Look past today's China-inspired volatility

The New Year has given investors quite a beating in recent days, with headlines dominated by Chinese equities, Iran-Saudi Arabia relations, and the resurrection of national borders within Europe. These three themes will be with us for some time, and we expect they'll continue to fuel market volatility throughout the course of 2016—but they shouldn't alter an investor's long-term financial plan.

China sneezes

The market jitters of the first week of 2016 have been largely blamed on China. The CSI 300 Index fell more than 7% on the opening day of the year, enough to trigger a new circuit breaker mechanism and halt trading for the rest of the session.1 A common reason cited for the Chinese equity rout was bad economic data. This may have played a role, but if so, it was only a small one. Chinese manufacturing purchasing managers' index (PMI) data disappointed this week, but services PMI data remained robust.

Furthermore, there is a mosaic of other factors that underpin Chinese equity performance beyond just economic data, which has probably been at play this week as well. The equity rout was likely in part the result of the planned expiration of a 6-month selling ban this week. Arguably worried that institutional investors will dump their stocks as soon as they can, retail investors might be trying to front-run the ban expiration. Second, a new circuit breaker implemented this year halts trading for 15 minutes if equities fall by 5% and, if they subsequently fall a further 2%, suspends the entire trading session—which did indeed happen. This appeared to cause panic as investors rushed for the exits, attempting to sell while trading was still permitted. Finally, the equity collapse may have been driven by disappointment that the People's Bank of China (PBoC) hasn't eased monetary policy further by cutting the reserve ratio requirement as expected.

Even if Chinese equities are to blame for the poor performance of U.S. equities this week, we don't think the Chinese government or PBoC will stand aside and watch the equity rout deepen. When Chinese equities collapsed over the summer of 2015, the PBoC was the primary actor to step in. The PBoC is a bit more constrained this time, as it's carefully juggling the managed depreciation of the renminbi while attempting to introduce more market-based dynamics into the economy. However, pronounced equity weakness followed by supportive policy intervention will likely become a key theme throughout 2016.

Worries in the Middle East and Europe, too

Another reason for this week's market rout could be the significant deterioration of relations between Iran and Saudi Arabia. The Saudi Arabian government began the year by executing a prominent Shia cleric. His death was met with outrage in Iran, becoming a focal point of the broader Shia-Sunni struggle. The conflict between Saudi Arabia and Iran will likely simmer throughout the year, which does not bode well for a solution in Syria. Indeed, tensions in the Middle East show no sign of abating in 2016.

Finally, another piece of news contributing to the fall of equities at the start of the year may have been Denmark's decision to resurrect the national borders it shares with Sweden and Germany. Europe is seemingly buckling under the sheer volume of refugees fleeing to the continent, and without a European-wide migration policy the European Union has had difficulty managing its external borders. Unless this changes, we think internal borders will likely return, undermining the central tenet of European integration-the freedom of movement of labor, capital, and goods.

Investment implications

In our view, the market-moving headlines represent themes that will persist, plaguing investors throughout the course of the year. With generally thin market liquidity and the repeated inflammation of each of these issues, we can expect market volatility to stay. So what should investors do? Avoid acting on the impulse to make rash decisions fueled by emotion by consulting a professional financial advisor. Stay diversified with representation from all the major global equity and fixed-income asset classes, and stay focused on the long view. Market volatility is unnerving, but sticking to an investment plan that supports your ultimate goal is especially important at points in the cycle like these. For those investors looking for ways to pare back exposure to sudden market movements, consider risk-managed absolute return strategies that target positive returns throughout the course of a cycle with significantly less volatility than traditional equities along the way.

MKTVOLVP-BLOG chart

The first week of the year was a bad one, and, unfortunately, this is the character of the current market—it will continue to deliver periodic kicks to investors. The negative headlines that got things going in the wrong direction aren't going away anytime soon. Longer term, a sound financial plan and a diversified portfolio gives investors the opportunity to prevail.

 

 

1 Source: Bloomberg, 1/4/16.