Despite the mild winter, it’s been a bitter start to the year in global markets. Chinese markets are down nearly 15 per cent since year end, the Canadian market just wrapped up a nine-day slide, and oil is testing a $30/barrel floor it last hit in 2004. Here we examine the factors driving the slide and why we think fears are overstated.
Oil prices at 11 year lows
The main catalyst behind the Canadian market sell off is the price of oil. The black stuff is in an all-out tail spin as OPEC countries refuse to cut their supply in order to maintain their market share, while newly efficient U.S. producers aggressively price and fuel the price drop. However, these low prices are starting to have an effect on key oil-producing economies. The $30/barrel price point is much lower than what some need to sell it at in order to maintain profitability (see graphic below). Countries, like Saudi Arabia, which rely heavily on oil exports to fund other government expenditures, are dipping into their reserves and will face more serious fiscal implications if low prices continue.
In the U.S. active oil drilling rig count has dropped by two-thirds in just over a year. At the same time, demand in the U.S. is up 3.5 per cent. You don’t need to be an economist to see the shifting picture in demand versus supply. Needless to say, at these prices, oil is testing several limits and it would not be surprising to see a rebound to a higher price.
(Source: The Economist)
Impact of Chinese intervention policy
With the Chinese economy slowing, market volatility is peaking as investors struggle to find a new normal growth rate. This most recent slide was triggered by a state-driven drop in the yuan (Chinese currency), and fueled by questionable market intervention policy the government enlisted to “calm” markets.
Let’s start with the intervention policy. Given the history of volatility in the Chinese stock market, the Chinese government implemented a “circuit breaker” rule which would shut down the market if stocks dropped by 7 per cent in any given day. Instead of calming the markets by giving participants an assured floor, the unintentional effects of this policy was to drive investors to scramble for the exits before the doors shut. The limit was hit twice during the first week of the year, and the government has wisely discontinued the policy.
The initial cause for panic, though, was the drop in the yuan which indicated to investors that Chinese manufacturing levels are too weak to maintain their current rate. While a free floating currency would allow for more gradual adjustments in the market, China pegs the yuan to the U.S. dollar. As a result, any currency moves are driven by policy makers in response to the market, thus creating more volatile swings. Global markets hate volatility, erratic moves shake investor confidence, and confidence (or lack thereof) is a very contagious thing. We saw that play out in the first few trading days of the year.
Ultimately, the less intervention from the government the better. The best way to keep capital in a market is not to limit its exit and the best way to price a currency is to let the market decide. Hopefully China’s rule makers will eventually heed these lessons; until then, expect volatility in China. From a long-term perspective, though, these moves are just the effects of policy makers trying to find the right spot to place their currency in a changing environment.
Our message remains the same – stay the course with your investment plan. If you have any surplus cash to invest, deploy it so it can start working for you. Setting up pre-authorized contributions is also a great way to take advantage of market dips like this and lower your average purchase cost.
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