2016 Begins With A Global Market Shock From China

[The following update was provided by Russell Investments.]

Back in August of 2015, Russell Investments’ team of global investment strategists said the mid-year global market volatility sparked by economic news in China reflected
“volatility consistent with the long grinding global recovery.” We wrote at the time: As far
as China is concerned, we belong to the “growing pains” camp rather than ascribing to
the “sky is falling” view.

As the first week of January 2016 wrapped up, China’s Shanghai Composite Index had
lost 10% for the week, marking its steepest decline since the week of August 21. This
sparked volatility globally, such as in the U.S. market, where the Russell 1000® Index
declined 6.7% for the week. Similarly, the Stoxx Europe 600 dropped 6.7% and Japan’s
Nikkei 225 Index fell 7%.

Looking through all this market noise, our strategists believe the volatility in Chinese
markets over the past week was due to market idiosyncrasies and does not reflect a shift
in the fundamentals of the Chinese economy.

As stated in the team’s recently released 2016 Annual Global Market Outlook, and
despite the recent sell-off, “we are witnessing a convincing program of market reform —
recently acknowledged by the International Monetary Fund with its inclusion of China’s
official currency in the international Special Drawing Rights (SDRs) currency basket.
Further, the transition from an economy driven by fixed investment to one driven by
consumption and services also appears to be on track.”

Specifically, our strategists do not see the economic and related events that unfolded in
China during the first week of 2016—including the disappointing Caixin China
manufacturing Purchasing Managers’ Index (PMI) for December—as negative enough to
sway their ‘soft landing’ assessment for China in 2016. However, given the magnitude of
growth in China’s market over 2015, the team expects to continue seeing air pockets on
the downside.

Three primary factors trigger “air pockets on the downside”

Russell Investments’ strategists noted the following three factors regarding China as converging during the first week of 2016 to trigger the week’s market sell-off:

1. Yuan devaluation: On Monday, China devalued its currency by placing the official reference rate at a four-year low. Accordingly, both onshore and offshore yuan markets weakened and raised concerns of weaker than previously thought domestic growth. Yuan devaluation continued over the week.

2. Regulatory uncertainty: In 2015, Chinese authorities put a ban on investors who owned stakes of over 5% from selling their shares on the secondary market.  This ban was due to expire on Jan. 8, 2016, causing some investor concern.  Following Monday’s sell off, Chinese authorities announced that this was no longer the case and the selling restriction was to be kept in place. Later in the week, regulators announced new rules: major shareholders of listed companies are restricted to selling a maximum of 1% of their holdings in a single entity via the competitive-bidding process every three months and are required to give 15 days’ notice in advance of a sale.

3. Disappointing Purchasing Managers’ Index (PMI) report: The Caixin China manufacturing PMI came in at 48.2, which was below the expectation of 49.0.  Meanwhile, the non-manufacturing (services) PMI came in at 50.2, also below the expectation of 52.3.

Looking ahead

With global markets very jittery, Russell Investments’ strategists are keeping a close eye
on daily currency fixings. We are also focused on Chinese trade data as well as the
fourth-quarter 2015 gross domestic product report on 19 January.

Despite global market volatility and the large sell-off in the Chinese market during the
first week of 2016, our team continues to hold a neutral view on Chinese equities for both A-shares and H-shares.  We are inclined to look through market volatility at this
stage and focus on China’s underlying economic fundamentals, which in our view, remain intact.

However, investment professionals across Russell Investments are closely monitoring
the situation in China and the knock-on effect to all asset classes. The consensus
agrees that underlying fundamentals of the Chinese economy are relatively sound and
the week’s market moves globally weren’t sufficient to shift our overarching views.

Bottom line – what does this mean for investors?

Russell Investments’ strategists do not expect China’s ongoing economic growing pains
to cause a global recession. However, the week’s global market volatility is a reminder to
investors that with stretched valuations and questionable growth, market risks remain
heightened.

Especially in periods of market volatility, it is important to remember that markets rise and fall, particularly over the short term. If you’re a long-term investor, it’s best to avoid knee-jerk reactions at the risk of ‘locking in your losses’—because you don’t truly feel the pain of market declines until you sell investments at a low. Sometimes, short-term volatility provides good buying opportunities.

As always, Russell Investments is continually monitoring its funds and seeks to help
clients manage risks through diversification and dynamic portfolio management by
looking to take advantage of any opportunities arising from market volatility.