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Current Views

Battening Down the Hatches

For the last two years we have called out a slowing China as a key risk to the global capital markets, given its size and connections to the other major global economies. Recent events have once again brought this risk to the forefront:

  • On January 3, the Caixin purchasing managers index indicated that China’s manufacturing sector contracted more than expected in December. Moreover, in our view, opaque and heavy-handed financial sector regulation by the central government is compounding this risk.
  • On January 4, the People’s Bank of China failed to renew a $20 billion credit line to China Development Bank, only to inject $20 billion into the financial system via a seven-day reverse repo the next day.
  • Also on January 4, the China Securities Regulatory Commission (CSRC) introduced circuit breaker rules into the Shanghai equity market, only to announce their suspension January 7, after full day market closures were triggered twice in the first four days.
  • On January 7, the CSRC introduced a new restriction on stock sales by large shareholders, limiting open market share sales to no more than 1% of shares outstanding over the next three months, as investor concerns had been building ahead of an abrupt January 8 expiration of the total ban on major investor selling.
  • The CSI 300 index of A-share stocks listed in mainland China declined 12% in this year’s first four days of trading, while the Chinese yuan depreciated 1.5% against the U.S. dollar over that brief span.

As we review the case for investing in U.S. equities, up until recently we found the risks to be more than balanced by the potential for attractive returns. However, with the increased efforts by Chinese monetary authorities to intervene in markets and further devalue their currency, and the recent increase in geopolitical risks, we find that the balance has shifted incrementally in the wrong direction.

Not only are we concerned about the Chinese central government’s potentially destabilizing missteps in its financial market regulation and currency devaluation, but also more generally about the ripple effects of the slowing Chinese economy. These include slowing demand for commodities and a weakening of emerging market currencies as those nations feel competitive pressure to devalue. We are also concerned about excessive financial leverage in the Chinese private sector, where borrowing has financed unproductive excess capacity, leading to the potential down the road for a credit crisis that could necessitate government intervention and bank bailouts.

In the U.S. there may be a risk of further widening of credit spreads, as weaker commodity prices and a stronger U.S. dollar exacerbate the challenges of levered companies in the energy and materials sectors. There is also the risk of a flattening U.S. Treasury yield curve as concerns about financial stability abroad could make it more difficult for the Federal Reserve to raise interest rates at the pace they forecasted on December 16. An additional risk on the horizon may be pressure on corporate margins from wage growth. While we have yet to see meaningful wage growth show up in the official statistics, there are plenty of anecdotes to suggest pressure on wages is growing both from a regulatory standpoint (mandated minimum wage hikes) as well as out of necessity from competitive pressures in a tight labor market.

While the last 12 months have seen their share of geopolitical events, the pressures have ratcheted up over the last few weeks with recent events between Saudi Arabia and Iran, as well as North Korea. We believe it is possible that given the lame duck status of President Obama that there could be heightened threats this year which pose challenges to global stability.

This overall backdrop may lead to increased pressure on share prices in the U.S. stock market, although we believe that equities of largely domestically-focused companies and those that pay substantial dividends may act as safe havens, at least on a relative if not absolute basis. We still expect modest but steady U.S. economic growth driven by the consumer to generate moderate corporate earnings growth in 2016, but against a more formidable backdrop of volatility as economies slow abroad, the Federal Reserve embarks on a tightening path, and election rhetoric gets more frenzied in the race to the White House.

We have reflected this slight shift in our viewpoint by positioning a bit more defensively, trimming some higher beta positions and generally raising a bit of cash from those areas of the portfolio that one might expect to underperform in market conditions driven by investor concerns about China. The overall goal in such periods is to reduce the downside capture ratio of the portfolio in the event of a more material market drawdown should investor concerns intensify in the near term.

This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.

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The Roosevelt Investment Group, Inc. is an independent investment management firm that is not affiliated with any parent organization. The Roosevelt Investment Group, Inc. manages domestic equity, international equity, domestic fixed income, global fixed income, and balanced assets for primarily U.S. clients. The Roosevelt Investment Group, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission and notice filed in all 50 states.

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