Markets have been in a cheerier mood this week, brushing off the past fortnight’s concerns over the coronavirus. Chinese workers are expected to go back to work next week with the world’s second largest economy, and the engine of global growth, set to restart. But have markets become too optimistic?
The initial reaction from investors around the world, when confronted with coronavirus and a Chinese shutdown, was to sell off. This, while being very reactionary, was somewhat understandable given some 80pc of Chinese manufacturing had shut down.
With the country accounting for nearly a fifth of the world economy and being involved in global supply chains, a shutdown of this scale could easily impact businesses around the world.
So which is the more sensible market mood: optimism or fear? Perhaps a bit of both. It’s logical for investors to be both concerned about how long Chinese industry will be shut down for but remain optimistic that it could probably recover in the long term, particularly if the rate of new coronavirus victims is slowing.
The most affected stock markets have logically been China’s or neighbouring countries. British stocks, by comparison, have only fallen 2pc, with Brexit trade deal uncertainty factored into this fall as well.
But if the Chinese economic shutdown continued, could we see more downward pressure on British share prices? The numbers suggest so.
One way to measure this is to look at Chinese industrial production and see whether growth or a fall in this ever led to a change in British share prices. A correlation between the two would imply some connection.
The charts below show the percentage growth over 12-month periods since 2001 for Chinese industrial production and the British stock market, and the correlation between the two. When Chinese production figures were falling, there was subsequently a fall in the British stock market, and vice versa.
The two measurements currently have a correlation of 0.56. This can be interpreted as suggesting that when Chinese industrial production rises or falls, the British stock market does the same 56pc of the time. Since 2001, the average correlation is 0.26, so we’re currently operating at a higher level.
This, of course, is not absolute. For one, it is worth remembering that the industrial production figures show what has already happened, whereas share prices are supposed to be factoring in future growth.
It also does not account for the extent of the correlation – how big the impact a change in industrial production has on share prices. It only shows that they can rise and fall together. Nonetheless, it would be foolish for investors to assume British stocks would be entirely immune from a harder economic slowdown in China. Causation can sometimes be implied by correlation.
Another way to break this down is to look at the constituents of the British stock market and study how much of a business’s sales are exposed to China, as the charts show.
Generally, businesses are quite well shielded as only 6.6pc of FTSE All Share sales come from China. However, the country’s fortunes will have a huge impact on its neighbours, and Asia and the “Pacific Basin”, along with Hong Kong and Singapore, account for nearly a quarter of all FTSE sales.
Looking at stock specifics, five companies earn more than 30pc of the sales from China while 25 businesses earn anything between 5pc and 30pc.
And, this is where we can chart and analyse the numbers. These figures do not even touch on China’s economic tentacles, or lack thereof, hurting other countries where FTSE companies have huge sales such as America and Germany.
Investors may be weaning themselves off a coronavirus news cycle, becoming more positive and buying back into markets.
This could be sensible given market slumps are generally temporary blips. But the number of cases is still rising and the virus is still spreading around the world. Investors have no guarantees that China will go back to work this month and the statistics show that if economic growth stutters any longer, there could be more pain to come for British stock investors.
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