Market Thinking

  • The year has begun with a combination of momentum for last year’s thematics and some value from a recognition that despite projections a year ago, we are in a period of co-ordinated cyclical growth.
  • Asia is at the heart of both and international investors are waking up to the fact that emerging market equities are as cheap relative to the US as they were post the Asian crisis of 1997, which is a world away from where we are now.
  • Long term trend lines favour both EM equities and debt and most EM currencies. Asia looks particularly good in all areas. Conversely, the dollar and US Treasuries have broken their uptrends. Commodities have moved back to an uptrend while the short volatility trade remains strong – even though it is a huge potential risk.
  • Higher cyclical inflation is coming but is a bigger threat to equities without pricing power than it is to bonds.

I have been fortunate enough to be invited to speak on some year ahead panels around the region by one of our major private banking ‘partners’ so have very much hit the ground running into the New Year. One thing I particularly like about the private banks is that the presentations are very much about giving advice to clients, in that they are practical, rather than simply a laundry list of forecasts. Thus nobody really cares about precise GDP forecasts or inflation projections, they want to know where they should be investing, which is a function of thematic growth stories and relative value.

As discussed here on multiple occasions, our thematic strategies (which formed the basis of much of the discussion) are global but many have a strong Asian bias and certainly an Asian, usually Chinese, catalyst. The robotics and automation theme for example really kicked off in 2014 as China became the world’s largest buyer of industrial robots, something we tie in to the stated policy of Made in China 2025. China is following the North Asia model of Japan, Korea and Taiwan in moving up the value added chain and that requires huge and ongoing investment not only in robotics but in smart factories, sensors, big data and the whole internet of things. One thing is clear, the fourth industrial revolution will have Asia at the heart of it. Similarly a digital consumer strategy is going to heavily feature the likes of Tencent and Ali-Baba as the 350million plus middle class consumers in China channel everything through their mobile devices. The drive to lower pollution and emissions, smart energy and smart cities is also coming from Asia, while the need for a transition away from a big bank dominated financial system in China towards a more distributed capital markets system is powering a fintech revolution.

These thematic drivers come against a background of cyclical growth globally and the prospect of an unwinding – or at the very least a slowing - of non-conventional monetary policy. This is likely to be a drag on areas and investments that have benefited from this, particularly in my view the spread trade and leveraged markets that essentially used financial engineering to create artificial investment products. The notion that you could take a low yielding bond portfolio and gear it up fifteen times while presenting it as ‘low risk’ simply because it had low volatility always struck me as showing that we had learned nothing from the credit default swap (CDS) debacle. The reality is that such products rely on institutional adherence to rules based systems that define risk very narrowly as volatility and correlation and whereby capital rules proscribe what can be invested in. Equities risky, highly leveraged illiquid products not risky and so on. It’s crazy, but those are the rules. By contrast, clients of private banks view risk as the probability of losing capital and particularly here in Asia it is that ‘back to basics’ approach to investing that is a welcome change.

The year has started with a combination of both value and momentum. The momentum plays from last year such as the Asian tech stocks have continued to run, but equally some of the cyclical value plays have also bounced quite sharply. Part of this I suspect is a function of valuation; not only are Asian stocks generally seen as good value compared to their US counterparts, but cyclical stocks are particularly good relative value.  Indeed according to a chart put up by the chief strategist at the private bank, emerging market equities are as cheap against their US counterparts as they were after the Asian financial crisis in 1997. This is extra-ordinary for a number of reasons. First and most obviously Asia is in a very different economic position than it was then. Earnings are growing steadily, balance sheets are strong, real wages are rising, dividend payouts are high and payout ratios are rising. Asia currently provides between a quarter and a third of all dividends globally and yet barely features in the portfolios of most income investors. Most important of all however is that back then Chinese GDP was less than $1trillion and that since 1997, China’s GDP has grown by a multiple of 11 times. Even if we only go back 10 years rather than twenty, we see that the Hang Seng has just taken out its 2007 high, meaning that, in rolling news speak, it is “hitting a new record all time high”. However, this shouldn’t be too surprising (as I pointed out on CNBC this week) given that the earnings base for the Hang Seng is over 60% higher than it was back then.

With that sort of long term perspective in mind, I jotted down a few of my own New Year resolutions for long term investors.

  1. Recognise what type of investor you are. If you are not capital constrained or driven by asset liability management don’t mimic people who are. The very biggest institutional investors may not ‘know’ anything you don’t.
  2. If you are a long term investor, recognise that patient capital gets returns from being patient, try and separate the signal from the noise.
  3. For a long term investor volatility is your friend, it’s a risk you can take to get a return. Traders avoid it, but you don’t have to.
  4. Diversification is good in a portfolio, but don’t make a bad investment simply because it is not historically correlated. There is little need to take credit risk.
  5. Be wary of products that take/impose liquidity risk or use lots of leverage. Despite claims, they are not risk free simply because they have low volatility. There is little need to take liquidity risk or leverage risk.
  6. Investing  thematically is on the rise – geographic and sector funds are less relevant than they were and focus on fundamentals, especially cash flow.
  7. Keep an eye on low volatility, it’s less a sign of complacency and more a sign of too many people chasing income and selling volatility.
  8. Quantitative easing (QE) is receding as an influence, be wary of products that have may have thrived on easy and cheap money this last decade. At best they have peaked, at worst they could reverse sharply.
  9. You can ignore China but it won’t ignore you. Watch the People’s Bank of China (PBOC) as much as the Federal Reserve (Fed) - if not more so.
  10. Crypto currencies are a symptom of wide ranging changes coming via the blockchain, but to my mind they should not be seen as an investment.

The chart below makes a further point on long term investing and the usefulness of long term moving averages as asset allocation signals. It shows MSCI China, which as we know was one of the best performing markets in 2017, but over the last five years. Because of the big squeeze up and subsequent sell-off in 2015 and into 2016, MSCI China began last year pretty much at the same level as it was in 2013. From an asset allocation viewpoint, while the long run moving average (green line) would not have got you out at the top (the shorter term moving averages give better signals obviously, but this is not hindsight portfolio management), they would have delivered a 15% return from June 2014 (crossing up) to June 2015 (crossing down), before putting you back in in June 2016 15% lower down still.

Chart 1: Market timing – don’t believe you can pick the turning points, focus on capturing the trend

Source: Bloomberg, AXAIM. January 2018

Currently the index is as stretched above its long term moving average as it was back in 2015. Is that a sell signal? Will we get out at the top? Depends, but to believe one can get in at the bottom and out at the top could be a fool’s game. If one can capture the majority of the trend I’d say they’d be in great shape.

The flip side to the China chart is probably the one of US Treasury yields. Notice how in Chart 2 yields on the 10 year Treasury had a short term peak in June 2015 on that China sell signal and bottomed in 2016, just as that buy signal on China appeared. Notice also that the 10 year yield broke above its long term moving average in October 2016, back below for three months between August and October 2017 and is now firmly above the long term moving average,. The short end is obviously much clearer in its up trend in yields and of course Libor continues to squeeze sharply higher threatening the funding costs of leveraged products.

Chart 2: US interest rates now all appear to be in structural uptrends

Source: Bloomberg, AXA IM. January 2018

High yield corporate bonds look to be struggling too, having broken their long term moving average to the downside on the index, while emerging market (EM) debt has broken to the upside. Intuitively this is not surprising given the spread of EM sovereign yields over western corporates for essentially the same or better credit ratings.

In terms of currencies, the euro, which is back to 2014 levels has been in an uptrend against the dollar since last April/May, as has sterling. As to where it should go, I was reminded of the Economists Big Mac index when I was in New York over New Year and we were required to make a pit stop to feed a hungry teenager. It felt ‘too expensive’, so I looked up their index. According to the economist’s calculations the price of a Big Mac in the US is USD5.30 compared to GBP3.19, which implies an actual ‘correct’ exchange rate of 0.6, or 1.67. For the euro area they suggest a correct rate of 1.35. Just to confuse things however, the price of a Big Mac in Arkansas according to a McDonald’s price tracker is only USD3.95, which is less than the UK cost at current exchange rates. New York is in fact one of the most expensive states for a Big Mac, which does raise some questions about the price indices being used more generally. If something as generic as the Big Mac can vary between states by up to 30%, how can we measure inflation or purchasing power parity (PPP)? Perhaps more important, do PPP calculations take into account the different state taxes or the ‘voluntary’ but ‘trying to getting away with less than 20%’, service charges? Intuitively the cost of living in New York feels too high compared to London at current exchange rates.

Not that the tourist dollar will necessarily drive the exchange rate, but I suspect that the emerging downtrend over the last six months in the dollars is starting to drive capital flows out of the dollar zone. Some of that will come into emerging markets on the theory that as a strong dollar is bad for EM, then a weak dollar must be good. Even though I no longer believe this relationship to hold – principally because EM growth is not fuelled by dollar debt like it was in the past – I think this will undoubtedly be having an effect and certainly driving some portfolio flows into strengthening EM currencies. When an EM BBB sovereign debt such as Indonesia is yielding 6% plus and the currency has just strengthened against the dollar through its long term moving average, then the fact that this is 12 x the yield on bunds or  4 x the yield on investment grade European corporates could start to attract attention, and flows.

Commodities, led by oil, broke up through their long term moving averages last October, which not only reflects cyclical growth and a supply demand imbalance in terms of fundamentals but is also a reflection of the market rotation towards cyclical value. Interestingly the Baltic Dry Index, which is a reflection of the supply/demand imbalance in dry bulk shipping and often a good lead indicator of global trade activity is dropping back down to its long term moving average.

Chart 3: Baltic Dry not telling quite such a bullish story as commodities generally

Source: Bloomberg AXA IM, January 2018

To be fair, the Baltic Dry is not a traded index in the way that commodities are and as such tells us less about financial market behaviour and more about real world demand and supply and as such has been a useful lead indicator of turning points in commodities. In early 2014 for example it warned of a top and in both mid 2016 and mid 2017 it gave positive signals ahead of rallies in commodities. Obviously much of this is to do with iron ore and we would just note that Chinese iron ore inventories are currently at extremely high levels. Partly this is a function of the upcoming Chinese New Year, but it is also likely to act as a brake on export activity in the coming months.

So far, bitcoin is off some 40% from its peak and while many can say that they are still up multiple times the party atmosphere and gold rush like enthusiasm has clearly dimmed in ‘dry January’.  Crypto currencies seemed to be all that anybody was talking about over the holidays. “You work in finance? What about me buying some bitcoin? I almost put (unlikely amount) in back in the summer, but didn’t. Should I buy now?” That anecdote in itself to my mind should act as a warning and my standard response was something along the lines of the fact that its real importance was in the emergence of initial coin offerings and the blockchain in general. On occasion I may have mentioned things I wrote before Christmas such as the fact that 40% of bitcoin is owned by less than 1000 people and that the marginal buyers before Christmas appeared to be leveraged day traders in Japan who usually punt foreign exchange, but largely people didn’t want to listen, they were just looking for confirmation of their existing views, which basically seemed to be ‘get rich quick and get out right at the top’.

Meanwhile some of the more questionable activities that have grown up around the whole crypto currency arena are unwinding very fast. I notice that bitconnect, an exchange that offered huge returns if you lent them your bitcoin appears to have closed down, wiping out most of their customers. I still believe that some core crypto currencies will survive and that the real importance is the emergence of the distributed ledger that is the block chain, but this feels like it is going to be painful.

Meanwhile, the truly disruptive currency, the renminbi (RMB), is getting stronger against the dollar, almost certainly helped this week by an announcement from Germany that RMB will be going into German foreign currency reserves. The currency is now back to the levels last seen in the wake of the June 2015 sell off in Chinese equities, and yes, from a long term investor perspective the currency broke down through the long term moving average (in this case this means strengthened) back last May. This should mean that China should benefit from the capital flow effect described earlier with respect to emerging market debt – the positive trend in the currency is seen to reduce the risk of a currency loss and thus increase the expected dollar returns from buying higher yielding Chinese assets. This in turn can drive the currency as well as the assets higher, triggering further flows. It doesn’t last forever, but it is certainly powerful in the short term.

So to risks and as we saw with crypto currencies, one of the biggest problems a market has is when it is gripped by greed rather than fear. It is often said that the low level of volatility in equity markets reflects complacency or even a perception that there is no risk out there, a lack of fear. However, I think actually a good part of this comes from greed. Chart 4 shows one of the great momentum trades of the last two years, XIV, the ETF that is the inverse of the VIX – a seven bagger over the last two years. Not bitcoin, but not bad!

Chart 4: Selling vol as a powerful momentum trade

Source: Bloomberg, AXA IM, January 2018

As previously noted, this phenomenon does concern me as by buying the ETF, the investor prompts the market maker to effectively sell volatility. There is obviously nothing wrong with a considered judgement about the attraction of selling volatility, but my fear is that this is less about taking a view on a the price of volatility and more on chasing a momentum trade. Obviously should they wish to unwind that positon then the VIX itself could spike sharply having knock on effects into portfolios. Encouragingly from a risk perspective volumes seem to have slowed, but the outstanding amount remains meaningful. We continue to watch this closely.

The other risks to my mind are unexpected inflation and too much leverage in a world exiting QE. While it would be an exaggeration to blame the woes that fell UK housebuilder and contractor Carillion on QE, there is no doubt that a focus on its debt problems would have saved equity investors a lot of money. Particularly interesting was the exposure of the UK company to German private lending known as Schuldschein. These private debt markets have increasingly been funding non German companies, encouraged no doubt by the willingness of yield chasing institutional investors to embrace ‘private debt’ as a so called alternative strategy. As outlined in my above New Year resolutions, I see no need for long term investors to take credit risk unless they are properly compensated and do appropriate due diligence, and certainly would be wary of private placement markets that need no credit rating or public disclosures. Equally I tend to be wary of any company using said markets. Carillion had other debts of course and undoubtedly the use of reverse factoring – in effect getting banks to settle your sub-contractor debts on your behalf – may have led the casual observer (or naive systematic quant model) to under-estimate the true debt exposure. But there is another factor worth exploring, even if it didn’t actually apply in Carillions’s case. Inflation.  I stress that I do not know if this applies in Carillion’s case specifically, but the construction industry can in my view misprice contracts in an attempt to land business and in many cases they are fixed price. This can go badly wrong if you lose control of your costs, be it poor management or unexpected cost rises, often due to raw materials. More broadly we are therefore looking at pricing power in a cyclical upturn. If your supplier can raise their prices but you can’t your margins will suffer. For most businesses their biggest ‘supplier’ is their workforce, so the wage rises that macro investors are always looking for as a ‘good thing’ because of consumption, can be a bad thing for a lot of companies. Being cyclical works both ways. Even worse when those wage rises are mandated because they don’t reflect an environment of strong aggregate demand that allows price rises. Once again this implies careful stock selection.

Notes to Editors

All data sourced by AXA IM as at Thursday 18th January 2018.

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