Market Thinking - A view from the equity market

Market Thinking - A view from the equity market

06 September 2017
  • As markets return after Labour Day, they will be focussing on Q4 and year end, traders in particular wondering whether to go for mean reversal or momentum on commodities and currencies.
  • Politicians are also coming back to work. With central banks in neutral, the US has to deal with the debt ceiling, the Chinese have their Party Congress in October while the UK conference season will focus on Brexit. Meanwhile they will all focus on North Korea.
  • Fundamentally, economies are stronger, earnings are broadly better (especially those benefiting from a weak dollar) and there is evidence of a stock building cycle. Hurricane Harvey may both help to clear excess auto inventory and potentially break the policy deadlock in the US.

Last week had something of a back to school feel about it and after the shortened week in the US due to the Labour Day holiday, investors will return later this week and next to consider the prospects for Q4 and the calendar year. For many macro traders it has been (another) difficult year as the consensus trade from January – rates rising and long dollar, long oil and short emerging markets has once again proved horribly wrong. While equity markets have been a bit more volatile, the net result has been to have traded largely sideways over the last month or so. By contrast oil and the dollar have moved down such that the traders are now short dollar for the first time this year. The euro meanwhile has developed a strong upward momentum ever since Marine Le Pen failed to win the French Presidency back in May. The question has to be whether to go for mean reversion or momentum?

While commentators love to show the chart of the US trade weighted index, the reality is that nobody actually trades this, they trade the crosses. On this basis, we can observe that the momentum on sterling is minimal. It has actually been trading sideways over the summer, while the momentum on the euro, while still positive, is starting to fade, suggesting not chasing it here, but too soon to reverse. The situation with the yen and the Swiss franc look similar. Oil remains stuck below $50, while copper continues to surge higher in one of the few momentum trades still running in the commodities space.

As investors rather than traders, the question is slightly easier as we can (and arguably should) ignore the noise trading in the traded prices markets of currencies and commodities. A break back below 1.10 on the euro, parity on the CHF, 1.26 on sterling or above 112 on the yen would be needed to suggest a reassessment of the medium term dollar picture. The oil price remains in my view a function of excess supply over (long term) shrinking demand and note that this week following the disruption from the US hurricane that the US authorities released oil from the Strategic Petroleum Reserve. This is something that we have discussed before, but should serve as a reminder that the US, which is now basically an oil exporter rather than an importer, still maintains a reserve of 90 days oil supply in salt caverns under the New Mexico desert. While it may be useful to have a few days reserve for emergencies such as Hurricane Harvey, the disruption is in any event more a downstream refining one, which is why gasoline prices have risen but oil prices haven’t. At some point the US may decide to properly scale back these reserves, which should bring into question any lingering belief that oil producers have much in the way of pricing power.

The assumption that oil supply is limited and thus shifts in price reflect shifts in demand is one of those legacy mental models that continue to mislead. The truth is that in recent years, price is more of a function of static demand and moving supply and thus the macro read across is false. Less so for copper, which is one of the few commodities with constraints on supply, such that its price moves do (still) tend to reflect shifts in economic demand, hence its nickname of Dr Copper, ‘the only commodity with a PhD in Economics’. This year the strength of Dr Copper reflects not only the pickup in economic activity signalled everywhere by the Purchasing Manager Indices (PMIs), but also the theory that electric and hybrid vehicles use significantly more copper than traditional internal combustion engine (ICE) vehicles. These same vehicles of course use far less oil, so we have a clear long copper/short oil trade. Of course these are multiyear trends playing out in short term commodity trades, but they neatly illustrate current thinking.

More broadly, the global economy continues to surprise to the upside (US Q2 GDP was 3%), while, as noted, the PMIs in US, Europe and China are all coming in at elevated levels. For consistency, I should point out that while the PMIs have a strong correlation with markets as far as short term hedge funds are concerned, they are an indication of the rate of change, not the rate of growth. They are the second derivative, not the first. Thus, when the Chinese PMI was below 50 it did not mean that China was going into recession (a point I made frequently over the last few years when the ’China is collapsing’ meme was being pushed by the Connecticut Consensus and sections of the media). It simply meant that growth was slowing from 7% to 6.5%. For the same reason, a PMI above 50 does not equate to a certain level of growth, just direction. China PMI is at 51.7, while US is at 58.8, but China continues to grow at between two and three times the pace of the US.

The other ‘big story’ of the summer has been the hyperbolic rise in bitcoin (something we discussed a month or so back) which essentially doubled in Q2, then doubled again. Ethereum, an alternative crypto currency has gone up 20 fold. Seemingly one of the big drivers of this has been the rash of initial coin offerings (ICOs), essentially crowd funding through crypto-currencies. There were predictions that the bubble would burst back in July when the US SEC discussed regulating the ICOs, but seemingly to no effect. This week however, the price of bitcoin has been hit sharply by an announcement by the Chinese authorities that they are going to crack down on (ICOs) – in effect the latest illustration of the Chinese shadow banking system. In my view, the mania for raising funding via the blockchain has all the aspects of a classic bubble, including a lot of schemes that would make the original South Sea Bubble operators blush - although nothing quite to compare with the famous “a company for carrying out an undertaking of great advantage, but nobody to know what it is.”

The US Hurricane Harvey obviously dominated press coverage there and has a number of potential impacts on the economy. While on the one hand Bastiat’s broken window fallacy reminds us that the money spent on repairs is not economic growth per se since it is money that could have been spent elsewhere, it does have potential sector effects. For example, it may well solve a problem for auto manufacturers who were threatened by excess inventory. On the other hand, the insurance industry will have to pay out, an amount brokers estimate to be around one quarter’s earnings. So, largely manageable. Having said that, I suspect that aside from autos, we may find that many people were ‘self-insured’ i.e. uninsured for most other damage, which could hit consumption more generally as repairs will need to come out of disposable income.

The other possible positive to come out of the Hurricane may be some sense of agreement on the US budget and the debt ceiling. After many years of squabbling, leading to little or no legislation and a slew of executive orders instead, there is at least the possibility that Congress can enact some legislation. Despite all the bluster, this is actually part of the point behind the latest announcement on ‘the dreamers’, children of illegal immigrants granted a form of amnesty by executive order from president Obama. The Trump administration is pushing for this to be made law, rather than a blind eye to the law and in doing so is trying to force Congress to commit to other immigration legislation. Whatever the outcome, the midterm elections will already be concentrating minds.

Against all this, we have the dominant media narrative of North Korea. One of the more interesting points recently made about the North Korea nuclear tests is that they appear to be timed to upset Chinese President Xi. The latest test coincided with the BRICS summit, while the other major summit Xi has hosted this year, on One Belt One Road was also overshadowed by a North Korean missile launch. Currently, nobody really seems to believe that this is anything but the ‘proverbial Mexican stand-off’, but in my view the question is now becoming, does the downside to China of the continued behaviour of North Korea start to outweigh the perceived negatives (from a Chinese point of view) of enabling a potential Korean unification? On the one hand, the Chinese are known to be reluctant to remove the buffer state between China and US and US friendly troops in South Korea, but on the other hand with a re-unification there would be no need for those troops. Meanwhile, the US is offering to sell billions of dollars more in weapons to South Korea. To follow this scenario a little further, were they to do this, how might they do it?

The obvious suggestion would be sanctions, mainly cutting off oil, and this is certainly the US ‘weapon of choice’. One suggestion has been that China might offer Kim Jong Un sanctuary if he stands down. However, to think out of the box for a moment, an alternative might be to reverse that process and simply drain the country of its population and thus the leadership of its power by offering some form of sanctuary city under the guise of a special economic zone. Rather like a medieval siege, offer to let the ‘innocent people’ safe passage while imposing a draconian blockade on the rest. Pyongyang only has a population of 2.5m people and the whole of North Korea is only 25m, which is not much more than Shanghai. The Shenzhen special economic zone, which is where the recent development of China all began was a fishing village of 30,000 and now has a population of over 12m. Indeed they could probably house all of Pyongyang in the so called ghost city of Ordos! (although that is increasingly filling up). To date of course the Chinese and the Russians have been assiduously turning North Korean ‘refugees’ back, but what if they didn’t? What if China (and perhaps Russia) exercised soft power and effectively left the Kim Jong Un regime in charge of a (temporally) empty country? Then, following regime change they promote Korean unification. While the Chinese have historically baulked at the idea of a unified Korea, there would of course no longer be any need for US troops to be stationed there. Moreover, if the Chinese were to offer monetary assistance for reunification it could further limit US interests in the Asian region.

Whatever happens it is unlikely China would undertake much in the way of initiative before the end of the 19th Party Congress beginning on 18th October. As previously discussed, the fact that five of the seven top politburo post holders are due to retire means that this is seen as an opportunity for Xi to consolidate power. Xi himself was effectively installed at the previous Congress, five years ago. Investors will be looking for evidence of both the willingness and ability of the regime to continue with reform. Here, I am reasonably confident that he will, albeit with the caveat that China remains in no rush to open up its capital markets, and certainly not to the timetable recommended by western financial markets. Similarly with State Owned Enterprises (SOEs), there is little appetite for the radical reform and a privatisation model that international bankers crave, the process will remain slow and steady. Meanwhile at this point Xi may use his political address to discuss the external as well as the internal challenges that he sees, which by definition must include North Korea.

To conclude. With central banks largely sat at neutral, Q4 policy changes are coming from politicians returning after the summer holidays. In the UK that means a focus on the Brexit negotiations, while in the US it means the budget and, as we have just seen, immigration policy. In China it will be about power consolidation and a plan for increased engagement with the rest of the world. Traders will try and place their bets for the fourth quarter in an attempt to rescue a year that has been characterised by consensus trades gone wrong and will be trying to balance continued momentum against mean reversion in commodities and currencies. Investors, meanwhile, whose buy and hold has generally helped them benefit from a continued rise in equity and bond markets are more likely focussing on rotation and locking in acceptable performance. All will be grateful that despite a few spikes, volatility seems to be less fragile than many had feared ahead of the summer

All data sourced by AXA IM as at Tuesday 20th December, 2016.

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