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Market Thinking - Back to School. History lessons needed.

Market Thinking - Back to School. History lessons needed.

Insight
30 August 2017
  • The markets have endured a bout of summer volatility to emerge largely unchanged. This is encouraging for those of us concerned about the potential fragility of a system overly geared to low volatility trades.
  • Because the dollar and rates went down instead of up as anticipated at the start of the year, US (and dollar pegged) overseas earnings have been stronger than expected. The strength of the euro, is starting to become something of a headwind for European corporates however.
  • One Belt One Road (OBOR) is transforming Eurasia, economically and culturally. Visiting western Russia, it seems very European, with little evidence of sanctions beyond an absence of American and UK tourists. There were however plenty of Germans, Italians and huge numbers of Chinese.
  • Along with greater economic co-operation across Eurasia, the recent Chinese move to price energy and also gold contracts in RMB  is a hidden but hugely important step in the ending of the petro dollar and dollar reserve currency status.

August is traditionally the quietest month in major markets, albeit with the ability to spring a few surprises. This year was true to form and while we certainly had some volatility - not least in the volatility indices - the summer break sees investors returning to markets not looking much different from when they left and wondering why some of the people left manning the desks look so exhausted. Broadly the earnings season has been positive, perhaps most surprisingly in the US although much of that reflected the weaker dollar impact on overseas earnings. The dollar of course was supposed to be strong and interest rates were supposed to be rising this year, when in fact the complete opposite has happened. This has helped support US indices, but also dollar linked countries such as much of Asia.

The market had several attempts to unwind the low volatility trade, leading to some choppy trading. The fact that equity markets recovered is actually quite encouraging on the basis that it was contagion and portfolio insurance unwinds that represented the biggest threat in my mind. If this is letting the air out rather than bursting a balloon then that is a good thing. If I am a bit more relaxed on equity, I am still nervous that the low volatility trade has extended to other markets, notably the traded prices markets of currencies and commodities. The reality is that there are no long term buy and hold natural buyers of these traded prices markets, only traders and speculators. Despite some attempts to classify them as such, currencies and commodities are not really asset classes and thus a shift in speculation can trigger a sharp spike in volatility. Given the leverage in these markets, a short volatility position could become extremely painful extremely quickly.

When you slip and break your ankle on the second day of a walking holiday in the French Alps, then things quite literally take on a different perspective. Not only is mobility restricted and exhausting on crutches or limited in a wheelchair, but one simultaneously becomes both more and less visible. Most people are kind and hold open doors, offer to take you to the front of any queue and so on, but a large number are dangerously oblivious to their surroundings and will quite literally walk into you, which can be very painful! To try and extract a market metaphor from this, I suppose it really means that not only should we not take everything for granted (complacency) but we need to look at the world from other investors’ viewpoint as well. For example, it is all very well to say that bond yields should rise because inflation is picking up, but for a manager with a fixed income mandate the question is ‘where?’ they are in the market, no ‘if?’ Equally, it’s easy to say that ‘equities are expensive’, but an equity manager is also simply deciding where not if. Moreover, if it is a tracker fund it is not even making that decision. Asset allocation dominates investor discretion and valuation is only relevant in so far as it changes that (slow moving) decision. The fact that the people claiming that equities are expensive  or that bond yields have to rise have been saying so almost continuously for 30 years makes it difficult to decide when ‘the market’ is going to believe them.

This touches upon an important phenomenon in markets that our historical/econometric models struggle to cope with; the shifting structure of market ownership. When equity markets are dominated by US mutual funds, or bond markets by European insurance companies, or currency markets by hedge funds, then the ‘rules of engagement’ can be observed, modelled and hopefully predicted. Much chartism is based on price signals giving us a clue to the rules of any particular market at any particular time. Index funds for example will tend to enhance momentum and their market cap weighting will tend to push liquidity into larger stocks, while driving correlations up sharply. On the other hand, ETFs and thematic investors can lead to increased stock volatility as relatively illiquid stocks get hit with large orders on both sides. Here in Asia we are observing an important phenomenon in terms of individual investors, particularly but not exclusively, via the private banks. Unlike insurance companies and mature pension funds, they are less concerned with asset liability matching in a mechanical sense and obviously have no regulator determining what assets they can hold. Moreover, as long term investors looking for growth they are far more interested in growth stocks and hence diversified portfolios of thematic growth equities than in holding fixed income. The behaviour looks and feels very similar to that of the US nifty fifty era of growth stocks and mutual funds - suggesting a new set of rules of engagement need to be added back to our modelling.

The other ‘different perspective’ that I got over the last few weeks came from the second half of my ‘block leave’ -  a trip to St Petersburg (in the wheelchair) to catch up with my son who was there at language school. As with China, most of our understanding in ‘the west’ of what goes on in Russia comes from western media and given the extent to which I have found over the last four years that the western narrative on China is flawed, so I was open to a different perspective on Russia. And so it proved, at least in the relatively short time I was there. St Petersburg is one of Russia’s most westerly cities and is probably its most western in outlook. For a European capital (it was capital of the Russian Empire up until the revolution and is the fourth largest city in Europe) it is relatively new, having been founded in 1703, but the historic centre remains very much as it was in the time of Peter the Great. Nothing is allowed to be taller than the Winter Palace, i.e. about seven stories, so none of the now ubiquitous concrete steel and glass towers that now homogenise so many cities. Well not exactly intact, more heavily restored. After the 900 day siege of Leningrad (as it was known at the time) there was extensive damage, but this has all been gloriously restored, particularly in the last 10 years and, not coincidentally because Mr. Putin comes from St Petersburg. Perhaps partly for this reason, Mr. Putin is extremely popular in St Petersburg. As my son reported, the middle class highly educated family he was staying with all love Putin.

So the first set of perceptions that were changed are that St Petersburg was prosperous, very attractive, clean, friendly and welcoming. The staff around the tourist industry spoke very good English and the food was international and extremely good. High end restaurants were London prices (with the occasional hilariously overpriced ‘prestige’ wine) but middle level restaurants were great value and high quality. Lest we forget, Russia is an agricultural country and used to provide much of the food for Europe, so the quality and freshness of ingredients was obvious - especially to anyone used to Hong Kong! Indeed last year Russia surpassed the US as the world’s largest wheat exporter and this year’s grain crop is set to hit new records making Russia the dominant supplier of wheat to Egypt, the world’s biggest importer. Speaking of trade, there was little or no evidence of sanctions and the only real discussion about them came from other western Europeans – notably Italian and German – who were angry about the latest US attempts to increase sanctions (affecting European exporters) on account of allegations about  Russia and the US presidential elections. “What” they asked “was it to do with them?” It certainly felt like the US has reached its limit wanting Europeans to impose sanctions. There was evidence of sanctions however in the deliberately complex visa process. It took my wife almost a month and much agony to get a visa (including biometrics and extra-ordinarily extensive questionnaires) from London, whereas my visa, also a UK passport but obtained via Hong Kong, was relatively simple. (The answer is to go on a 72 hour, no visa, trip by ferry or cruise liner). Not surprisingly therefore there were very few Americans visiting, apart from a few cruise passengers, nor many Brits. There were however a lot of Italians, Austrians and Germans and lots (and lots) of mainland Chinese, which was my second change of perception. From a geo-political perspective this ought to give the US pause for thought, especially if they are students of British Victorian era writer Halford Mackinder’s Heartland theory or US academic Nicholas Spykeman’s adaptation of the Rimland theory or even former US security advisor and geo-political guru Zbigniew Brzezinski’s Grand Chessboard concept all of which stress the importance of the Eurasian heartland to world power. Certainly from my visit and talking to people, Russia appears to have little conflict with either Europe or China, indeed they are enthusiastically embracing the forthcoming One Belt One Road (OBOR) initiatives that will bring them closer together. US sanctions on Russia and their activities in the South China Sea are actually driving China and Russia closer together and the OBOR initiative is intruding exactly the system of roads and rails that Mackinder foresaw as shifting power from Rimland and maritime powers to heartland powers. Certainly when I read the Grand Chessboard back in the late 1990s it was seen by many as a blueprint for US world hegemony and has certainly been either prescient or self-fulfilling depending on your viewpoint. The extent to which these theories persist under President Trump is one of the key questions for the region.

Meanwhile, economically the impacts are growing. In April this year for example, the first train of Russian wheat was sent to China and China’s state owned COFCO foodstuff conglomerate announced that this year’s planned target of 1m to 2m tonnes may well double in the near future. Economically, the mainland Chinese tourists are not doing much so far for the local economy despite their numbers. Most seem to be mid to low end rather than high end luxury goods chasing high end types. They arrive with Chinese owned travel agencies, stay in Chinese owned hotels and eat at Chinese owned restaurants. They also shop in Chinese owned souvenir shops - and have accordingly pushed the price of amber (the Amber Rooms in St Catherine's Palace just outside St Petersburg are a major attraction) through the roof. The real benefit however is likely to be the soft power aspects. In May this year, Presidents Xi and Putin signed a cooperation deal between China and the Russian led Eurasian Economic Union (Russia, Kazakhstan, Armenia, Belarus and Kyrgyzstan) that is likely to increase ties, spur foreign investment and shift China’s trade away from sea towards more land based initiatives. It may also let the EU bypass some of the Russian sanctions. Incidentally this week Egypt declared an interest in free trade deals with the Eurasian Economic Union.

One other aspect worth watching is the behind the scenes moves by China to price assets such as oil and gold in renminbi (RMB) rather than in dollar as a step to further internationalise the currency.  Note that this week Saudi said it was considering raising debt in RMB – which makes sense as China is one of the biggest buyers of its oil. Equally Russia is said to be considering accepting payments in RMB for its gas. This of course has profound implications for the concept of the petro dollar that undoubtedly will have the gold bugs excited, especially as my good friends at Gavekal point out because the Hong Kong stock exchange has announced that investors will soon be able to buy and sell gold contracts in RMB. This means that having accepted payment for oil or gas in RMB, the seller, be it Russia or Saudi (or anyone else for that matter) does not have to worry about having excess RMB, they can simply trade it back into gold. At no point does the dollar or the US banking system become involved. If the US geo-political strategists aren’t currently worrying about the ‘heartland theories’ of allowing Russia, China and Europe to come together, they will certainly start to worry about the loss of what former French President Valery Giscard d’Estaning referred  as “The exorbitant privilege” of being the international reserve currency.

We are moving to a multi polar world more rapidly than many realise and it is unlikely to be smooth.

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

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