2016 begins with a global market shock from China

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:

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.
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.
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 inflation data, 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-shares¹ . 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 overarching views summarised in the 2016 Annual Outlook.

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.

If you want to evaluate your specific situation, contact your financial adviser or Russell Investments' relationship manager.

¹ A-shares are shares in mainland China-based companies that trade on Chinese stock exchanges. A-shares are generally only available for purchase by mainland citizens. H-shares are shares in companies incorporated in the Chinese mainland, but listed on the Hong Kong Stock Exchange.

Disclosures:

Issued by Russell Investment Management Ltd ABN 53 068 338 974, AFS License 247185 ("RIM"). This document provides general information only and has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources believed reliable, but is not guaranteed. Past performance is not a reliable indicator of future performance. Copyright © 2016 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred or distributed in any form without prior written permission from Russell Investments.

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The Caixin China Manufacturing PMI is a composite indicator designed to provide an overall view of activity in the manufacturing sector and acts as a leading indicator for the whole economy. When the PMI is below 50.0 this indicates that the manufacturing economy is declining and a value above 50.0 indicates an expansion of the manufacturing economy. Similarly, the Caixin China Services PMI captures activity in the non-manufacturing sector.

Sources: Equity market returns are sourced from Thomson Reuters Datastream as of January 8, 2016.

The Russell 1000® Index is an index of 1000 issues representative of the U.S. large capitalisation securities market.

The STOXX Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalisation companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.

The Nikkei 225 Stock Average is a price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange.

Russell Investments is a trade name and registered trademark of Russell Investments Group, a Washington USA corporation, which operates through subsidiaries worldwide and is part of London Stock Exchange Group. First used: January 2016. UNI10722