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Market Bulletin - Halting the slide

17 August 2015

Markets in risk-off mood as China’s central bank flexes its muscles.

The week saw equity markets struggle to gain traction, while oil prices came under pressure as traders remained cautious in a week dominated by China’s decision to devalue its currency. However, towards the end of the week, the volatility abated as the Chinese authorities allowed the currency to modestly strengthen again. The initial mood had been one of surprise as the People’s Bank of China undertook the largest devaluation of the local currency in more than two decades, firstly raising the ‘reference rate’ against the US dollar by 1.9%. This followed news of a sharp drop in Chinese exports last month, which prompted price falls in commodities and equities, while government bonds and gold gained ground.

Speculation began immediately as to the future plans of the Chinese authorities, and the concerns intensified after the central bank further manipulated the rate over the following two days, claiming that it wanted to implement a more market-determined framework for the renminbi and that there was no appetite to weaken the currency considerably. The assumption of analysts was that China was not targeting a major competitive depreciation, and this was a short-term adjustment. What the events did show was that China is not willing to sit back and allow its economy to weaken without using the considerable power that it allows its central bank. The People’s Bank of China is clearly willing to do whatever it can to halt the slide.

Although gold had a strong week as the risk-off mentality took hold, elsewhere in commodity markets there was no such optimism. Worries over economic growth, as well as increased Chinese import costs, ensured that commodity prices, particularly oil and copper, fell over the week. Within equity markets, Europe suffered most, falling 3% for the week in response to concerns over the many carmakers and luxury goods manufacturers that rely on Chinese imports for a vast amount of their revenues. A continued depreciation of the renminbi would cause severe pressure on companies heavily reliant upon Chinese consumers. Within the UK market, equities fell around 2.5% as oil stocks and miners came under sustained pressure, with the share prices of BP, Royal Dutch Shell, Rio Tinto and BHP Billiton all seeing extreme volatility.

Beijing’s move prompted speculation that the US Federal Reserve might hold back from raising interest rates in September, though economists were still undecided about whether the week’s economic data really offered any clear guidance. Causing particular confusion was the strong upward revisions to US retail sales data, which offset the concerns over the impact of China’s situation.

Japan powers up

Japan restarted one of its nuclear reactors this week for the first time since new safety requirements were introduced after the 2011 Fukushima disaster, ending a two-year period where all of Japan’s reactors were offline. Kyushu Electric Power Co. said the reactor would begin generating electricity and resume commercial operation by early September following inspections. A second reactor is scheduled to be brought back online later in the year. The country has a total of 43 reactors that have been closed since September 2013; as yet, only five have passed tight security inspections. Japan relied on nuclear power for 30% of its electricity, but has since turned to coal, natural gas and oil for more than 90% of its needs.

Despite polls suggesting that the majority of Japanese people oppose restarting its reactors, Prime Minister Shinzo Abe has insisted that Japan needs to reduce reliance on imported energy for the sake of the economy. Given that the country has taken great steps to weaken the yen, which is crucial to the country’s export growth, it is easy to see why there needs to be less reliance on costly imported energy.

Richard Oldfield of Oldfield Partners holds Kansai Electric, one of the potential beneficiaries of these developments. “The restart of the first nuclear reactor in Japan is absolutely part of our investment thesis on Kansai Electric. Following the Fukushima nuclear disaster in March 2011, Japan took offline its entire nuclear fleet in the face of mass public pressure. This meant it was then reliant on expensively imported LNG [liquefied natural gas]. Nuclear energy was a key part of Japan’s generation, with it having few natural resources of its own for power generation.

“Earlier this year the Japanese government signalled that it would look to progressively restart a number of nuclear reactors and reduce the drag on the economy that the cost of power generation had become. This prompted us to review the sector, which looked very cheap versus international peers. Kansai Electric looks to us to be one of the best placed to benefit from this policy and to have the most potential upside in terms of share price appreciation. The share price of Kansai was the best performer in the fund for July.

“Kansai was previously one of the most reliant of the Japanese power companies on nuclear energy, with around 50% of its electricity output coming from its 11 nuclear reactors. It also has conventional thermal power generation assets on which it has relied once its nuclear fleet was taken offline. It is looking to eventually restart nine of its nuclear reactors – it is decommissioning two of its oldest and smallest reactors. This will greatly reduce its operating costs, as it replaces expensive LNG with nuclear generation, which has the lowest marginal cost of production and will be used as ‘base load’ generation [always on]. As the nuclear reactors come back online, the fuel cost will fall dramatically, in our view driving a huge uplift in profitability well ahead of current market expectations.”

Greek bailout III

The Greek saga rumbled on as the beleaguered country agreed terms to receive up to €85 billion (£61 billion) in loans over the next three years, in return for tax rises and spending cuts. The initial tranche will be €26 billion, including an immediate €10 billion to recapitalise Greek banks. However, the International Monetary Fund warned that the debt was unsustainable, calling on eurozone ministers to offer debt relief to the Greeks – a consideration that is highly likely to be discussed by ministers in the autumn. There had been reports that Germany may have blocked the agreement but it gave the go-ahead on Friday. Germany had several issues with the proposals, offering a bridging loan ahead of further talks, but its finance minister Wolfgang Schäuble struck a note of optimism by publicly stating that he believed there was a positive result.

Stuart Mitchell of S. W. Mitchell Capital commented, “We have always felt that the possible implications of the Greek crisis have been wildly exaggerated by most commentators. At the end of the day, what most people forget is that the overwhelming majority of Greeks want to stay within the eurozone. There was always going to be some sort of deal. Tsipras was only empowered to get the best possible compromise that he could. We now have a ‘technical agreement’ between the Greek government, IMF, ECB and ESM [European Stability Mechanism], and it’s not a bad deal for the Greeks: an €85 billion package which requires only a 3.5% primary surplus by 2018, no new austerity measures, raising the pension age to 67 by 2022 and deregulation of the gas market by 2018.

“The Greek debt package is just one small part in the ongoing move towards economic normalisation across the eurozone. Most commentators have struggled to accept how deeply companies and governments have restructured elsewhere at the periphery of Europe. Just look, for example, at the 40% reduction in costs that the airline IAG achieved [in its Iberia brand]. At the same time, German wage growth is beginning to accelerate quite quickly. The recent 3.4% pay award struck by employers and the highly influential IG Metall trade union is the highest since 2007. In fact, a significant proportion of peripheral Europe’s productivity gap with Germany has now been eliminated over the past few years. Closer to the core, furthermore, Matteo Renzi and François Hollande are beginning to make real progress with reform. We will look back at this time as the moment when Europe made the necessary adjustments to secure the future of the currency.”

Oldfield Partners and S. W. Mitchell Capital are fund managers for St. James’s Place.

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The information contained is correct as at the date of the article. The information contained does not constitute investment advice and is not intended to state, indicate or imply that current or past results are indicative of future results or expectations. Where the opinions of third parties are offered, these may not necessarily reflect those of St. James’s Place.

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