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Market Thinking - A view from the equity market

A view from the equity market

Market thinking

Mark Tinker, Head of Framlington Equities Asia, comments on Asian Markets:

  • As the Turkish Lira takes on all the traits of a classic Emerging Market (EM) currency crisis, the divergence between classic EM and North Asia EM becomes stronger, suggesting a new asset allocation style on the next rotation.
  • Insulation from the impact of US tariffs and monetary policy will now become a greater priority for many countries and will affect Dollar-dominated capital markets, shifting longer term economic alliances.
  • Meanwhile, with short term traders out of equities, medium term Asset allocators out of EM and benchmarked investors flat to their benchmarks, long term stock pickers are selectively picking up value around company fundamentals.

In recent weeks we have discussed the divergence between North Asia and other emerging markets, notably in places like Turkey which fit very much into the textbook role of the current account deficit country dependent on foreign capital. Indeed, Turkey has recently followed the playbook for EM weakness, particularly with the currency, and the market is finding it difficult to see how it can avoid a classic EM default. Investors in EM baskets are not waiting to find out and will continue to jump ship, further exaggerating the EM into DM rotation we have been discussing for the last six weeks or so. The fact that the US dominated financial markets have turned on Turkey at a time when President Erdogan has fallen out with the US administration has not been lost on other emerging markets. Nor was it meant to be. It is an uncomfortable truth that the US is bringing its financial status into discussions on international policy. Some people say that we shouldn’t talk about politics when discussing markets, but unfortunately when markets look like they are being used as a coercive policy tool it is unavoidable, especially when the relative performance of bond and stock markets as well as currencies is seen in some quarters as not only a measure of success, but also a means of leverage to achieve policy, or even regime change. This may of course all be political posturing ahead of the US mid Term elections and there is no doubt that none of President Trump’s usual critics are defending Turkey, Russia, Iran or China for this more muscular foreign policy stance. It used to be said that when a politician had trouble at home the temptation was to start a war, a tactic known as Diversionary Foreign Policy. Well perhaps we are seeing this theory played out as Trade War rather than Military War?

Regardless, this is already having some interesting second order effects. Russia for example has sold almost all of its US treasuries and has bought a lot of gold, while steadily making itself ‘sanction proof’, and while it too was hit with further US sanctions last week,, the economic impact is diminishing so that at some point the traders will start picking up the relative value on the carry trade from Russian bonds. Meanwhile the external pressure from the US is acting to push Russia, China, Turkey and Iran closer together, which may not be its long term intention. Certainly, as previously discussed, there is a likelihood of greater use of renminbi (with the option for exchange into Gold via the Shanghai gold exchange) in energy transactions for example. Other effects from the law of unintended consequences include a stronger Dollar, which harms the very exporters the US is claiming to be trying to help as well as many emerging market countries otherwise counted as US allies, who, almost by definition of being allies have large amounts of Dollar denominated debt on balance sheets that are now under threat from higher Dollar interest payments and tighter liquidity conditions.

If not the countries then perhaps the banks. Chart 1 shows the correlation between the Deutsche Bank Emerging Market Currencies Index and the Stoxx 600 Banks index. While correlation doesn’t imply causality, the logic is clear, European Banks have been big lenders to Emerging Europe in particular and a combination of tariffs, sanctions and sharply weaker currencies is usually bad news for Non-Performing Loans (NPLs).

Chart 1: European Banks vulnerable to US sanctions and tariffs policy via Emerging Market loans

Source Bloomberg, AXA IM, August 2018

Of course, US policy isn’t just about sanctions, it is also about tariffs and before the latest bout of weakness from Turkey there was much talk about how badly the Chinese economy would be affected “by $200 billion of tariffs”. Of course there are several problems with this, first that “$200 billion of tariffs’ actually means tariffs on $200 billion of goods, which, were it to be 25% would actually mean $50 billion of tariffs, while secondly we should not forget that the impact of tariffs depends on who has the pricing power, which in turn depends on the nature of the goods. In the case of China threatening 25% tariffs on US LNG for example, the impact would certainly be taken almost entirely by the US gas industry, as the consequence would result in US LNG becoming 25% more expensive than Australian, or Qatari LNG. Currently China imports hardly any LNG from the US; indeed this was to be a key initiative to help China reduce the bilateral trade gap, which is of course exactly why China is mentioning it. By contrast, if the US were to slap a 25% tariff on, say, Auto Glass from China, it would have a problem, since almost 90% of auto glass comes from China and the US importers would have nowhere else to go.  The serious risk is that US auto-manufacturers would have to pay the higher tariff themselves and attempt to pass them on to customers, which given that on-shoring auto production to the US is another key policy also seems counter-productive. It is also important to note the dramatic change in the nature of China’s exports to the US. Thirty years ago, when the dominant driver to the economy was the export sector, it was all about items such as clothing and footwear. Now it is machinery and electronics, for example, over 90% of the world’s computers are made in China.. Putting a tariff on them is hardly going to lead to new US computer factories setting up in competition; it’s simply going to raise the import price of computers for US consumers.

Now that the dominant factor to Chinese growth is the consumer, rather than exports or investment, we should not lose sight of the fact that the biggest positive from free trade is the benefit to consumers who get access to better goods or at a better price, or both. Tariffs therefore punish consumers at the benefit of exporters and domestic producers who aren’t otherwise subjected to import penetration, which is of course why the latter always lobby so aggressively for tariffs. To see if China risks damaging its own consumer through retaliatory tariffs on US imports, I thought it worth repeating a chart from earlier in the year created my colleagues here in Hong Kong, Aidan Yao and Shirley Shen. It shows the importance or otherwise of the US to China in terms of its imports, which I think, is particularly important in the context of commentary that should China impose tariffs it will “cripple its economy”. Not so.

Chart 2: China’s Imports from the US

Source Bloomberg, AXA IM, August 2018

Here we can see that on the left hand side China represents more than 40% of all US exports of skin and leather, but that the US is less than 20% of total Chinese imports of skin and leather. Thus, should China choose to put a tariff on the US exports, then the likelihood is that Chinese consumers would be largely unaffected (the shortfall would be made up by equivalent imports from elsewhere) but that US exporters would lose one of their biggest markets. Indeed from this chart, food and beverage, and transport equipment look to be the only areas where a Chinese tariff may have to be passed on to Chinese consumers, assuming of course that there is no alternative source. Food is dominated by pork and soya beans, and while the US is the biggest market supplier for soya beans ahead of Brazil, China is also the biggest buyer of US soya-beans, and the second largest buyer of cotton. Undoubtedly the suggestions of retaliatory tariffs here are aimed at the US farming lobby.

 

While much of Europe appears to be on a summer holiday, Asia seems as busy as ever. Last week I was travelling around the region with a colleague from London talking with our distribution partners about our thematic strategies while this week I am once again trying to write a few words on markets from 36,000 feet as I head to Kuala Lumpur. This is all very exciting for the active managers at Framlington as our way of looking at the world in terms of thematics, rather than countries or industries, is striking a chord with the way that savers in the region want to invest their money. Hence this note is a bit longer than normal!

 

Last week, I was asked to write 200-300 words at short notice for a trade magazine about the markets! The subject was ‘safe havens’ which gave me the opportunity to discuss the different actors currently at play in markets, all of whom have different attitudes to risk; the traders, the asset allocators, the benchmarked investor and the bottom up stock picker. The following paragraph sums up the essence of that article, much of which sums up discussions here in previous weeks, but is, I believe, nevertheless worth repeating:

“Investors are currently said to be looking for safe havens in Asia, but where and what they are depends on the different types of investor and how they balance acceptable risk and required return. If you want a safe haven, to reduce your risk, you need to accept a lower level of return. The ultimate safe haven is cash, but for most investors this is a short term tactical trade, especially with inflation adjusted rates being almost universally negative. Currently the equity and bond markets have heightened volatility risk, which means that traders have certainly cut their gross and net exposures, reducing leverage and liquidity. Longer term investors however, for whom volatility is not a problem and is thus a risk they are prepared to be paid to accept, are not changing their asset allocation. On the other hand many of them are moving within asset classes because of perceived benchmark and credit risk. The most obvious example of this is the allocation between Emerging Markets (EM) and Developed Markets (DM) and I would suggest that it is a classic EM/DM rotation that is underway at the moment. As such we have a reasonably familiar playbook to work from with the Dollar playing a lead role. At the end of Q2, a stronger Dollar triggered a rotation out of EM back into DM and while the concern over trade wars has been the economic rationale to justify selling, much of the activity has been to reduce an overweight position in EM equity and debt. For companies and indeed countries that have borrowed in Dollars, local currency weakness also presents higher credit risk which has led benchmark constrained investors and also some bottom up stock and credit fund managers to reduce exposure to companies with poor quality balance sheets. This movement has been exaggerated by a structural shift to tightening of liquidity conditions in China as the authorities seek to de leverage the shadow banking system.

“Thus the trader sees their safe haven as more cash and reduced leverage while the asset allocator and the long term benchmark driven institutional investor see their safe haven as hugging the benchmark. Meanwhile, the bottom up manager, acknowledging the ‘market weather conditions’ moves to higher quality balance sheets. To me, these current market conditions are not particularly unusual and nor are the responses. At some point the traders will put on more leverage and the asset allocators will rotate back into EM - although this time I believe that they will carve Asia and particularly China out from the rest of EM. In the meantime the bottom up managers are looking for value situations where high quality stocks and bonds have been oversold.”

This background was useful in discussing with clients about the ‘right time’ to invest in funds. Rather like the old saying that “the best time to have planted a tree was twenty years ago, but the second best time is today”, the regret that we didn’t buy a fund two years ago before it doubled, should not confuse our decision as to whether we should invest in a particular strategy today. Certainly when the traders are heavily (positively) active in equities as they were in Q4 and early Q1, then you are likely to be buying into some speculative froth, especially if the active asset allocation is also in your favour. One way to think about it is if the price index you are looking at is above the short term moving average (traders like it), medium term moving average (asset allocators like it) and long term moving average (bottom up investors like it), then you are likely at the top end of your valuation range.

Things can and often do get more expensive from here, but when the short term trend breaks, the traders will jump out and if they have been driving the narrative in one direction they will either drop it, or sometimes reverse it. Here I generally find that the use of currency or commodity narratives to support buying or selling of equities tends to reveal the traders at work. Investors can wait to see if the medium term trend holds and watch as the narrative tends to shift more to economic fundamentals as a reason to buy or sell. ‘Economic cycle’ or ‘hard landing’ are often keywords here when the asset allocators have taken over.  Also we need to watch around derivative expiry and quarter ends as asset allocators will either renew hedges, put them on, or indeed take them off. A break in the medium term average tends to trigger the asset allocators and here the fundamental rhetoric will tend to shift to support/enhance the new directional trend and we see benchmarked investors moving to flatten out any bets against the benchmark. Often this can be counter-intuitive, if benchmarked investors have been underweight in, say, cyclical stocks, then more often than not they will appear to be taking more risk (buying cyclicals) when the consensus is most gloomy, because they are actually reducing risk from their perspective, which is benchmark risk, not economic cycle risk. Finally the stock picker has to make the decision as to how these ‘weather conditions’ affect the direction of their absolute return focussed fund. They might choose to sell some of their ‘hot positions’ into the trader inspired euphoria and rebalance into less popular names that nevertheless fit their strategy. They may also choose to rotate away from areas where benchmarked investors have become notably ‘overweight’, for that is a rotation waiting to happen. This helps to protect the strategy from the worst of the technical rotations, but frequently means an ‘under-performance’ on the upside in order to outperform on the downside. This is something that is not always clearly explained to the end investor who is sometimes led to believe that an active manager will always beat on the upside and on the downside. An upside like Q4 last year that actually reflects a serious increase in short term risk needs to be recognised as such.

However, it is difficult to avoid at least some of the down draft when the short and medium term trends break and the experienced stock picker tends to wait until the short and medium term rotations are over before adding into favoured (now better value) positions. To some extent they are able to adjust their timing around the ‘real fundamentals’, the corporate earnings that come though, although even here we need to bear in mind that the company statements may reflect the current gloomy news headlines.

If we look at the chart we can see how this evolves over time. We can pick any chart, but I have just picked the MSCI China chart for recent events.

Chart 3: Short, Medium and Long Term moving averages reflect different market ‘players’

Source Bloomberg, AXA IM, August 2018

We can see how the traders jumped out (price below yellow line) in November, but then aggressively back in again in mid to late December, before getting spiked out in February. Although the price moved either side of the yellow line the trend was down, so the noise traders largely went elsewhere. Meanwhile the asset allocators and benchmark investors who tend to think quarterly didn’t really move until June, when the price moved below the purple line during q2 and it began trending down. Long term stock pickers also started to sell as price broke through the green line  end June and while the trend line is just about still upward sloping they are not rushing back in just yet. They are however, watching that yellow line for signs of an upturn (and remember, they tend to be looking at this at the individual stock level).

Thus now we are in a position where the traders have flipped from overly positive to out of the market (in February) while the asset allocators have rotated out of EM into DM (late June). Cyclicals and industrials have been sold off on the back of economic rhetoric around trade wars and hard landings suggesting asset allocation and benchmarked investors are still at work, which tends ironically to favour small and mid-cap names over the big caps in the ETFs and Index baskets that the asset allocators tend to use.  I suspect the benchmarked managers will now be ‘flat’ so they are not contributing in either direction at the moment. Bottom up results are still coming through ‘positively’ in so far as they are not supporting much if any of the bearish Asset Allocation narrative. In terms of prediction, I suggest we watch the moving averages, when the short term breaks up; the traders are likely to fade as a negative influence and may even start as a positive one, so we need to listen to their rhetoric on currencies and commodities. The medium term trends (obviously) move more slowly and will not rotate back to EM any time soon, but to the extent they diminish as a negative the stock pickers can add to oversold positions.

The fourth quarter should see peak noise on trade ahead of the mid-term elections and then politics is likely planned at least to be delivering positive news on how the US has ‘won’ and that tariffs will be coming down. If true (and obviously no guarantee) then the traders will lead the charge followed by the benchmarked investors and then the asset allocators. However, I would still expect the next rotation away from DM to be towards a new version of EM, one that treats the still troubled economies of Argentina, Turkey, Brazil and South Africa very differently from Taiwan, South Korea and of course China. 

Indeed the traders are already there, albeit on a bear tack, driving the noise about Turkey and EM and pointing out that breakdown of EM currency baskets through their Fibonacci retracement levels.

Chart 4: traders will be driving an EM currency Crisis narrative for the next few weeks

Source Bloomberg, AXA IM, August 2018

To conclude. Travelling around Asia over the last few weeks I am reminded of how far it has come since the Asian Financial crisis of twenty years ago, especially in Kuala Lumpur, which was in many ways the epicentre of the crisis, facing a run on the currency not dissimilar from that taking place in Turkey this week. This only reinforces my view that the next rotation towards growth and Emerging Markets will carve out North Asia in particular from the rest of the group.

Developed market economists and analysts need to understand this pace of change. Back then, just after handover, Hong Kong was about 23% of Chinese GDP, now it is less than 3%, while just over the border Shenzhen, which had grown from a collection of fishing villages with a population of around 30,000 people in 1980 to round 2.5 million by 1997, now has almost 11 million inhabitants. With a GDP of around $330 billion this one Chinese city alone is almost the size of Hong Kong in terms of GDP and is bigger than whole countries such as Malaysia, Singapore, the Philippines or Vietnam, let alone developed markets like Ireland, Denmark or Portugal. Visiting the city and staying in its five star hotels, riding in its electric taxis and eating high quality food (although the service isn’t quite there yet) it is difficult to agree with the common perception that, deprived of US import and export markets the place will suffer much at all, let alone collapse. We have gone from a world where China exported low value added goods to the US to one where it now exports machines and technology and where the US mainly exports commodities to China.  Behind all the political noise, we should not lose sight of the fact that this trade war is about getting US access to Chinese consumers, particularly in the high tech arena, while trying to prevent China becoming dominant in those new technologies. Focussing on companies that will benefit from this new reality rather than relying on models based on historic relationships remains key to stock selection and fund performance.

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