The heightened sensitivity of financial assets to Chinese policy is a relatively new phenomenon, which has important implications for understanding risk and reward in markets today. We can see how even relatively small falls in the Chinese yuan (just 1.5% against the US dollar in the first four business days of 2016) have had a major impact on global markets. Despite confirmation of a modest global expansion in some December economic data, China's increased risks and wide credit spreads lead us to believe it is prudent for investors to review their exposure to stocks. We have reduced our exposure to equities overall to a neutral position.
China has not yet developed a market-acceptable way of dealing with either its equity market interventions or its currency depreciations. In suspending the "circuit breaker" mechanism in its stock market in the first week of 2016, China has demonstrated that its policymaking can be both pragmatic (the move was received positively) and erratic (it was only put in place on the first business day of the year).
With respect to the currency, our base case remains for an only-modest depreciation of the yuan, to 6.80, over the next 12 months. However, uncertainty over the government's policy choices has risen. With China already experiencing relatively weak nominal growth, a risk scenario of sustained depreciation in the yuan could push sales growth for global companies in China into low single digits (in US dollar terms), a major change from the double digit growth of recent years. Additionally, the use of "circuit breakers" to stymie daily losses on the onshore A-share market had counter-productive effects, forcing investors to sell out of the offshore H-share market.
Furthermore, increased China risks come at a time when credit spreads, particularly in the US, have widened in recent months. Spreads have remained relatively stable year-to-date. But we should note that the higher cost of debt, not only in the energy sector, is creating more restrictive financial conditions. While we expect lower US credit spreads in our base case, recent moves have increased the risk of a broader slowdown driven by higher corporate borrowing costs.
To be clear, we do not believe that risky assets have peaked for this market cycle. We think that the year will end better than it started. The US, Europe, and Japan are all making economic progress, earnings growth should be decent, and low oil prices should ultimately aid consumer spending. Global monetary policy remains loose by historical standards, and China should have enough domestic policy tools (such as interest rate cuts, fiscal flexibility, and scope to cut bank reserve requirements) to deal with its issues, even if these tools have been used ineffectively so far.
Within equities our favored market remains the Eurozone. Eurozone stocks should benefit from earnings growth improvements, relative to underweight positions in the UK and emerging market equities, which have less support from central bank stimulus, yet exposure to the risks related to China and to commodity prices. We reaffirm our neutral stance on US equities.
We also maintain an overweight position in European high yield credit, which is well-positioned to benefit from improving Eurozone economic data, relative to high grade bonds. Last, in currencies we continue to hold an overweight position in the Norwegian krone relative to the euro. We expect the krone to strengthen, as an improving economy and rising inflation lead the central bank toward more hawkish policy.
For investors with a long-term time horizon, the recent sell-off could represent an opportunity, in particular for those who have been awaiting the right time to put cash to work in financial assets. However, over our six-month tactical investment horizon, we believe that the new uncertainties over China and credit markets will create turbulence. Additionally, sustained periods of equity market volatility, as experienced over the past three quarters, could leave markets more vulnerable to further bad news.