Market Thinking - A view from the equity market

• Following the Italian referendum, markets are focussed on the risk of a referendum on euro membership. A fracturing of the euro is the biggest volatility risk to investors in Europe, especially those playing bond convergence.

• In China, financial markets are opening up further with issues such as the Shenzhen Stock Connect this week, but the government is cracking down on leakage from the country, closing loopholes and likely slowing some of the more aggressive M&A.

• The broad regime change is now underway however, from regulation, austerity, QE and bond markets towards, more growth, market pricing and real assets. Macro data is supporting this and the narrative is shifting. Inflation may not actually be coming, but people are starting to believe it is, and for some assets that is enough.

“First they ignore you, then they laugh at you, then they fight you, then you win” (Mahatma Gandhi). I can think of little else to link Nigel Farage, Donald Trump and Mahatma Gandhi, but that quote neatly illustrates the confusion amongst much of the western establishment at the events of the last six months. Amazing to think that, since the G7 meeting just two years ago, the leaders of Italy, Canada, and the UK have all gone, as have both Mr Barosso and Mr Van Rompuy from Europe. They are to be followed shortly by the current leaders of France and the US, leaving just two, Mr Abe and Mrs Merkel, from the original group of nine. In a world where markets have become increasingly focussed on policy, this represents a significant rotation in the cast list.

Markets, ever realists, are now pricing a higher probability of contagion, by which I mean fatter tails in their normal distribution models. In any other year the prospect of impeaching the Korean President next week would be major international news, but as suggested last week, attention is now turning to Europe; the euro is down and the bond yield in Italy continues to rise as traders digest the referendum result and the resignation of Mario Renzi. While many are understandably focusing on the shorter term timetable for the Italian banks, (Unicredit’s corporate meeting next week will be closely watched) perhaps more relevant in my view is the range of possible outcomes that could now bring the Five Star grouping to power, a group that has pledged a referendum, not on EU membership, but on membership of the euro. The, likely technocratic, interim government will almost certainly seek to resist calls for an early general election, but even if they succeed, 2018 is not that far away.

International investors, who tend to look at three broad blocs, US, Europe and Asia/emerging markets (EM) are likely wondering where the upside is in investing in Europe at the moment. The first half of next year promises yet more tension, with elections in the Netherlands and France, (and perhaps even Italy if my Italian colleagues in London are reading the sentiments right) followed by Germany later in the year. Of the three, France is probably the most important for markets, reflecting its central role not just in the euro, but in the whole European project. The emergence of Mr Fillon and the standing down of Mr Sarkozy would have been a shock in any other election year, but now seems par for the course, while the prospect of Marine La Pen as President and a possible Brexit like challenge is now focussing minds in France and beyond. The bookmakers moved probably rather too aggressively (in my opinion) to price her in as a winner and now have her trailing Mr Fillon. But we have all grown wary of bookmakers and pollsters recently. Meanwhile the foreign exchange (FX) markets are signalling their disquiet with the euro now trading down to 1.05 against the dollar and although the dollar generally is stronger, we note the recent relative strength of sterling against the euro. Despite the ongoing dialogue over article 50 the UK looks to be the more stable part of wider Europe to investors right now.

Italy is of course no stranger to changes of government. When I first started work in the early 1980s, part of my job as a bank economist was writing country risk reports and Italian Prime Ministers were something akin to English football managers. Following the three different variations of government under Giulio Andreotti between 1976 and 1979, there were five different governments and four different Prime Ministers in the four years that followed, before a period of relative stability under Bettino Craxi from 1983- 1987. Then another three Prime Ministers in less than two years before Andreotti reappeared for his sixth and seventh terms from 1989 to 1992. Or to put it another way, during the time that the UK had Margaret Thatcher as Prime Minister, Italy had nine Prime Ministers. Of course, during that time Italy had a policy of almost constant currency depreciation and even after joining the European Exchange Rate Mechanism (ERM) it could not hold the currency stable, being forced out in September 1992 along with the UK. Since the arrival of the euro in 2000, the depreciation route to relative competitiveness has been cut off and the Italian economy and the Italian market have steadily but persistently under-performed Germany. The bond convergence trade has been very profitable as both Italian and German bonds are effectively ‘the same currency’, but the understandable concern now is that that may no longer be the case.

Chart 1 reproduces one from a few weeks back, showing the so-called Target balances with the European Central Bank (ECB) of Italy versus Germany. In short, liquidity has been pouring out of Italy and into Germany and the balances show the ECB’s commitment to push money the other way.

Chart 1: ECB Target balances – Money flowing out of Italy into Germany

Source: Bloomberg

This of course was an issue that previously arose back in 2011/12 and the European financial crisis, before (Italian) Mr Draghi said he would ‘do whatever it takes’ to preserve the euro. The flows out of Italy have exceeded those back in 2012 and the concern is that this time the people of Italy may not give him the option. Were Italy to leave (and devalue), this would represent a form of sovereign default and understandably non domestic investors are thinking that the best way to hedge this risk is to walk away.

Against this backdrop we sense that year ahead discussions for international investors may focus a little more on EM and Asia. The Shenzhen Connect opened officially this week (Monday 5th December) and while activity was subdued, it is a further piece of the very important jigsaw puzzle that China is assembling as it moves steadily towards a fully open capital market. When the Shanghai Connect opened two years ago, Hong Kong Chief Executive CY Leung described it as a way to “connect the rest of the country with the rest of the world” and this week’s move further consolidates that view; that Hong Kong is seen by Beijing as the portal connecting China to the rest of the world as it steadily opens up its capital account. As previously discussed, a key step in opening up Shenzhen is diversification. Shenzhen is much more exposed to the ‘new economy’ than Shanghai is and also much more exposed to smaller, private sector businesses as opposed to State Owned Enterprises (SOEs). Perhaps the biggest difference from a sector viewpoint is that whereas Shanghai is 4% and 39% IT and financials respectively, the numbers for Shenzhen are 22% and 10%.  As institutional investors embrace the Stock Connect – in both directions – this diversification benefit will assume greater significance. Currently the flows are limited by a daily quota, which understandably makes institutional investors a little cautious, but, as with the Shanghai Connect, this largely reflects the ‘pilot’ nature of the scheme. Quotas are not meant to prevent the scheme from working, just to try and make sure it is done so in an orderly way. At a recent lunch with the Hong Kong Stock Exchange, Chief Executive Charles Li said that the next step is likely to be the inclusion of ETFs and there is also the prospect of trading other exchange traded derivatives under the connect scheme. This remains an important work in progress.

The opening up of Chinese capital markets is very much a two steps forward, one step back process however and this week, much of the news locally has focussed on attempts to slow down ‘unofficial’ cash transfers out of China. This is linked to a falling value of the renminbi (RMB) against the US dollar, although in the current situation it is more the strength of the dollar against almost everything. It also has the tendency to be self-fulfilling, which is why the authorities are so keen to step in. If the currency falls, then people try and get their money out and into the rising dollar. This in turn causes more RMB weakness, triggering further outflows and so on.

As to the US and President Elect Trump, there is a fair amount of fuss being made over the fact that Mr Trump ‘took a call’ from the President of Taiwan. Are the Chinese upset? It doesn’t really appear so from the noise here in Hong Kong, but in any event on the subject I defer to Scott Adams, who I have discussed before as having a very interesting ‘take’ on the Donald. His point is that Mr Trump views the world through the prism of ‘the deal’ and that this is likely to be his opening gambit. He may also be encouraged that an A share stock with a Chinese name sounding vaguely like ‘trump’ went limit up on election day while the makers of this electric vehicle, ‘Trumpchi’ are said to be doing brisk business!

If we were to extend this thought process a little further, we could argue that this is part of the swing back towards prices being set by negotiation between buyer and seller rather than by regulators. Ultimately if prices are set by clearing between unconstrained buyers and sellers, then, I would argue, resources tend to be allocated more efficiently. If they are set by government, or regulators, however well intentioned, there is a growing risk of inefficiencies and externalities. At its extreme we get the establishment (and failure) of command and control economies, from tractor production statistics in Soviet Russia to the Great Leap Forward of Chairman Mao and, more recently the market failures in Venezuela and, in the news this week, Cuba. More prosaically we have seen the creeping over-regulation of markets in the so called capitalist west. Probably starting post the dot.com bubble, but particularly since the global financial crisis (GFC), legislation and regulation have been smothering free markets. The GFC was cited as an example of a failure of capitalism, but in reality it was a failure of mercantilism and crony capitalism. Unfortunately the response has been more interference not less.

The political landscape is currently being presented as being between ‘left’ and ‘right’, but in reality it is between the state sector and the private sector. The anti- establishment or so called populist votes are a vote against the current level of interference in markets from the state sector – with many on the traditional left complaining about ‘right wing government supporting bankers’ while those on the traditional right are complaining about ‘left wing socialist governments promoting too much identity politics’. The new wave of G7 politicians coming in, from Theresa May and Donald Trump to the new leaders of France and Italy signal a likely change in attitude that will have important implications for asset allocation and markets. This doesn’t have to be radical, but at the margin a shift from policy driven markets towards fundamentals driven markets will be quite profound in its effects, and the market is moving already. The Federal Reserve (Fed) is now appearing to follow, rather than lead markets, US Libor continues to rise, regardless of what the Fed announces next week and the stronger dollar is tightening monetary conditions in the whole dollar zone. Meanwhile and as noted last week, the recent sell off in bonds is not so much about a change in views on inflation and growth (the new narrative to ‘explain’ bond yields), as it is a normalisation of interest rates away from QE towards ‘free market’ valuations, ones which are set by inflation and growth and would be much higher. In effect this is a move from bonds as a special interest group to being the same as other assets. Similarly, small and mid-cap stocks in the UK rallied on the prospect of improved access to markets outside the customs union, while US banks rallied on steeper (more free market) yield curves and a prospect of an easing of regulatory burdens.

This is not to say lobbying disappears, or that we are going to an era of pure free markets, rather that there is more of a ‘deal’ to be struck. Take as an early example, the deal with US air conditioner Carrier. Even before taking over, Mr Trump prevented a US company relocating abroad, apparently by offering subsidies (though $7m over a decade to keep 100 jobs looks a bargain by previous standards), but also doubtless by reminding the ultimate managers of the conglomerate just how much business they did with the US government. Ironically this was slammed as a form of government interference and crony capitalism (which it is) by the very people who have previously been happy to bail out other institutions from Wall Street to car companies. The point is not to defend either previous or upcoming administrations but to acknowledge that they will operate differently. Companies need to adjust and so do equity and credit analysts. As my colleague Nigel Thomas always says: “Things won’t necessarily be better or worse. Just different”.