The Chicago Board of Exchange (CBOE) Volatility Index (VIX) jumped to its highest level in more than six and a half years last Monday following a broad early morning stock sell-off, triggered by the Chinese stock market plunge. The VIX, also commonly known as the “fear index”, is a sentiment indicator that helps determine the level of fear in the stock market. The VIX level that “black Monday”, indicated an extraordinary level of fear in the stock market.
Nesbert Ruwo/Jotham Makarudze
Generally, volatility indices measure the implied volatility of a basket of put and call options on a specific index or exchange traded fund. The CBOE VIX, the most popular of the volatility indices, measures the expected volatility of the S&P 500 index. The VIX has an inverse relationship to the stock market — VIX advances when stocks decline and declines when stocks advance. It is an important tool for investors who follow a contrarian trading strategy.
The sell-off started in Asia, where markets in China closed 8,5% down on the Monday. This was Shanghai Composite’s worst single day fall in eight years. The Chinese market closed over 7% weaker on Tuesday as the sell-off continued. However, the Chinese stock market, proxied by the Shanghai Composite Index which climbed 134% in the 10 months to June 2015, was bound to experience a correction at some point. The correction since June has taken the market down 43%, but the market is still showing a positive one year return of 34%.
The sell-off spread all over the global markets — from stock markets, currencies, and commodities. Emerging market currencies bore the brunt of the sell-off as investors pulled out of emerging economies in a typical flight to safety. It triggered “risk-off” trades. Emerging currencies already had been under pressure from the possibility of US Fed Reserve raising interest rates this September. The South African rand touched a record low of just above R14 to the US$, triggering the SA Reserve Bank to issue a statement to the effect that the bank may consider “becoming involved in foreign exchange markets to ensure orderly market conditions”, that is effectively, to intervene to save the rand. The signal appears to have moderated the fall in the currency. However, central bank intervention in foreign currency markets usually runs out of steam if the exodus of foreign capital is sustained and as such, can only work as a short-term measure. Brent crude oil touched a six and a half year low of below $45 per barrel. Even gold, normally considered as a safe haven, shed off some value.
But what triggered this extreme market sell-off? Our view is that this pullback has been brewing for some time now. The Chinese markets were trading in overbought territories at a time when the underlying economic performance was showing signs of slowing down.
The strong Chinese stock market bull run has been supported by a combination of interest rate cuts and financial reforms which facilitated easier equities trading between the Shanghai and Hong Kong markets and allowed margin trading. All this in an economy with double digit economic growth and growing individual discretionary income. Retail investors (ordinary investors) had begun to borrow against their retirement savings to participate in the bull market. A majority of individual investors were driven by “irrational exuberance” and this drove the Chinese stock market into an overbought territory. Something had to give.
A string of interventions to stall the sell-off post the June market peak supported a short-term rally as the main indices recovered. Post that, a surprise devaluation of the yuan two weeks back could be viewed as an acknowledgement by the Chinese authorities that the economic performance was stalling. China devalued the yuan to make its exports more competitive and provide a kicker to the economy.
China’s economy, which has been experiencing decades of impressive economic growth on the back of massive industrialisation and urbanisation, has been showing signs of faltering. Double digit growth rates are seemingly becoming a reserve for the past. The first seven months of 2015, combined exports and imports were down 7,1%. There has been a lot of scepticism regarding China’s ability to meet its 2015 GDP growth numbers. Disappointing economic data which suggested that China’s industrial activity is slowing sharply could have triggered the market rout and investors voted with their feet.
But why does China matter in the global market context? As the second largest economy in the world, China accounts for at least 15% of global GDP and close to half of global GDP growth. The world’s economic growth has now become dependent on China, India and the United States, which combined, contribute at least 80% of the global growth. As such, China is an important part of the global economy and any slowdown in China would have far-reaching effects. If China sneezes, the global market catches a cold.
To halt the market rout, China’s government was quick to unleash a further intervention — it cut interest rates, the fifth time since November last year and relaxed banks’ reserve requirements. For now, the markets are assessing the Chinese authority’s actions, but China faltering economic growth still remains the fundamental challenge facing global economic growth.
l Nesbert Ruwo (CFA) and Jotham Makarudze (CFA) are investment professionals based in South Africa. They can be contacted on email@example.com