Market Thinking - In 2018, thematics endure, but cyclical winners and post QE losers offer opportunity

Market Thinking - In 2018, thematics endure, but cyclical winners and post QE losers offer opportunity

13 December 2017
  • To link macro to micro it helps to think about balance sheets as well as cash flows. Central banks will only shrink their balance sheets if other sectors can expand. North Asia’s balance sheets are the strongest in the world and China is all about restructuring theirs.
  • Structural tailwinds from China include financial sector restructuring but also (inter alia) digital consumer, robotics and automation, and One Belt One Road infrastructure spending. Thematic investment strategies favouring companies that benefit rather than fight these trends remain appropriate.
  • Long term themes endure, but, as last year, it is worth a contrarian view on some of the most loved and ‘most hated’ sectors.
  • Bitcoin is like Chinese equities, a market phenomenon disguising a meaningful and highly disruptive economic change (the blockchain). Hidden leverage, volatility, instant riches for some and massively energy intensive, people are talking about it without really accepting it as a reality.

Year ahead pieces are often quite macro, ranging from rotational trades – sector or country – to longer term thematics. Positive GDP forecasts tend to lead to calls for ‘risk on’ and vice versa, which often leads to reverse engineering. Bond houses are usually gloomy and equity houses optimistic. It also tends to miss the impact of operational gearing and relative pricing power by equating a nominal GDP forecast to the aggregate level of profitability for the relevant index, rather than regard it as a backdrop against which different companies can thrive or struggle, which is why I have always found bottom up aggregations more useful. In recent years however rather than affecting asset allocation these macro  views tend to appear within asset classes - in rotation between cyclicals and defensives or in credit spreads and duration trades. Inflation forecasts tend to lead to predictions on policy and yield curves, even though the two have not correlated for many years now, which in turn tend to lead to currency forecasts. While this all serves to satisfy the internal modelling needs of many institutional investors matching forecast returns and existing liabilities, it tends to be less helpful for absolute return and equity investors and in particular can give a degree of false certainty. Meanwhile in years like 2016 and 2017 they also generate a lot of cynicism as almost all the asset class predictions from the macro turned out to be wrong. Investors are looking at the consensus bearishness on Asia a year ago versus the optimism on the dollar, higher Federal Reserve (Fed) rates and the Trump trade and wondering if this year’s consensus will be equally wrong. For what it is worth, we believe the forecasting frameworks are necessary but not sufficient, that many of the important thematics will continue to play out in 2018, but there may also be some tactical value in challenging the consensus in certain areas.

Importantly, it is less that the consensus macro forecasts were wrong, (although China certainly was) but rather that the read across to markets and the concept of sustainable earnings went missing. One framework that we like to use to connect top down and bottom up is what I refer to as our Balance Sheet Framework. I have used this for many years now, but as a brief refresh, the concept is that just as no bottom up analysts would try to predict sustainable earnings growth without considering a corporate balance sheet, so long term sustainable economic tailwinds need to be rooted in a sustainable balance sheet framework. If GDP growth is coming from increased leverage in the system, it is not only less sustainable, but increases the risk of a liquidity shock. An obvious point perhaps, but one that is rarely discussed, such that too often we confuse short term, leveraged growth (think US, UK and Irish housing related consumer booms) with longer term structural growth. In a sense it is akin to the Dupont Approach to deconstructing return on equity (RoE) used by stock analysts. Is the RoE coming from asset turn, profit margin or leveraging the balance sheet? It matters to our bottom up earnings forecast and should matter to our macro forecasts as well. In an economy we need to consider four balance sheets: consumer, corporate, government and financial sector. Obviously since the financial crisis we have seen the biggest expansion as being in the government balance sheets – most noticeably the part controlled by the various central banks. This has been necessary because of the shrinking of the balance sheets elsewhere in the global economy, notably the consumer and financial, but also in many cases the corporate sector. For governments to walk away from un-conventional monetary policy next year therefore requires a belief that the other balance sheets are no longer shrinking and that the existing stock of money actually starts to increase its velocity of circulation. Thus the Fed and the European Central Bank (ECB) will not abandon quantitative easing (QE) unless they see velocity of money pick up and balance sheets elsewhere stabilise and take up the slack. Obviously the other part of the government balance sheet could do so – which is why US tax cuts and possible infrastructure expenditure are equated to a shrinking of the Fed’s balance sheet – but in my view the caution we have seen by central banks for so long is precisely because they doubt the sustainability of economic activity due to continuous de-leveraging, notably by the consumer. With no balance sheet expansion and little in the way of real income growth it is hardly surprising that demand in much of the west remains sluggish.

Unconventional monetary policy has unintended consequences of course and we are already into a form of unwanted feedback loop as QE has encouraged US corporates in particular to expand their balance sheets and retire their equity, increasing their interest rate sensitivity at precisely the wrong time. Possible changes in the tax regime (notably limiting interest relief) could shift this however and could be one of the surprises for 2018 – the Organisation for Economic Cooperation and Development (OECD) action plan on Base Erosion and Profit Shifting is still out there and despite its boring sounding title could be a shock to many if it is enacted. It would certainly have potentially serious ramifications for the private equity model for example.

In Asia, the balance sheets are in a very different position. There is very little tradeable corporate debt as bank lending still dominates and post 2009 there has been a tendency to hoard cash. Balance sheets are generally very strong and payout ratios are low but rising making high yielding equity a very attractive (sub) asset class in our view. Government balance sheets tend to be split North versus South, with surpluses in the North and deficits (often in foreign currency) elsewhere. Households similarly. The biggest balance sheet of all of course is China – incidentally few people realise that the People’s Bank of China (PBoC) balance sheet is 20% bigger than the Fed and that they actively direct it rather than providing ‘guidance’ – and here the key insight is that there are only really two balance sheets in China at the moment, not four. There is the household sector and the government sector, the latter including most corporate debt and the financials. This is a key reason why we are relatively relaxed about the ‘debt problem’ in China. The household sector is relatively un-geared, helped by the fact that they own their own homes and have not had a leveraged housing bubble in the traditional boom/bust western inspired ‘development’ model. Meanwhile, most of the corporate debt is in the State Owned Enterprises (SOEs) and is thus really a form of government debt. Finally almost all of the debt is ‘owned’ within China as opposed to borrowed in US dollars from western banks, similar to other North Asian economies that have defied the western consensus and not collapsed.

The Chinese economy is thus about restructuring but also about cash flow. Corporate profitability is rising as policies shift away from simple sales growth, which has restored pricing discipline and is why the producer price index (PPI) stabilised and rose this year, while real wages continue to grow 8-10% fuelling the consumer. The co-ordinated global growth we have seen this year is largely a function of the demand this is putting into a world that was operationally geared to profit from a pickup in sales. This is a key reason why profitability has been stronger than expected and why markets are higher. In my opinion these trends extend into 2018.

Our structural focus here in Asia therefore remains on the Chinese policy developments and how those balance sheets are carved out of the government sector. The four key thematics remain: China 2.0 (the development of the Chinese consumer, especially digital), Made in China 2025 (the move up the value chain in manufacturing, particularly automation and robotics), the development of Chinese Capital Markets (away from bank dominance to asset backed securities, mistakenly termed deleveraging) and One Belt One Road, the recycling of China’s vast savings surplus into cap ex and infrastructure projects throughout Asia. These are our economic tailwinds, companies with exposure to these areas have a better prospect of generating supernormal profits than do those fighting these trends. It is clearly possible to make cyclical profits while being on ‘the wrong side’ of these trends, but generally we regard this as uncompensated risk.

There are of course other thematics, but one thing that we notice is that this time China is leading rather than following the rest of the world. Far from America sneezing and the world catching a cold, it is China that is setting the marginal demand. We do have synchronised global growth, one only has to look at the export sectors of Korea and Taiwan for that, but China is at the heart of it. The best performing US and Japanese companies in terms of earnings are exporters, particularly of products designed to make Chinese factories smarter and more automated. By contrast, as Louis Gave of Gavekal pointed out to me recently, the western model of ‘platform Companies’ – a terminology Louis came out within 2005 - may now have run its course. The idea that the western multi-national focussed on design at one end and marketing at the other while outsourcing the physical manufacturing (and resultant cyclicality) to emerging markets (EM) and especially China may be under threat as the increasingly smart factories in Asia start to take pricing power. One example that Louis gave was Apple, who rely on one of their biggest rivals, Samsung, to produce the LED screens essential to its latest high margin phone, the Model X. Another was the problems that Elon Musk appears to be having with manufacturing in scale. As we discussed last week, China is using its factories in China to make things for the rapidly expanding domestic market, which western companies are struggling to get a foothold in, while simultaneously exploiting existing EM manufacturing bases such as Vietnam and Cambodia to export Chinese designed products into the west avoiding trade tariffs. The frustration that many western companies express about China’s need to allow them to invest and make money in China is something we have noted before, along with the response from China, which is effectively that ‘we don’t need you, or your money’. This is absolutely key to understanding China, unlike traditional emerging market development, it doesn’t need western capital, or increasingly since 2009, western capital markets.

Meanwhile Chinese real wage growth rather than a traditional housing based EM leveraged boom is the key to sustainable consumer demand. In my view the perpetual anxiety about Chinese debt completely misses the point, the consumer is hardly leveraged while the State Owned Enterprises represent the bulk of the corporate debt, which is thus really government debt that is being restructured as part of the development of Chinese capital markets. The digital consumer trend is as much bottom up as top down (although naturally they tend to blur somewhat in China).Tencent and AliBaba may have dominated the market headlines, but they also reflect a powerful digital trend, especially amongst the Chinese middle class who now outnumber the total population of the United States and are fast approaching that of Europe. Almost nobody uses cash these days in Tier 1 cities, while taxis here in Hong Kong that have long resisted taking credit cards are increasingly signing up to WeChat pay and Alipay. As the country moves to become almost cashless – without the disruption caused by the top down attempt in India to do the same - the Chinese internet giants will also undoubtedly capture the bulk of much Chinese spending abroad as businesses that currently insist on Visa and Mastercard realise the need to adapt to their new and biggest customer. Stocks focussed on digital are disrupting traditional business models and keeping out overseas competition. This will be an increasing source of tension between China and the west I believe as multinationals pressure for ‘the right’ to compete in the Chinese market.

For our income focussed strategies, we continue to like the strong balance sheets, low payout ratios and powerful operational leverage to cashflow available here in Asia. While the evolution of the capital markets will deliver us a lot of interesting future opportunities in securitised assets – infrastructure, real estate investment trusts (REITs), local government bonds, corporate bonds – for now one of the most attractive ways to capture the strong corporate sector in Asia is through equity and particularly equity income.

More tactically, one lesson from 2017 was that ‘value’ can work as a powerful factor in that the noise in markets can deliver an excessively high risk premium as the consensus deserts a sector or an asset class due to ‘risk’. As noted many times this year, if one had bought everything the consensus hated last January – China, Japan, emerging markets, Europe and sold everything that they loved, US dollar, commodities, bonds, Trump Trade inflation stocks, then the relative performance would have been extremely impressive. For such a trade to work again next year would require that the market was positioned in a relatively extreme way for ‘risk’. Looking around and reading all the year ahead notes coming across my desktop (all digital these days thank goodness, the days of boxes of hard copy ‘books’ arriving on Christmas eve are long gone) I would suggest a few of the following for the contrarian. Note that in contrast to last year when the risk premium was high but the narrative largely wrong (in my view), most of these below are simply that the existing narrative is already heavily enforced in prices.

Volatility. The XIV inverse VIX ETF is up 180% on last year and 324% on 3 years. It is like a momentum stock and is distorting capital markets. Seemingly everyone is ‘earning premium’ by selling volatility a phenomenon last seen in 1987. The Fed withdrawing from buying mortgage backed securities means that the new (traditional) buyer will once again resume duration hedging which the Fed did not do. This should increase volatility and yields at the long end of the bond markets and we may find this spreads to equity. Contrarian buy.

The UK market seems to generally be out of favour and the polarisation of the whole Brexit debate means that those who oppose it have structured a rather powerful negative narrative that has put a risk premium on UK assets far higher than was on Chinese or EM assets a year ago. Similarly the long term negative narrative on energy and oil stocks is now so powerful that despite oil prices remaining firm due to higher risk premium around conflict, energy stocks continue to trade with a very high risk premium, especially in the UK.

The European Equity Market surprised to the upside in 2017 as high political risk premia came down and overseas earnings were strong thanks to China and an earlier weak euro. While China remains the other two are no longer present yet European based brokerages are very positive on market returns for 2018. Also we have a potential resumption of political pressures with Italian elections early next year.

Asian Equities. Despite doing extremely well last year, Asian equities (including Japan) remain underweight in most international investors’ portfolios, much of it still based around an enduring bearish view on China (which we don’t share). At some point these underweights will be closed. Tips or other inflation linked products. Cyclical inflation is creeping back in, even though the deflationists insist it is not. Commodities such as copper or shipping (the Baltic Dry index has broken out) can offer some strong tactical upside. Trump Tax Trades. The majority of US consumers will not benefit much from lower income taxes as few pay them while the actual rate paid by corporates is not that different from the new, proposed, lower rate. The idea that lots of money will be brought back onshore also ignores the reality of global banking. Since 2012, Apple’s offshore cash position has increased by $147bn, but its onshore debt has increased by $115bn as it borrowed onshore US dollars and bought back its own shares.

Private equity and unicorns. Everybody loves private equity, almost as much as they love low volatility products. Our reliable long term ‘Petrus Indicator’ (who are the guys buying the Petrus in the restaurant?) confirms that the private equity sector is currently scalping the most fees in financial markets as it’s ‘no need to mark to market’ model that drives returns from leverage and an illiquidity premium continues to attract large scale institutional flows. The need to source value and the need to realise value as well as the need to sustain leverage are all increasingly difficult, not least because as mentioned earlier the favourable tax treatment could change. Meanwhile the unicorns, valued at billions by venture capitalists after only investing millions are starting to face reality.

Finally, bitcoin. This is not so much a contrarian call on cryptos as a wakeup call to the concept of co-ordinated GDP growth producing profitability across the board. In looking at the year ahead it is always useful to distinguish the cyclical from the structural and as we put it last week, the signal from the noise. In that sense the huge noise around bitcoin as we move into year-end needs to be separated from the underlying signal. Last week we discussed how the emergence of capital markets enabled ‘capital’ to be applied to labour and land to enhance the productivity of both and thus lead to economic growth, a process that has not only led to four industrial revolutions – or one continuous one if you care to look at it a different way - but also one that has created multiple financial crises along the way. One of my favourite short reads on financial markets is ‘A short history of financial euphoria’ by J.K. Galbraith in which he examines speculative booms over the last three hundred years, from the invention of the joint stock company – which gave us the south sea bubble – to commodity margin trading - which led to the tulip bubble – up to the junk bond boom/bust of the late 1980s. Obviously we have subsequently had the dot com bubble and the great financial crisis, but Galbraith’s point remains valid. The common feature of all of them is gearing, the ability of ‘investors’ to leverage their positions that offer the illusion of great gains on the way up and the reality of large losses on the way down. All about the balance sheet, not the cash flow. Equally the common factor is that they all represented a structural shift in the structure of capital markets.

On this basis I have not been so worried about bitcoin as some pundits declare themselves to be. Principally because the one classic bubble indicator it has not exhibited so far is leverage – although the arrival of bitcoin derivatives is just about to change that. Thus when asked on a Sky TV interview last week if bitcoin was ‘keeping me awake at night’, I was able to say no, although I got the sense that the panel in the studio would perhaps have liked me to join in the more general finger wagging and gloom. I described the currency as ‘digital gold’ in so far as it is an alternative currency, not that it is necessarily a stable store of value and also to contrast it with other crypto currencies such as ethereum, which are more a form of digital oil or other commodity. To my thinking, the real significance of crypto currencies is what they highlight about the new underlying technology of the blockchain. As with other bubbles (if that is what it is) the crypto currency world and the Initial Coin Offerings are another example of how the markets evolve to raise capital for new ventures and just as the dot com bubble fuelled real world investment in the internet with all its subsequent disruption, so the crypto bubble is fuelling investment in the blockchain and that is where we should be focussing our thinking.

In that sense the crypto currency world is rather like watching the Chinese stock market. Lots of (other) people seemingly making a lot of money very quickly, attempts by the authorities to restrict the use of leverage producing sudden crashes but underneath it all an emergence of a new capital markets landscape and genuine economic disruption. To extend the analogy further, we now discover that there has in fact already been some hidden leverage in bitcoin – the Japanese in particular have effectively been trading a form of betting on the price of bitcoin – so that there is already something of a leveraged bubble in play and that the growth in bitcoin mining (we discussed this a few weeks back) is actually incredibly energy intensive due to the computing power required. We also discover that the ownership of bitcoin is very narrow, according to AQR, just 1000 people control over 40% of the world’s bitcoin, including we were intrigued to see this week the Bulgarian government, who discovered they own 200,000 bitcoin as a result of seizures from criminals (worth around $3bn depending on which day of the week you do your calculations). The mysterious founder of bitcoin, Satoshi Nakamoto, is the likely owner of the biggest account, with almost a million bitcoins. In terms of whether it survives, no one really knows, but to my mind there are two main threats beyond the obvious risk of a simple collapse in confidence. The first is that governments regulate it out of existence. The second is much more scary, the arrival of quantum computing. Tech giants such as IBM and Microsoft are working at a furious pace on this and the possibilities are quite mind boggling. Essentially it will be possible to crack ‘impossible puzzles’ because a 300 Qbit computer (which they are building) has the equivalent of 2 to the power 300 conventional bits. It is exponentially faster than a conventional computer. To put that in context, an iPhone 6 may have the computing power of 1 billion bits, but a 300 Qbit quantum computer has 2 to the power 300 bits, a number equivalent to the number of particles there are in the universe(!) The basis of encryption is that the key is an ‘impossible to break’ puzzle based on computing power, so obviously we will be needing to move to a post quantum encryption world. This is not impossible, but if someone develops the quantum computer before we change our encryption algorithms, it could be very messy. 

Thus to conclude. 2018 should continue to favour the powerful multi-year trends we have seen emerging over the last two years. China is at the heart not only of Asian demand but the cyclical global recovery. Moving up the value added scale (China 2025), One Belt One Road infrastructure spend, the emerging Chinese digital consumer (China 2.0) and the restructuring of the Chinese government and financial sector balance sheets all provide tailwinds for our robotics, automation, digital consumer and income strategies. While the west focuses on the ending of quantitative easing, which will only happen if household and corporate balance sheets stabilise and cashflows improve, Asia has de-coupled and is driven by strong corporate cash flow and real wage growth. Because it is now adding net demand rather than net supply to the world, Asia will deliver a wider inflationary pulse which could present a dilemma to western central banks as consumer price indices rise. This in turn could present a challenge to some of the financial sector models based around leverage and low volatility that have emerged as favourites for investors since the financial crisis happened and QE began. Cyclical winners emerging and structural winners failing thus could provide most of the opportunities for contrarians in 2018.


Note to editors

All data sourced by AXA IM as at Wednesday 13th December 2017.

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