The markets remain engrossed in the narrative of Trade WarsMarket thinking 28 June 2018
- Markets continue to focus on the notion of a destructive trade war, pricing in everyone as a loser. More likely we are (over) reacting to twists and turns of a US led negotiating strategy as the Trump administration seeks to reset bi-lateral relations across all aspects of its economy.
- Together with a stronger dollar this has triggered an aggressive rotation out of emerging markets running into the quarter/half end. In turn this is driving a narrative of slower and non-synchronised global growth that is probably unwarranted.
- Meanwhile easing of monetary conditions by China is only partly in response to concerns about a growth hit and more to do with (sensible) ongoing balance sheet restructuring. Pragmatism, not panic.
The markets remain engrossed in the narrative of trade wars which have also become the ‘get out clause’ for investors in emerging markets (EM) looking to cut their exposure as we approach the half year. Fund flows show a rush from many EM strategies with a clear preference for the US. Countries like Indonesia and Mexico have been forced to raise interest rates in a classic EM squeeze as the dollar has rallied and once again current account deficit countries with heavy funding in foreign currencies have found themselves subject to US monetary policy, fuelling a narrative of non-synchronous global growth. Fixed income bond benchmarks are most heavily exposed to the countries with the most debt and thus most exposed to tightening monetary policy. This creates its own form of ‘duration’. Not so China, of course, a point we have made repeatedly, with almost no foreign owned or denominated debt and modest exposure to the US economic cycle - for all the noise and bluster, Chinese exports are less than 4% of GDP - China is very different to most other emerging markets in terms of factor sensitivity. Indeed, one of the big differences about this latest trade spat is that America is demanding access to Chinese consumers to solve its trade deficit. The last time a global empire ran into this problem, the British launched the opium wars. Let’s hope we can find a better solution this time around.
As well as trying to sell more ‘stuff’ to the Chinese, the US is clearly keen to prevent the Chinese dominating the industries of the future (not something the British were worried about in the 19th century). Lest there be any doubt about the real drive behind the so-called trade wars, last week, President Trump’s key trade advisor Peter Navarro repeated his comments about the new economy rather than the old: “China has targeted America’s industries of the future and President Trump understands better than anyone that if China successfully captures these emerging industries of the future America will have no economic future while its national security will be severely compromised”.1 As such, commentators talk about the US invoking emergency laws to allow the limitation of Chinese investment in US companies involved in these so-called industries of the future. These include, aerospace, AI, robotics, medical devices and railways. In effect this could be the US trying to prevent China from succeeding in its ambitions for ‘Made In China 2025’, but, in my view at least, the idea that China can only succeed in these areas by buying US companies already exposed there is rather naive. In high speed rail for example, the fact that China already has more than 35,000km of high speed rail, more than the rest of the world combined, suggests that far from needing US expertise, the US could probably do with some Chinese capital investment. Indeed, this may be part of a forthcoming ‘deal’, perhaps China invests in US high speed rail, but has to compromise on using Chinese contractors? Aerospace is also an interesting one, especially in a week where Airbus said it might relocate out of the UK because of Brexit but then strangely said it might build in the US or China (neither of whom, obviously, are in the EU). Perhaps we might see a combination of European technology and Chinese capital instead? As to AI and robotics, obviously this is an area where we at Framlington Equities spend a lot of our time when investing in our thematic investment strategies. Here too, European, Asian and of course Japanese companies are highly advanced, while domestic Chinese corporates are already making huge technological advances. Ironically of course, any restrictions on accessing US tech through investment could strengthen the non US tech sector and in China much of the early stage investment is currently embedded inside the giant, cash rich, tech companies such as Baidu, Alibaba and Tencent. For years now, South-East Asian countries have exploited what UBS economists refer to as ‘Patronomics’, the competition between Japan and China to offer Foreign Direct Investment (FDI). The emerging competition between the US and China to dominate the new economy may offer some interesting opportunities to companies looking for different forms of FDI.
Partly in response to these trade tensions, the Chinese authorities have eased the Reserve Rate Requirements (RRR) for major banks, in my view therefore also taking advantage of the situation to make further moves for corporate and financial sector restructuring. Banks are being encouraged to use new funds for debt-for-equity swaps in many cases, while also being encouraged to lend more to small business. In other words this liquidity is targeted at the real economy more than financial engineering, with restrictions on housing speculation and shadow banking. Compare, for example, how much of US liquidity has gone into areas such as leveraged loans and private equity war chests, or indeed equity for debt swaps, otherwise known as share buybacks. Of course as my colleague Aidan Yao, Senior Economist at AXA IM, points out, the areas the government is targeting - debt for equity swaps and SME lending - are both areas that are more risky for banks and they have historically been reluctant to participate, so this will likely be a slow process. Rather than any sort of ‘emergency response’ to trade tensions, we see this as the start of an ongoing policy ‘put’ on the Chinese economy. It should be noted that the People’s Bank of China (PBOC) together with the China Securities Regulatory Commission (CSRC) and the newly created banking and insurance regulator have also been driving regulatory change in the shadow banking sector, which has been adding to the broader credit tightening.
China has had a 10, or even 20 year export boom, followed by a 5 to 10 year investment boom and is now in the middle of a consumption boom. However, unlike most western and emerging market consumption booms this has not been driven by mortgage finance and leverage, but by wage growth (and sheer scale). As such we need to be careful in our interpretation of the talk about deleveraging. When applied to most western economies it describes a world of consumer deleveraging, reducing mortgage and other finance at the expense of consumption. Sometimes it suggests a dramatic unwind of complex financial sector structures. Neither is true in this case. As previously discussed, the optics of tighter rates and shrinking loan growth in China can be misleading, not least because the nature of the previous shadow banking system meant that the metrics we have adopted, in particular total social financing, risk double counting the same loans. By way of illustration; consider a small or medium enterprise (SME) looking to raise RMB1million from the shadow banking system. One popular way would be via a Wealth Management Product (WMP) issued by a bank. This product might cost the SME 13% and be funded by the ‘shadow’ bank offering a guarantee to investors of perhaps 9%. We may then find that the underlying investor is actually a large state owned enterprise (SOE) such as a steel company and that they in turn have borrowed money from the traditional banking system at, say 4%, locking in a nice carry of around 5%. Counting both the loan and the WMP is rather like counting corporate bonds and the leverage to fund them from the financial sector in a western economy. The whole point is that China is shifting away from a pure banking + shadow banking model to a banking + capital markets model.
Assume now that the monetary authorities pressure the banks to bypass the shadow banks and lend directly to the SMEs (as they are now doing) and that they also raise lending rates to SOEs to discourage both mis-investment and shadow banking/property speculation. From the outside we would observe a sharp drop (in this illustration a halving) in Total Social Financing (TSF) as we would no longer have RMB1m lent to the SOE and a further RMB1m subsequently lent to the SME. There would be just the one loan and thus we would not see much change in bank lending as we are simply cutting out the extra layer of lending, (as well as a lot of the margin) and indeed this is exactly what we observe. We would also see rates to SOEs rise and assume that monetary conditions were tightening, when in all likelihood the rate paid by the actual economic borrower – the SME - will have fallen from 13% to perhaps 9%. Thus by using western metrics, we may observe a rise in rates and a fall in lending and thus worry about a credit crunch, whereas in reality we are seeing a fall in the cost of borrowing for the real economy and a shrinkage in margins for some SOEs and shadow banks.
Nevertheless, as these are unwound, monetary conditions can tighten and to our view, this fine tuning by the authorities is both warranted and sensible. We are clearly seeing signs of distress in some of the credit markets as corporates struggle to roll over financing and it is my belief that the authorities have no desire to cause unnecessary problems for good companies simply as they reset the markets. As ever though, bad credits remain bad credits regardless of the official rating given to them or the index they happen to be sat in. As the strategists at Jeffries point out, the best performing styles in China since credit conditions started to tighten back in March are sales growth and net cash. One area of concern is the property sector – particularly for the credit markets where they are heavy borrowers. Having been shut out of domestic markets due to regulation, Chinese property names have tended to be some of the biggest players in the offshore markets which makes them vulnerable in the manner of emerging market borrowers elsewhere as the dollar rallies and liquidity tightens. Jeffries calculate that around 80% of listed (A&H) property shares have an Altman Z score below 2. For reference, a score below 1.8 is regarded as a sign of distress. Moreover, around 40% have a net debt to equity above 90% and around 45% of them have interest cover (EBIT / interest expense) below 2 times. We have said frequently that a focus on positive cash flow and sound balance sheets is essential in this environment of tighter liquidity, whether it is at the sovereign, the corporate or the household level.
To conclude. As ever with President Trump we need to take him seriously rather than literally and to watch what he does rather than what he says. I remain convinced that his ‘Make America Great Again’ (MAGA) project has at its heart a plan to renegotiate all the existing multi-lateral agreements that constitute the Washington Consensus to suit the 21st century and (naturally) his voter base. For example I believe that his threats to pull out of NATO are aimed at reducing US defence expenditure on behalf of western nations like Japan and Germany - as was the issue of North Korea. In my view, President Trump wants US weapons manufacturers to benefit, but he wants other countries to pay the bills. On trade, pulling out of the TPP and threats to pull out of NAFTA are aimed at reversing the trend whereby multi-nationals are exporting components to Canada and Mexico and then these countries are exporting finished goods under NAFTA to the US. I suspect that we will shortly hear that the component exporters are now going to assemble directly in the US, while I would not be surprised to see the US re-enter the TPP as part of a new agreement to counter China ambitions in the new economy. The fact that US auto-makers also assemble in these countries and re-import will not have been lost either. Meanwhile, as discussed earlier, President Trump probably wants Chinese infra-structure capital to build high speed railways in the US but wants US companies involved in the construction - including the steel. The iron and steel and autos tariffs meanwhile are highlighting the protectionist nature of the EU customs union and while the EU have targeted politically sensitive US imports (aimed at constituencies of influential US politicians) in retaliation, the reality is that in these areas President Trump has clearly stated he wants lower tariffs all round.
Trade concerns have catalysed a sell-off in emerging markets, who were already having a bad quarter as the old problems of having borrowed too much money in someone else’s currency come home to roost. A stronger dollar is thus both the cause and the consequence of asset allocators selling EM assets. China is largely immune to this, although in a few areas where corporates do have overseas debt, most notably property, they are facing similar issues. At the same time, necessary restructuring of the Chinese financial sector is making liquidity conditions tighter more generally and while the authorities may step in to help ‘worthy companies’ and will not want an aggressive or dangerous unwinding of leverage, certain stocks and sectors (such as property) remain vulnerable. Focus on positive cash flow and low leverage.
Financial markets always need a narrative and thus for now it is a negative one of a return to Smoot Hawley1 and the protectionist follies of the 1930s (those bond guys really need to get the 10 year down and a bull market back on track). At the same time the ‘debt to GDP’2 guys are focusing on China and its necessary deleveraging as an imminent collapse in global demand. This is equally unlikely in my view. For now though, For now though, tactical investors will continue to play the noise, even if the strategic move is to plot the signal.
1 The Smoot Hawley Tariffs refers to the Tariff Act of 1930 which raised protectionist tariffs on over 20,000 products imported into the US. The retaliation by US trading partners led to a severe reduction in levels of world trade and is widely accepted to being a major contributory factor in the great Depression.
2 Debt-to-GDP ratio is the ratio between a country's government debt (a cumulative amount) and its gross domestic product (GDP) (measured in years).
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