You can't ignore China

Ok, so it's not quite, 'What have the Romans ever done for us?' but hopefully you get the point.

China is one of the principal reasons why the FTSE 100 is around 6,200 right now, rather than 7,100 as it was just a few months ago. If you are invested in a FTSE tracker, then the main driver behind your recent investment performance is China's economy, and not the robust UK economy as you might expect.

In the FTSE 100, only around 20 per cent of earnings are made in the UK. Emerging markets are not far behind at 15 per cent of profits. Energy and materials make up around 20 per cent of the FTSE. As China slows and reduces infrastructure spending, it has less demand for commodities which adds pressure on world prices to drop.

The crash

Of course many of the headlines have been about the recent crash in the Chinese stock market and this doesn't directly affect most UK investors. Even if you have a specific China fund in your portfolio, the chances are most of the stocks within it are actually listed in Hong Kong rather than Shanghai.

For most international investors it is very difficult to invest in the China mainland. Hong Kong listed 'H' shares have not seen anything like the same falls as mainland listed 'A' shares, as they are known. Of course, they did not see such a great surge upwards either.

It is worth noting that, despite the recent drop, over the course of 12 months, Shanghai stocks are still up around 80 per cent. Given this and the small allocation of international investors to the Shanghai or Shenzhen markets, the knock on effect of the China market crash is relatively limited.

More worrying was the panicked response from the Chinese authorities in attempting to prop up the markets, which has caused nervousness that things are worse in China than they seem.

What about inflation

The Chinese economic slowdown affects more than just shares. The slumping commodity prices have contributed to very low inflation, just 0.1 per cent in July after being zero in June. This is one reason why interest rates are unlikely to go up until at least next year. While the UK economy is performing strongly, the Bank of England is meant to target inflation of around 2 per cent a year.

There is little chance of inflation returning to 2 per cent any time soon. If the bank puts up rates, this could drive the pound higher, making imports cheaper and compounding this disinflation. In this worst case scenario, this could turn low inflation into destructive deflation.

The recent Chinese devaluation of its currency has exacerbated this disinflation as their exports become cheaper to the outside world. This has also pushed down stock markets in countries seen as competitors of China. Those with big cash savings may have to wait a while longer to see any decent levels of interest.

You're not buying the economy

It is worth pointing out that economic growth and stock market returns do not necessarily go hand in hand. If economic growth is poor, you would expect earnings growth to be poor. However as markets are forward looking, then expected drops in future profits are reflected in prices now.

The principal determinant of the return on an investment is the price you pay. You tend to see a much better return from equities when the price/earnings ratio is low and a poorer return when it is high.

The Chinese market (or at least those Chinese companies listed in Hong Kong) actually trades on a very low price/earnings ratio, relative to other markets and to its own long term average. The fears around the economy are already reflected in prices and as a result, we quite like Chinese equities.

Turning back to the UK, the FTSE 100 remains quite expensive in our view and is very exposed to the Chinese economy.

We live in an increasingly globalised world and you can't ignore economies as large as China or the US. Events in those countries have an impact on a lot of things that you might not expect. If, for example, the US presses ahead and increases interest rates next month as many believe they will, the impact on pretty much every asset class could be much bigger than that caused by recent events in China.

Colin Lawson is founder and managing partner of Equilibrium Asset Management

He writes a regular blog about wealth management for Private Client Adviser