November 2015
Schroders
Talking Point
Where is China in the Sentiment Cycle?
Malcolm Melville, Emerging Market Debt Fund Manager
China has been headline news once again following slowing growth and the mini-devaluation of its
currency. Volatility in financial markets has risen, but what happens now and how should investors
react?
Source: Schroders. For illustrative purposes only.
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China’s Sentiment Cycle
According to latest figures, growth in China is slowing. Given China is the world’s second largest economy and
global growth remains sluggish at best, investor uncertainty has risen and as a result markets around the globe
have corrected. As an investor, deciding on your next move can be difficult; will markets rebound or continue to
fall? Is the worst over or is there more pain to come?
In times like these, crunching the numbers and looking at the economic data can be useful, but if the numbers
only reflect reality it can be hard for investors to make a decision. Another approach is look at China through
the prism of the Sentiment Cycle. The chart above shows how China has moved round the cycle. Based on
this analysis China has further to go before investors can buy with confidence.
How close is China to capitulation?
Investors should buy assets as they emerge from “Out of Fashion” and sell as they enter “Blind Faith”. China is
currently in the “Acceptance” phase of the cycle. “Capitulation” hasn’t been seen and the economy may spend
years in “Out of Fashion” before a new bull market starts. For example, China was in the “Out of Fashion”
phase during the late 1980s through to late 1990s, when a series of social and financial incidents occurred.
The evolution of China’s economy
Since then the Chinese economy has changed beyond recognition, as the reforms of the 1990s started to pay
dividends, enabling the move into “Early Adoption”. The strong growth between 2002 and 2007 allowed China
to move through the positive sections of the Cycle. Faith in the economy’s ability to withstand shocks was
cemented with the rapid recovery following the Global Financial Crisis (GFC). The successful navigation of a
crisis is often the last event before entering “Blind Faith”. Investors started to accept Chinese growth forecasts
as fact, without question.
China shakes the Fed
Investors have forgotten it was the reforms of the 1990s that set the stage for the years of prosperity and not a
newfound ability to generate growth by saying “GDP will be 7%”. This “Blind Faith” conditions investors to
ignore the warning signs, until asset prices fall too much to be ignored. Commodities were the first asset to
respond to Chinese economy weakness and moved investors into the “Acknowledgement” area. However, it
was not until the stock market fall in mid 2015 and the mini currency devaluation of August this year that
investors recognised fundamentals have changed.
Where next for China?
China took 10 years to move from “Out of Fashion” to “New Paradigm” and has since taken seven years to
reach “Acceptance”. Investors have yet to give up on China completely and importantly it needs to spend time
in “Out of Fashion” while the excesses are unwound. This can be achieved quickly with bankruptcies and
reform, or much more slowly by propping up failing institutions with endless supplies of new credit. The latter is
less harmful in the short-term and is probably more politically acceptable but will be painfully slow. Whichever
route is chosen, from a sentiment perspective, China is not out of the woods yet.
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