Market Thinking - Short term dollar rallies, longer term petrodollar threatened

Market Thinking - Short term dollar rallies, longer term petrodollar threatened

30 October 2017
  • Despite the Bank of England looking likely to raise rates for the first time in over a decade, the rally in sterling looks to be fading. Indeed, the dollar looks to be strengthening across the board.
  • This may prompt profit taking in EM, but we would be selective, selling only those companies where the fundamentals of a stronger dollar are material. There are plenty of examples of strong cash flow in the region and while not as cheap as in January, most international investors remain underweight.
  • Bond markets are nervous about the Treasury yield, once again looking to break out through 2.4% as oil heads above $60 and traders rotate into cyclicals, while further out, the potential emergence of a petro-yuan threatens widespread disruption.

China’s 19th Party Congress produced the expected changing of the guard and a widely acknowledged enhancement of the power of President Xi, but the key message to the outside world is probably one of continuity. The fact that Xi’s anti-corruption head Wang Qishan, often regarded as the second most important man in China, has stepped down does not diminish the anti-corruption stance, rather it reflects respect for the age conventions of politburo members, while the fact that Li Keqiang remains as Premier despite much speculation, points to respect for continuity. The identity of the successor to People’s Bank of China (PBoC) governor Zhou Xiaochuan is unlikely to be revealed until next March however. Economic and financial sector reforms remain a priority and, as previously discussed, the relative priority is very much that of the Chinese rather than the westerners seeking to ‘advise’ them. The key point is that China has a surplus of savings and has no need to import western capital and thus regards pleas by western investors to open up their markets (so that westerners can earn profits) as self-serving and irrelevant. The role of western capital is to set prices at the margin, nothing more. Thus the fact that China returned to the international Bond market last week for the first time since 2004 with  $2bn of 5 and 10 year offering is much more significant for the pricing that it obtained (30-40bps over Treasuries) than the amount that was raised. Also for the fact that it was unrated by the traditional agencies. Those seeking rapid opening up of the capital account or dramatic restructuring and privatisation of state owned enterprises (SOEs) are likely to remain disappointed. Meanwhile, the well documented and multiyear themes of China 2.0 – the digital consumer, Made in China 2025, One Belt One Road and the building out of a financial sector infrastructure all remain very much in place as drivers of future investment returns.

With the Congress over, the world of macro has switched back to its old playbook, specifically, the dollar, central banks and the end (or not) of quantitative easing (QE). The Bank of England (BoE), the Federal Open Market Committee (FOMC) of the Federal Reserve (Fed) and the Bank of Japan (BoJ) all meet this week, with only the BoE expected to raise rates, reversing the cut in August of last year and signalling the first increase since 2006 and the first change in direction since 2009. Given that the rate is only 25bps, this is more about the signal than the economic impact – Libor for example has already moved to price in a rate rise (black line Rhs).

Chart 1: UK rate rise already being priced in

Source: Bloomberg, October 2016

The market most sensitive to this is probably the currency and we can see how when expectations about UK rates switched back in September that sterling jumped sharply.  What is interesting to note however is that even though Libor rates continued to rise throughout October, sterling did not. Indeed, technically it is on the verge of breaking down against the dollar. We see something similar with the euro, which having hit 1.20 against the dollar is now threatening to break down, perhaps all the way back to 1.12. In part this has been blamed on reluctance by Mario Draghi to end the European version of QE, but I suspect that, as is often the case, this is more a dollar story than sterling or euro one and it certainly looks like the dollar is regaining strength across the board. This may well be to do with a shift in expectations about the Fed or about a renewed optimism over tax cuts, although as we discussed at the end of Q3, it is probably more about an unwind of excessive short dollar positioning.

When currency markets move, there tends to be a domino effect into other capital markets based on ‘what happened last time’ and the extent to which these trading moves are maintained then depends on subsequent fundamental flows. Thus a stronger dollar tends to produce a trading move to sell emerging markets (EM), based not only on historic correlations but also on a fundamental story around dollar debt. emerging markets have traditionally held a lot of dollar debt and are thus vulnerable to tighter US monetary policy and a stronger US currency. However, this fundamental story is increasingly out of date as emerging markets have learned that lesson (and borrow in local currency) and also because the biggest of them all, China, has very little overseas debt – one of many reasons why the western bears have misread China. As such, we would be surprised to see any meaningful correction in EM based on a stronger dollar, also reflecting the fact that most international investors remain underweight EM and those that are invested have tended to have a relatively defensive portfolio.

In our view, it is nevertheless still important to avoid individual names that have dollar debt and to focus on free cash flow. In terms of valuations, Asia has gone from being cheap at the beginning of the year (when the consensus hated it) to being nearer to ‘mid-range’.

Meanwhile, the traders in the bond markets are nervous that the US Treasury yield has broken above 2.4% as markets start to focus on the new Chairman of the Fed, with President Trump widely expected to announce his candidate before he leaves for his trip to Asia at the end of this week. The current favourite is Fed governor Jerome Powell, but the real importance is not so much on what the Fed do to short rates, but in how they transition away from QE. As noted before, the Fed’s balance sheet is due to shrink from this moment forward as various bonds mature and a decision simply not to reinvest – as opposed to actually sell anything will still have a meaningful impact on bond markets, not least because the new marginal buyer of bonds in the private sector will likely have a very different attitude to hedging and other aspects of risk management.

Interesting that as the stock markets focus on co-ordinated global growth that the US Treasury yield is over 200bps above the German 10 year and even above Spain (+160bps), despite the dramas unfolding over Catalonia. This of course tells us much more about the anticipated actions of the European Central Bank (ECB) (more bond buying) versus the Fed (no more) than it does about any aspect of the relative economies. 

An interesting piece by my old friend and colleague Rob Buckland (now head of Global Strategy at Citi Group) picks up on another aspect of these historic correlations and tactical trades. As he points out, the correlation between bond markets and equity markets does not work in the way that it used to except in so far as a weakness in bond markets appears correlated with an outperformance of cyclicals over defensives. Thus while we might challenge the ability of the bond markets to actually predict economics (a sell off is more about market positioning than economic forecasting), it does appear to drive rotation within markets and this can have a meaningful effect for tactical allocation if it leads to managers neutralising sector positioning ‘bets’. Thus we have two contradictory ‘playbooks’, one that says a stronger dollar is bad for emerging markets and commodities and another that says a sell-off in bond markets and higher interest rates is good for cyclicals and growth related assets (like emerging markets). Given the above noted cash flow positions and underweight allocations I suspect that the latter will prevail. One way to look at this is the relationship between gold and copper – a security commodity and a cyclical commodity – albeit one with the most attractive supply curve. Now we can acknowledge there are probably other factors at work – the focus on electric vehicles (EVs) that need more copper and the rise of bitcoin for the ‘don’t trust fiat currencies’ crowd for example – but if we overlay the US 10 year yield (yellow) it tells an interesting story.

Chart 2: Copper versus gold – more cyclical, less defensive.

This rotation to cyclicals may also be linked to the recent move for oil above $60, although I can’t help feeling that this is also helpful to those trying to push through a partial float in Saudi Aramco. This remains one of the bigger puzzles out there for investors, as well as one of the bigger challenges for the investment banks. Saudi Arabia, a country overly dependent on hydrocarbons, understandably wants to diversify away and invest in a raft of new technologies. In doing so it is entering a space already crowded with other sovereign wealth funds as well as companies like Softbank, AliBaba and pretty much all big tech globally.  Its proposal is effectively that international investors, who already have a vast array of hydro-carbon investment options, many of which they are actually trying to dis-invest from, should buy into a tiny stake (5%) of a state owned oil company based on their valuation of $2trillion. In other words, they want to raise $100bn from international investors by selling them something they can already buy but choose not to (oil reserves) in order to raise enough money for Saudi Arabia to invest in the things international investors are currently buying. Perhaps it’s just me, but I can’t see that as a very compelling argument. Undoubtedly some of the investment bankers are hoping for an index effect if the company has a market capitalisation of $2bn, but here they might be tripped up by the stock exchanges and the index providers. The idea of a free float of 5% is against the principles that most exchanges subscribe to, although the temptation is huge to make ‘exceptions’ with fees of up to $1bn at stake. Nevertheless, recently the London Stock Exchange has suggested that they might not in fact partially list the company in the UK, while the index providers have made it clear that should the IPO take place, they would not put the company in the market index. A company that size being in the market but not the index would make an interesting challenge for active investors, that’s for sure.

All which brings us to the (perhaps) obvious question. Should China buy the stake in Saudi Aramco? In many ways it makes a lot more sense for both sides, not least because as a (very) minority shareholder, your stake holding is rather better protected if you are simultaneously the largest customer. This in turn takes us back to a subject that we discussed when it was first announced in September, which is the notion of the petro-yuan. China is launching an oil futures contract denominated in renminbi (RMB) and backed by gold which will enable China to reduce its use of US dollar for international trade, while at the same time recognising that its trading partners may be unwilling to hold a currency that is not fully exchangeable. It also has the advantage that several of its energy trading partners such as Iran, Russia or Venezuela could use such a system to avoid US sanctions, since it is the use of the US dollar for payments that gives the sanctions their power. The notion is that were China to be a cornerstone or even the sole investor in the Saudi Aramco stake then they might use that position to compel Saudi to trade oil with China in RMB rather than US dollars. This would of course be highly significant, not least because the petro dollar was ‘born’ in 1974 in Jeddah, Saudi Arabia.

Meanwhile, this Friday President Trump heads to Asia, where he will meet with the newly re-elected Prime Minister Abe of Japan, travel to Korea and Vietnam and of course most importantly meet President Xi.  As previously noted, it was not until these meetings, where Xi has now consolidated his power in the wake of the Party Conference that I expected any progress to be made on North Korea.  We know that Trump and Abe will likely talk a lot about military build-up with the Japanese, but it is the deal that is struck over the Democratic People’s Republic of Korea (DPRK) that is most important and that is effectively a bi-lateral deal between the US and China. Here’s hoping that sense will prevail.

To conclude, in the short term a rally in the dollar and weakness in sterling and euro looks to be underway, likely prompting some rotations from the traditional playbook, out of emerging markets and commodities. However such moves are likely to be short lived, not only because the fundamentals have shifted so as not to support them unlike the past but also because a separate set of macro moves – in bond yields and interest rates – are triggering a different set of moves, this time into cyclical and out of defensive assets. Looking beyond the next couple of months, the emergence of China is introducing a bi-polar world, not only in terms of a new approach to US/China trade relations, but a downgrading of the importance of a wide range of multi-lateral institutions. Asia has de-coupled from the west in terms of economy and markets and if anything is now in the driving seat, while China’s energy needs and the desire to meet them in local currency rather than petro-dollars threatens a significant disruption to the US dollar based financial system.

All data sourced by AXA IM as at Monday 30th October, 2017.

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