Midterms to dominate headlines, but there is structural growth in the long termMarket thinking 07 November 2018
Mark Tinker, Head of Framlington Equities Asia, comments on US Markets:
- Traders are obsessing over the midterms, but realistically have not been behind market behaviours so far, and are unlikely to significantly impact direction of policy or economic fundamentals even in the US, let alone globally.
- The recent rallies have an air of short covering about them and the bears are likely to double down on the noise. However, we are rapidly approaching Thanksgiving and it is likely that markets will continue to deleverage. This can mean that speculative longs, like Oil, can sell off even as speculative shorts are squeezed.
- Lowering liquidity tends to lead to higher volatility, but this can be a good time to focus on quality fundamentals. In Asia that can mean high quality equity yield plus growth strategies offering close to 5% yields.
After a fairly torrid October offering lots of opportunities for commentators to talk about Halloween Horrors and what they are scared of and so on, markets have recovered a little of their poise over the last few days, no doubt reflecting some short covering as more positive noises have been made over the Trade War between the US and China. The sharp moves in response to broad headlines are symptomatic of a market dominated by shorter term traders and as such this current situation has been equal and opposite to that which we saw twelve months ago.
It is interesting the correlations that we discussed previously are holding – the Australian dollar for example has duly followed the Chinese markets higher. At the start of this week, much of the commentary from the Investment Banks serving those traders is doubling down on the negative side, but it will be interesting to see if, having in many cases been squeezed out, the traders have the conviction to step back in on the short side. The rapid approach of Thanksgiving may give pause, as traditionally a lot of US hedge Funds and leveraged players like to flatten their books between Thanksgiving and year end. Last year for example, when everyone was bullish about China, the FXI US Equity ETF, which as we discussed before acts as a reasonable proxy for US investor enthusiasm over China, rallied 10% from the beginning of October 2017 up to Thanksgiving before giving almost all of it back into year end. It then rallied 17% in January as the leveraged traders returned, before getting caught out in the volatility spike in February. My sense is that after a June sell-off by asset allocators and a basically flat q3, the noise traders returned in early October, but this year on the short side. The FXI dropped 11% from the start of October until the short covering rally began last week. We shall see if they can succeed in talking it down again.
The US midterm elections are usually a time when voters ‘send a message’ to the incumbent President and the overwhelming consensus is that the Democrats will take the house but not the Senate. Should that occur, (although these days elections have a way of not conforming to the polls) then I would suggest little will really change. US politics will remain hugely partisan and as happened during President Obama’s second term, President Trump will likely continue to use executive orders to enable policy. International investors may see some dialling back of the rhetoric on trade, since although being tough on China is seen as a ‘winner’ with US voters, delivering a solution will be a better strategy ahead of the next Presidential Elections. Should the Democrats also take the Senate then we can look forward to two years of inward looking politics focusing on impeachment, Russia, and healthcare, and President Trump may choose to go for an ‘all in’ approach. Another, albeit unlikely, possibility is that the Republicans hold both houses, at which point many people will have to recalibrate their future plans This would obviously include the Democratic Party strategists in selecting their candidate, there is a very real possibility of a high profile independent candidate running for the party nomination – what would Bernie Sanders do for instance?
Having said all of that, I believe that the long term path of (hopefully) ‘friendly conflict’ between the US and China is already set and will dominate the investment background for the next decade in the way that QE has dominated it for the last ten years.
Last week we also noted that the oil complex had joined the rest of the markets in breaking its long term moving average and was thus liable to some forced selling. That has continued this week even as other markets rallied, likely as leveraged players cut positions. Speculators have certainly cut their net long positions to the lowest in a year and headlines over US oil production and easing tensions with Iran, just ahead of the threatened commencement of sanctions on November 4th, accelerated the selling. The announcement of (apparently temporary) waivers for 8 countries last week came after several months of speculation and are thought to include India, South Korea, China, and Japan, although details are still scarce. It would be interesting if the list also includes Turkey, which, as a large net importer of oil, has seen a dual threat from a much weaker domestic currency and a perceived tightening of supply. This pushed oil prices significantly higher earlier this year, and Turkey at the time was very much the poster child for emerging market distress earlier this year.
The US dollar of course is the other big ‘noise trade’ and is currently very interesting, more for what it isn’t doing. Despite all the calls about US interest rates, nonfarm payrolls, everywhere (else) being terrible, and so on, the trade weighted index is not rising. We are watching the JP Morgan emerging market currencies index closely – currently attempting to break up through its short and medium term moving averages – for signs of a bottoming, which as we discussed previously is needed to restore any confidence to emerging market investors generally.
In a presentation I made this week to a large group of Australian fund advisors here in Hong Kong I deliberately refrained from using many numbers, since my own experience as a member of the audience at conferences is that it is the ideas that are what you take away not the numbers. Pictures – and graphs – are what tell us the story. In notes like this however, numbers can help tell the story.
Thus, the fact that Yu’e Bao, the cash management account for AliPay (the name literally means left over treasure and is in effect a money market fund) had reached $268billion by the end of March this year made the Tianhong Fund the fund that manages it the largest money market fund in the world, and prompted Ant Financial, part of AliBaba, to add two more funds to the platform to diversify liquidity risk. What is also very important though is that, as with much in China, this number is made up by a large number of individual investors, approximately 325 million of them, whereas the mega funds we are used to seeing such as the JP Morgan Money market fund that is second to Yu’e Bao in size at around $140 billion tend to be owned by institutional investors. Thus, while there is always a risk of a market panic from retail investors, there is far less of a risk from large institutional redemptions. It is worth remembering that is was exactly this sort of institutional redemption of the Reserve Primary fund, then almost $65 billion, when it broke the buck back in 2008 after its Lehman bonds were market to zero that triggered the liquidity crisis in the US. In essence, two thirds of the fund’s assets were withdrawn in a matter of days and it had to be liquidated, which effectively closed down the US commercial paper market. Sometimes what is seen as safe and stable (large institutional ownership) is actually very fragile, whilst what is seen as unstable (a large retail base) can be more robust.
Another statistic worth highlighting is that dividends in Asia grew 16% in the 12 months to July 2018 compared to around a third of that growth (5.5%) elsewhere. As we like to say about our Asia Income strategy, if you want dividends, look at Asia since that is where almost a third of the world’s dividends now come from and where they are growing, and if you want Asia, look at dividend strategies as a way to play it.
This sort of statistic may become even more important if, as we expect, the announcement by General Electric to cut its dividend last week is not the last of its kind. With over $5 billion in interest payments alone last year, General Electric has seen its financing troubles worsen thanks to a downgrade that restricts access to the Commercial paper market, that while not threatening its solvency, make secondary claims on cash flow (such as dividends) vulnerable. Somewhat ironically for a market obsessed with Chinese debt, which largely sits on the State balance sheet, after years of debt accumulation and share buybacks under quantitative easing, the status of US corporate balance sheets is, rightly, coming under scrutiny as the cost of funding normalises. Perhaps more important from an investor perspective, following recent market weakness the strong balance sheets, good cash flow, and higher pay-outs coming from Asia means that it is entirely feasible to construct a yield plus growth strategy focused around companies that were they to actually have any corporate debt would be investment grade credits and have an unleveraged gross yield of over 5%.
Bottom up numbers continue to come through pointing to a robust Chinese economy rather than one that is collapsing. Where we do see evidence of a slowdown in Chinese sales, for example from robot manufacturer Fanuc, this seems to be more about market share than anything else. This is not to be complacent, it would hardly make sense in current circumstances if investment was not being delayed and/or inventories were not being run down. But as we pointed out last week, demand, as measured by the consumer side, remains robust. A particularly interesting announcement this week for our Robotics strategies is that while Fanuc may have issues, robotics manufacturer ABB is to open a giant factory in Shanghai, at around 75,000 square feet, the new facility will use humans and co-bots to manufacture – robots. Not quite a singularity, but another step towards full automation.
One of the concerns over China doing the rounds last month was the concept of private sector companies having pledged shares against loans from banks and this is certainly an important structural issue. Gavekal Dragonomics estimate that the number of private firms in China in which the largest shareholder had pledged more than 50% of their stock had risen from a third to almost half since the beginning of 2017. This is obviously a potential source of systematic instability and is something the authorities are aware of, indeed they made it quite clear to banks that were holding such shares as collateral that fire sale selling because of mark to market positions would not be allowed. As with most things in China, the problem is real, but it is not likely to be catastrophic and the authorities are dealing with it in the manner of structural reform rather than short term aggressive moves.
To conclude, as markets start to position for year end it will be interesting to see how the deleveraging of trading positions plays out. Certainly the equity markets seemed to have something of a short squeeze last week, while commodities, notably oil, seem to be unwinding in the opposite direction. The bears amongst the macro commentators have made to double down on their sell calls this week so it will also be interesting to see if they can force any more long term investors out, since the last few weeks on the negative side has felt much more like traders going short. The midterm election results will likely dominate the high frequency data headlines for the next few days, but long term investors as opposed to traders will likely be looking to rebalance portfolios towards long term structural growth and even cyclical growth which in many areas is 30% cheaper than it was a few months ago. While that is the nearer term trade, we would suggest investors also think of the five to ten year shift that is coming. As we have said recently, we would suggest that investors start to consider the world in three currency blocs, US dollar, Euro, and Renminbi centred around the Americas, Europe, and Asia respectively, with the Euro and RMB sharing Eurasia as the world moves away from the USD standard in response to the increasing policy weaponisation of the dollar based banking system. Capital as well as trade will start to flow more intra bloc than inter bloc, but there is now enough non US capital to make this sustainable. As such tastes and preferences, such as for strong cash flow, sound balance sheet companies in Asia as opposed to stretched balance sheet share buyback driven companies in the US, with little concern for western equity market cap benchmarks, will start to shape markets.
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