It’s a jungle out there!

it's a jungle out there
The Amazon rainforest covers some 7 million square kilometres and includes territory belonging to nine nations., Inc. the electronic commerce and cloud computing company is the largest internet based retailer in the USA. Both Amazons have one thing in common, they are massive!

Much as the Amazon rainforest is under threat from deforestation so many traditional retail business models are under threat from disruptive technology such as the internet and Amazon. The risk to investors from disruptive business models should not be underestimated. For example, in the UK, you only have to look at the havoc that the discount food retailers, Aldi and Lidl have reaped amongst the big four supermarket groups in recent years. While consumers have enjoyed lower prices, sadly shareholders have lost out.

However, there may be more disruption ahead for the big four UK supermarkets. Towards the end of 2015, Aldi announced that it would move online in 2016, selling wine which would then be followed by non-food special offers. However, Amazon UK has announced that it is to add thousands more grocery products to its online ‘Pantry’ service in 2016. On-line, home delivery food retailer Ocado fell sharply on the news. Perhaps a sign of the growing pressure on the UK food retail sector, was the news that J Sainsbury had made an offer for Home Retail, owner of Argos, but that this had been rejected.

Which got us thinking. It’s a jungle out there! Businesses that have taken decades to build can suddenly be decimated overnight by a disruptive internet business model developed in a matter of years, whether its food retailing, ordering a taxi, booking a holiday or ordering a takeaway meal. Companies that do not have the resources to invest and adapt to changing technology and consumer internet shopping habits are not going to survive.

What have we been watching?

2016 got off to an awful start as markets saw a repeat of last year’s ‘Great fall of China’. After a 7% collapse in Chinese equities at the start of last week the Chinese authorities once again stepped in an attempt to control the market. However, this was in vain as later in the week turmoil returned with another 7% fall in just 30 minutes of the Chinese market opening, leading to the triggering of 15 minute market circuit-breakers to halt trading temporarily which then saw the closure of the market. The circuit-breaker control was subsequently suspended which was viewed with a degree of relief by global investors and Chinese share prices briefly edged upwards before sliding once more.

China Flag
The initial sell-off was triggered by disappointing Chinese manufacturing data which caused obvious worries about the growth of the Chinese economy. The second phase of sell-off followed the news that the PBoC was effectively devaluing the renminbi. The PBoC lowered the renminbi’s daily fixing to the US Dollar to the lowest level since mid-2011. This was the eighth consecutive weakening and the largest adjustment since August. The market took this as a sign that the poor manufacturing data more truly reflects the state of the Chinese economy and that the currency would be allowed to depreciate further against the US Dollar to support economic activity. To add to the gloom veteran investor George Soros said that he sees a crisis in global markets that echoes 2008.

Other global equity markets dropped on the back of the Chinese turmoil. So, why is China creating shock waves around the financial world? Basically, the rapid growth of the Chinese economy in recent years has been fuelled by the cheap borrowing from overseas banks. The Chinese currency devaluation makes Chinese exports cheaper to stimulate the economy, but risks exporting deflation to the rest of the world through lower priced consumer goods. However, currency devaluation increases the value of China’s predominantly US Dollar related debt relative to the value of Chinese company profits and cash flow. This increases the chance that corporate borrowers are unable to repay these debts leading to default which in turn creates bad debts for western banks who have lent money to Chinese companies, creating the risk of another bank credit crunch just as the global economic growth is starting to gain traction on the back of massive central bank support. The additional concern is that other Asian countries follow China’s move and attempt to lower their currencies to remain competitive in export markets. Given this could happen at a time when the US is raising interest rates this could create the same debt problems for other Asian countries as China.

Adding to the turmoil is the fact that China remains a major consumer of commodities. The oil price spiked up last week after tension between Saudi Arabia and Iran appeared to escalate following the former’s execution of a leading Shia cleric. Tensions were further increased with Iran accusing Saudi Arabian led coalition warplanes of bombing its embassy in Yemen. However, this was more than countered by the Chinese turmoil where falling economic growth expectations subsequently led the oil price to drop to a fresh twelve year low with Brent oil below $33.

British Flag
The UK market could not escape the Chinese driven global sell-off. However, adding to the UK market’s woes, is the fact that natural resources remain a significant part of the FTSE 100 index while mild weather and record levels of rainfall, besides creating enormous flood damage have caused havoc with parts of the UK high street, particularly the clothing retailers. UK Chancellor George Osborne has warned the UK faces ‘a dangerous cocktail of new threats’ citing the Chinese slowdown and falling oil prices.

2016 has gotten off to a rotten start particularly for many who have suffered flooding and equity markets also look soggy. Well it could be worse. For example, North Korea could have an H bomb……oh dear, apparently they have!

So is it the end of the world? Hopefully not, but China does have a prolonged painful period of adjustment away from manufacturing to the consumer and the world has to cope with the shock of more US interest rate increases while the situation in the Middle East looks ugly. Nonetheless, central bankers remain supportive and the world economic recovery should continue to stutter forward, albeit with more shocks along the way.

It is worth remembering that China’s stock market was subject to a bubble created in the first part of 2015 that only partly deflated last year because of measures put in place by the Chinese authorities. The market is still a domestic retail market which tends to be driven more by the behavioural mood of Chinese retail investors. Basically, we expect more volatility as the Chinese economy goes through realignment. China is slowing down but is not melting down. While Chinese equities are sliding in 2016 it should be remembered that China was still one of the best performing global equity markets in 2015 having rallied 15% in the last quarter of the year.

However, ‘every cloud has a silver lining’. UK consumers have never had it so good with low interest rates, falling petrol prices and wages starting to pick up. Sterling has also continued to weaken against the US Dollar as there is no sign of interest rates rising in the UK in the immediate future while there is concern about the EU referendum vote. Sterling weakness against the US Dollar should help many of the UK quoted companies with US earnings and exports.

Let’s look at things a different way. If you work in the oil industry or oil services sector it no doubt feels like the end of the world. Some 250,000 oil related jobs are estimated to have been lost worldwide so far due to the collapse in oil prices. By comparison, if you work in the building trade in the UK, recruitment, for an estate agent or for a car dealer you are no doubt enjoying the best of times. This neatly sums up our current investment strategy which remains focused on finding pockets of growth ranging from UK consumer spending to cybercrime. The market sell –off while not pleasant is beginning to create some interesting buying opportunities for stock pickers like us.

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