Market Thinking - Are ‘old economy’ trade restrictions shifting to the ‘new economy’?Market thinking 08 March 2018
- The end of QE continues to reset the environment for bonds, while the aftershocks from the collapse of a number of short volatility trades in early February continue to affect equity markets.
- Talk of US tariffs on China is arguably more political than economic and reflects a realisation that with the removal of fixed term Presidential limits in China, there is now a genuine ‘challenger model’ to the Washington Consensus.
- While tariff talk focuses on the old economy of steel and aluminium, the TPP 11 meeting this week will highlight freeing trade in new economy areas such as data storage and cloud computing which are ultimately far more important for many equities.
March has begun as February left off, with a heightened level of volatility in equity markets and upward pressure on interest rates from the ending of quantitative easing (QE) and the unwinding of the Federal Reserve’s (Fed) balance sheet. The selloff in equities in February took most major equity markets down more than 10% from their highs, but they have recovered somewhat to leave high single digit losses for the month. However to put that in context, we had had high single digit rallies in January, so year to date most equity markets are broadly flat. As previously discussed, much of this was centred around what I like to call ‘market mechanics’ rather than economic fundamentals. In particular the use of leverage through margin finance, call options and other forms of leverage meant that the January rallies were very momentum based and inherently fragile. In effect the traders from the ‘noise markets’ of currencies and commodities had made one of their periodic forays into the genuine asset markets of fixed income and equity, with the usual results. In particular the increase in leveraged trading came at a time when another market factor, volatility, was being treated (incorrectly) as an asset class in its own right, with ‘investors’ buying ETFs such as the now fatally wounded XIV inverse Vix ETF as a buy and hold momentum trade rather than as a hedging tool. When actual investors took advantage of the artificially low level of Vix, which rather than being seen as a ‘fear index’ is better regarded as the price of put options, the resultant rise in the price of put options, which had become increasingly cheap relative to calls thanks to the noise traders, exploded the pyramid of leveraged structures.
We are still seeing some aftershocks from this as trading balance sheets are shrunk and portfolios are repositioned and I wouldn’t expect much to change between now and the big March options expiry at the end of next week. Meanwhile, as discussed in our year ahead pieces, trends such as emerging markets (EM) and technology continue to do well, while the enthusiasm for so called cyclical and commodity stocks from the macro traders appears to have evaporated. US 10 year Treasuries have resisted breaking through 3%, but the US now has some of the highest bond yields in developed markets (DM), with last week’s US 2 year trading higher than Italian 10 year bonds! Perhaps more important is that US libor, which we regard as the price of ‘raw materials’ for the structured products that have emerged under QE, has broken up through 2%.
The Chinese National Party Congress (NPC) this week caught global attention mainly because of the announcements around the prospect of an end to fixed terms for Chinese Presidents. Even though Xi was already due to remain until 2023, the western media in my view became very excited about China’s ‘imperial ambitions’ and, as I discuss below, may well have been the trigger for the increased talk on tariffs. The reality is however that the US policy of containing China has shifted gear.
The period between the start of the calendar year and the end of the Chinese New Year holidays tends to be a busy one and I realise that in these first two months of 2018 I have been in the Americas, Europe, Asia, Australia and Africa. I haven’t been to the Arctic or the Antarctic, but with the so called ‘Beast from the East’ bringing severe weather into Europe from Siberia this week and the ’Polar Vortex Weather Bomb’ that hit New York in early January, I feel that they have come to me! The point is not a travelogue, but to highlight the different attitudes to China currently pertaining in each continent, particularly when people find out I live in Hong Kong.
In the United States, I think the prevailing attitude is a defensive one (see below). China is seen as a threat, but very much through the prism of the ‘old economy’, as this week’s announcements on tariffs on steel and aluminium highlight. In Europe, by contrast, and certainly in the UK, there seems to me to finally be a realisation that China matters. Partly this reflects the visible nature of Chinese tourism - especially at Chinese New Year - but also the growth in perceived business opportunities in Asia, particularly in the service sector. For the first time in the almost five years I have been in Hong Kong, people in the UK not only knew it was Chinese New Year, but also that it was the year of the dog. Blenheim Palace even staged a Chinese New Year festival, which while hitting the headlines for the wrong reasons caused visitor numbers to surge. In Australia, as previously noted, the mining sector already knows everything about the ‘old economy’ in China, but Australians are also advanced in understanding the opportunities offered by the 375 million (and growing) middle class Chines consumers. The same goes for much of the rest of Asia.
In Africa, however, I think it is still very much about the prospects for investment capital from China. When I was in South Africa last week, there was much talk about BRICs (Brazil, Russia, India and China) and how China would perceive the new government of Cyril Ramaphosa. On the one hand the Uber drivers (always a good source of anecdotes and in South Africa a necessity) thought that the levels of corruption of the previous government had got to what was essentially intolerable levels and that a Chinese style purge on corruption was not only likely but essential and would be a good thing. It seems that the water crisis in Cape Town has essentially been the catalyst that finally brought down the government of Jacob Zuma whose attempts to blame it on climate change or the previous apartheid regime were increasingly disbelieved, but it was interesting that the South Africans were not worried about what ‘the west’ thought, but rather what China did. However, on the other hand most of them seemed worried about the vote for expropriation of land without compensation. In this they are certainly in tune with mainstream investor opinion where the memories of similar policies in Zimbabwe are still raw, if not apparently in the calculations of the South African politicians. Here again, the attitude of the Chinese seemed to me to be seen as vital.
Against this background, it was interesting to read the latest edition of the Economist, which has an article about how the west got China wrong because they argue the west expected it to be a market based economy and eventually a democracy. Thus the argument goes, the fact that it is still state controlled companies running everything means that the west can’t compete, and thus not coincidentally is a justification for the west to impose trade sanctions since China is ‘not a market economy’ as set out in the World Trade Organisation deals. This story appeared at the same time as similar ones on Bloomberg and shortly before President Trump announced the prospects of trade sanctions.
I think the approach of imposing trade sanctions is unfortunate and a little ironic. Unfortunate in the fact that trade sanctions tend to benefit exporters and producers with powerful lobbying ability and disadvantage importers and consumers who have little political clout. Ironic in that over the last decade it is the west that has sought to fix prices while the Chinese have allowed them to play a far greater role in allocating resources. In particular the western central banks have sought to fix the price of capital with QE while western governments have sought to fix the price of labour with minimum wage legislation and even the price of land through differentiated tax regimes for foreign buyers in major cities. Sat here in China for the last almost five years since Xi notably said that “where the market can set prices it should be allowed to set prices” this all looks to me rather backwards. Certainly the state owned enterprises in China made a lot more profit last year, but that was because the government told them to cut back on over-capacity -the very problem the western economists had been flagging. But the two biggest names in Hong Kong / China last year were Tencent and Alibaba, both of whom are thriving on the basis of providing market derived products to the rapidly growing Chinese consumer. Perhaps what the western press and economists mean is that western companies have not been able to make money from the rapid growth of the Chinese middle class? I would suggest that the west only got China ‘wrong’ in that the Chinese refuse to behave according to the ‘Washington Consensus set of rules’ that have driven globalisation but seemingly have left many emerging markets stuck in the so called middle income trap.
This is not news to many of us in markets, but it certainly seems to have come as a shock to some of the geo-politicians and the broader concern we should perhaps now have is that many in the US administration and in the foreign relations departments and their associated think-tanks seem to be suggesting according to the Economist that “America now has not just an economic rival, but an ideological one too”. In my view, this shift to a multi-polar world with competing ideologies actually began after the Global Financial Crisis ten years ago, but it seems only now is it starting to influence US policy. The fact that the Trump administration appears to have back-tracked somewhat on the tariff announcements following revelations that they would actually damage ‘allies’ such as Canada and the EU is supportive of this. It also suggests that if the real motivation is containment of China then the US may revisit the Trans-Pacific Partnership (TPP) - which, remember, was originally formatted to explicitly exclude China. The TPP 11 (i.e. excluding the US) are meeting in Chile this week to sign the long delayed trade pact which will be cutting tariffs on old economy items such as steel, but much more importantly allow greater trade in new economy areas such as cloud computing and storage. In other words, trade between Australia, Canada, Japan and most of Asia is becoming easier and more importantly with a greater emphasis on less obvious new economy relationships. I suspect therefore that the US could once again shift policy and that this will include trying to engage with ideological ‘allies’ on new economy trading while also seeking to limit China’s involvement.
To return to China for a moment, in my mind it is no co-incidence that the most successful emerging economies of the post war era have been those that did not suffer from the so called resource curse and thus China was always more likely to follow the ‘North Asia’ model. Japan, South Korea, Singapore, Taiwan and now China have little in terms of valuable resources to export, indeed they need to earn overseas income (basically dollars) in order to purchase those basic materials from elsewhere. This has led to a more mercantilist set of institutions, aiming to grow a balanced economy behind a protective trade wall, the precious foreign exchange being controlled by central government to ensure sustainable access to basics such as fuel and raw materials. Compare this to the more resource rich countries of Africa and Latin America. Following the Washington consensus prescription of open markets, floating exchange rates and a form of democracy, power was concentrated in the hands of those who controlled the basic resources. This was the playbook for emerging markets for most of the post war period. Resource booms, followed by current account deficits as western imports were sucked in, requiring in turn capital account surpluses to balance the accounts. Primarily western bank loans - but latterly equity and debt - these were mainly denominated in US dollar, but fuelled a consumer boom, usually centred around housing and imported consumer goods that initially drove currencies higher (and thus made dollar financing look ‘even cheaper’) before the inevitable inflation pushed domestic interest rates higher, crippling domestic institutions but causing a final rush of western investors to chase ‘high yields and an appreciating currency’.
This is not ancient history, Japanese investors in 2010/11 spring to mind chasing 12% interest rates in Brazil with an ‘expected 15% return on a stronger currency’ on top. And to this they added leverage! The fact that the currency gain they were extrapolating reflected the very flows they were chasing seemed to elude the analysis, as did the fact that a 12% nominal interest rate reflected the fact that inflation was exploding. The currency was collapsing in value internally and yet they were betting (and that has to be the word) on it appreciating externally! It didn’t of course. The combination of higher nominal rates, inflation and an artificially higher exchange rate induced by the late stage money flows hammered the domestic economy, much of which was export dependent, so we got the seemingly inevitable bust. The currency collapsed, killing the carry trade and the reversal of capital flows made this even worse. Inevitably, those capital outflows included those of the elites who had secured most of the benefits of the boom time with the ongoing tales of corruption and political misdeeds as well as the reality that the emerging economies are starved of long term capital until the next resource boom comes around. The domestic industry remains very low value add while the resource industry once again resumes power and control. Along the way, banks and other institutions are bailed out - often by the western institutions such as the International Monetary Fund (IMF) and World Bank - while capital market participants take a huge loss, raising the cost of future capital. Sadly this bust period often involves violence and political instability, which equally sadly tends to get overlooked next time the resource boom arrives.
Emerging markets investors therefore tend to be highly pro-cyclical, looking to chase demand in order to capture the profits on the upturn, hoping to get out before the downturn. However, I would argue that for countries such as Brazil this last time there was another factor, China. The boom was not caused by a traditional western economic cycle, but by China and thus the usual obsessions with the Fed, non-farm payrolls and the dollar as lead indicators did not work nearly so well. At that time, Vale, the iron ore miner and major beneficiary of the China inspired commodity boom hit 60, helped by the flow of funds and enthusiasm for all things Brazil. However, not only did Chinese demand for oil and iron ore subsequently slow down, but the scramble by western capital markets to invest in new supply - Australia for iron ore and US shale for oil and gas caused a sharp fall in prices and Vale, among others halved over the next two years. In dollar terms of course the result was even worse, the American depositary receipt (ADR) on Vale went from a peak of $35 in early 2011 to a low of just over $2 five years later. Thus traditional EM countries had a recession, but China did not, contradicting the widespread predictions that it would do so.
The reality is that the Chinese government knows all this, which is exactly why they prefer the North Asia route of a balanced economy behind a trade barrier, rather than being an export factory of low value added goods to the west. The frequent appeals to open up the exchange rate and the capital account look to the Chinese (and to me) as utterly self-serving, while the demands to allow greater access by powerful western multinationals bring forth (again in my view quite rightly) a response of “what’s in it for us?” As previously noted, the analysis from western hedge funds that China must devalue by 40% to protect its export growth looks both narrow and somewhat naive in this context.
So to conclude. Bond yields look in an uptrend as QE unwinds and a degree of normalisation returns to interest rates, while equity markets remain (largely) in uptrends, supported by growing cash flow. Between now and the big March derivatives expiry next week however we would anticipate continued volatility as hedging by long term investors combines with deleveraging and rebalancing by the trading funds who stimulated the roller coaster rides of January and February. This was very much market mechanics and the unwind of low volatility structures in early February was far more important a factor than a sudden change of views on inflation or any other fundamentals. Talk of renewed trade wars and tariffs from the US looks to me to be more about geo-politics and could do more damage to Europe, Mexico and Canada than China. As such I would expect a dialling back on this rhetoric and a pivot to other ‘controls’ to Chinese growth, such as limiting Chinese M&A or other interactions with the west, while at the same time re-engaging with perceived ‘ideological allies’, such as the TPP-11 who meet this week and are discussing greater co-operation in areas of the new economy rather than worrying about raw materials and semi manufactures.
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