the rest of the Emerging Market world will have. This is not surprising
since we have never been here before. Emerging Market economies now account for 40%
of global GDP, with China alone representing 13%. Any significant slowdown in those
economies will undoubtedly hit global growth. The question for developed market
investors is how big an impact will it have on developed world growth and profits?
Our economists think the effect is likely to be modest
Extensive work by our economists suggests that even if the Chinese GDP growth halves
they would only expect euro area GDP to fall by around 0.4%. If the boost from lower
commodity prices is spent by consumers it could be less than that. Recent data out of
the euro area would seem to support the view of a limited impact, with German survey
data actually improving despite being the most exposed economy to EM weakness.
Profits could be hit more but it seems to be in the price
For an equity investor it is the effect on profits that is key. We put European sales
exposure to China at a little over 5%, Asia as a whole at around 15% and EM at 27%. If
we assume the profit share is the same and that there is a 30% hit then Pan-European
profits would be 8% lower. Given that European equity markets are 11% lower over the
last month much would seem to be in the price.
We remain positive into 2016 with 20% upside expected
Despite the near term risks we are constructive further out with the ECB firmly committed
to maintaining a euro area recovery and our economists confident on developed world
growth in 2016. European equities are attractive on sub-14x consensus earnings and a
3.9% dividend yield in 2016. Even allowing for cuts to those earnings numbers we have a
Stoxx 600 target of 425 in 12 months, implying 20% upside potential from here.
Sector strategy – domestic growth over EM exposure
We cut the China plays at the start of July and see no need to change that just yet. Yes
those sectors are vulnerable to squeezes but until the situation turns around in China we
think investors will be reluctant to buy them back. Accordingly we remain underweight
Basic Resources and Autos. We prefer a focus on domestic growth. Banks remain our
preferred overweight, but we add Telecoms and Media to Technology today.