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Market Thinking - Trump (and) Trade. One year on

Market Thinking - Trump (and) Trade. One year on

Insight
08 November 2017
  • The new Chairman of the Fed implies continuity as equity markets continue to melt up.
  • While the Middle East sees new tensions emerging from Saudi Arabia, President Trump’s visit to Asia can put policy initiatives back into geopolitics on trade and hopefully on North Korea.
  • Largely un-noticed, China has helped eliminate lots of excess capacity in SOEs as well as excess housing inventory in the private sector. These quiet reforms are de-risking the Chinese economy for global investors, but could be stoking future inflation.

In the old days, a new Chairman of the Fed would be a ‘big event’, especially if the existing Chairman was not being re-appointed for a second term and wasn’t even a trained economist. But as we know, these are unusual times and the announcement by President Trump that Jerome Powell is his nominee for Federal Reserve (Fed) Chairman left markets relatively unperturbed. In my view, the fact that he is from capital markets rather than a classically trained economist is not necessarily a bad thing at this point in time as his job will be to navigate the US financial sector through an unwinding of conventional monetary policy. As noted in previous commentary, the idea of John Taylor had unnerved some people, not so much for the fact that he was an economist as for the perceived threat from his eponymous rule, which if applied would suggest an aggressive tightening of rates. The chart below is one I have used often over the years and illustrates where Fed funds ‘ought’ to be if the Taylor rule is applied properly.

Chart 1: Looks like the Taylor Rule will continue to over-predict
Source: AXA IM, November 2017

As can be seen, while the rule has never been particularly great at predicting rates in the post Volker era, (even where the lines look close it is up to 100bps different) it has been particularly ‘poor’ since the great financial crisis (GFC). This is not to criticise, rather to explain and to issue a word of warning. The rule seeks to encompass much of the conventional economic wisdom about the ‘correct’ level of interest rates based on the concept of full employment levels and the output gap in an economy. As such the high frequency data like non-farm payrolls still gets interpreted through this lens and traders will still chase short term moves in rates and exchange rates on this sort of playbook. However as regular and certainly long term readers will know, I believe that for investors (rather than traders) this is largely a waste of time as the Fed simply isn’t following these rules. If you want to know what the Fed is likely to do, rather than what the theoretical model says they ought to do, then we clearly need to incorporate different variables, of which the key one I would argue is financial market stability. As such, having a markets man rather than an economist is probably no bad thing.

Meanwhile, President Trump celebrates his first anniversary by visiting Asia for the next couple of weeks, which is obviously very important for the region as it settles down after the (lack of) excitement following the Chinese 19th Party Congress. Given the tensions built up in recent months over North Korea, defence will obviously be a key focus of much of the conversations in Japan and South Korea, but trade will also undoubtedly feature and as discussed before, this looks to be the right time for the US and China to come to an agreement on the correct approach for North Korea. While the markets may appear to be disappointed that there were no big new policy initiatives coming out of the Party Congress - although there was never any real suggestion that there would be - the reality is that President Xi is now in a position to move forward across a range of initiatives and the issue of North Korea will be high on the list. Interesting to note for example, is that China has already restored diplomatic relations with South Korea and is making noise about the need for North Korea to negotiate.

This week however, even that has been rather over-shadowed by some extra-ordinary events in Saudi Arabia over the weekend. Just as we were musing on the potential for Saudi Aramco as the biggest story in the country, the Crown Prince and de-facto ruler of the country, Mohammed bin Salman, (MBS) launched an anti-corruption drive and immediately arrested a swathe of Saudi Princes including any possible rivals to his father’s throne, up to thirty former and acting ministers and the heads of all three major TV stations. He now controls all three of the different armies in Saudi Arabia, as well as the main economics assets and now, the media. Meanwhile, the rebels in Yemen – fighting an ongoing war against Saudi Arabia managed to launch a ballistic missile at Riyadh airport while a helicopter carrying another Saudi Prince crashed near the southern border killing all aboard. Finally, Prime Minister Hariri of Lebanon suddenly resigned after only a year – live from Saudi Arabia and on Saudi Arabian television - as rhetoric against Iranian interference seemed to go up significantly. Thus as the war in Syria against ISIS reaches its final stages, we may find that peace remains elusive in the region as attention switches to Lebanon and Iran. Oil meanwhile looks to have broken out to the upside, although as Chart 2 illustrates, this is very much a function of Brent Crude rather than West Texas Intermediate. The two often trade with a gap reflecting differing supply and demand characteristics and refinery set-ups, but if we normalise the two oil prices from January this year we can see that Brent is up 12.99% while West Texas is up 6.76%.

Chart 2: Brent Breaks away from West Texas

Source: AXA IM, November 2017 

The gap is not entirely down to the recent Saudi moves, as the chart shows, it started to open at the end of August thanks to the disruption from Hurricane Harvey, which took out gulf coast refining capacity and left US crude stocks higher, while another factor is almost certainly the debt default issues in Venezuela, which are already leading to lower production, something that could escalate rapidly if there were asset seizures. There is almost certainly some speculation involved in Brent futures as well – the market talk about the Organization of Petroleum Exporting Countries’ (OPEC) cuts and higher prices is reminiscent of similar wishful thinking this time a year ago – suggesting that unless the fundamentals really do follow through the rally could unwind quickly. Should the spread persist then there are other likely consequences. US east coast refiners may once again find it worthwhile putting oil on railcars as they did back in 2014/15, while US oil exports going direct to places like China would likely pick up further along with recent announcements on US liquefied natural gas (LNG). This is all something I am sure will be mentioned in Beijing next week as will a proposal for Sinopec to help build a 700 mile pipeline from the Permian Basin to the Gulf coast and to expand its oil storage facility on St Croix in the US Virgin Islands. As the Bloomberg report (linked above) points out, the Sinopec deal alone could reduce the US trade deficit by $10bn.

In the short term higher prices would help alleviate some of the budgetary strains for MBS as well as theoretically make the Saudi Aramco deal easier to get done, although the fact that former finance minister and Aramco board member Ibrahim bin Abdullah Al-Assaf was amongst those caught up in the recent anti-corruption moves certainly raises the risk premium. US shale producers are likely to benefit, as are the Russians. Longer term however, the reality remains that supply exceeds demand and with Brent above $60, history shows that OPEC unity is weak, while with the Syrian conflict almost over (hopefully) that would make for further supply increases – likely in alliance with Russia. Moreover, with shale, the US remains the swing supplier and its bi-lateral deals with the world’s biggest consumer should arbitrage that spread away.

Post the Party Congress, Chinese markets have been flat to down, with a sense of disappointment that there were no grand initiatives. However, as we pointed out last week, there was never much prospect of anything meaningful being announced; it was about people not policies. However, one of the important things about China policy is that it is doing a lot of things behind the scenes, all of the time. As a result, many of the issues that people in the west like to talk about are already somewhat out of date. For example at one conference here in Hong Kong last week a well-known academic was giving his equally well known “China has too much debt and needs to do something about it and I think GDP growth is only 3%” presentation to enthusiastic nods from the American investor sitting next to me. The problem was that the speaker did not acknowledge that China is already doing something about it. In particular he said that the Chinese consumer needed to grow so that consumption as a percentage of GDP went up and that something would have to be done about local government debt. I am not disagreeing with this analysis and indeed agreed with it when the same author said it five years ago, it’s just that since that time, real disposable income for Chinese consumers has been growing at around 8% per annum, while urban disposable income and nominal GDP have been growing at pretty much the same (high single digit) rate for the last five years.

The previous phase of Chinese growth (well documented by said academic) was very much one of consumer repression; low wages, low interest rates and low exchange rates all favoured capital over labour and not coincidentally exports boomed and the capital reserves grew rapidly. The shift away from export and production towards import and consumption has already started when the financial crisis hit, but was knocked off course temporarily by the stabilisation measures put in place, notably the boost to credit and fixed asset investment. The misallocation of credit that took place at that time is well known, but what is less discussed is the series of measures that have subsequently been under-taken to help rebalance the economy.

As I replied to another (much more up to date) economist in a later presentation at our offices when they  said, “the market hasn’t yet realised”,  in fact the market has already realised, it’s that many  economists and academics haven’t yet done so. An obsession with debt to GDP ratios and a perceived ‘need’ for state owned enterprise (SOE) reform is leading too many of them to ignore the investment opportunities opening up before us. As we saw from last week’s results from Alibaba, with sales growth up 61% for the September quarter (!) far from being a drag on the economy, the Chinese consumer continues to grow rapidly and in particular to spend aggressively online, which also explains why Alibaba’s share price is up 120% over the last two years. Next week of course sees ‘singles day’ on 11/11, which is now the world’s biggest shopping day. Last year Alibaba reported sales of 121 billion renminbi (RMB), or around $18bn, in a single day. Just for comparison, that is about the same as Starbucks sales in an entire year, globally.

One really interesting area that our visiting and more up to date economist did discuss however was the impact of the slum clearance subsidies on the housing market. In essence, these are subsidies and grants from the government and local government to allow people to buy better housing. This has been instrumental in driving around half of the new housing units sold in China last year, with a particular emphasis on third and fourth tier cities. It is important to note that while the headlines may focus on Tier 1 cities, the third and fourth tier cities are where the bulk of China’s people live and thus where economically the housing market is most important. As such the $170bn scheme is exactly the sort of shift from government to consumer that China ‘needs’ while also helping to solve a huge oversupply problem amongst developers. By late 2014, housing inventory in tier 3 and 4 cities had reached 34 months (almost certainly an under-estimate), now it is down to a rather more comfortable 15 months. As the linked article points out in Wenzhou, the housing stock is down to 3 months inventory from almost four years in mid-2014.

This undoubtedly helps explain some of the tremendous performance of Chinese property developer stocks this year, but combined with the well documented reductions in excess capacity that helped some of the ‘old China’ stocks regain pricing power over the last twelve months has significant implications for inflation. China’s growth has resulted in increased global demand, but also a huge increase in global supply, which has caused a commodity bust (to follow the boom) and dis-inflation in manufactured goods prices. However, by moving to limit capacity and restore profitability, not only have they improved the balance sheet of the SOEs, but also their pricing power such that China may already have stopped exporting dis-inflation, much as Japan did in the 1980s. Some cyclical spikes will doubtless appear, such as the spike in nickel associated with China’s push into electric vehicles discussed by Glencore this week, but I suspect that the structural over-supply issues are a thing of the past. As competitive analysis tells us, shifts in pricing power drive profitability and if, as is clear here in Asia, corporate profits are rising then we need to watch how those profits are distributed. We know that dividends are rising across Asia, but we also observe an upturn not so much in capital equipment spending (why would you if you are trying to maintain pricing), but in Selling General and Administrative Expenses or SG&A. Conferences, corporate travel, food and beverage are all picking up (certainly anecdotally here in Hong Kong) and prices are too as supply is slow to respond. Add to this that these items are also where the rapidly growing outbound Chinese tourists are spending their money and we have the basis of a cyclical boom in inflation. Macro investors obsessing about China’s debt to GDP and the need to restructure its corporate sector may find that they got rather more than they bargained for.

Finally another presentation at the conference brought together two of our favourite topics – blockchain and China. With an overview of the Chinese crypto currency industry, Cao Yin, who amongst other things is credited as ‘chief expert of blockchain’ for Cinda China (known as Cinda it is effectively a largely state owned merchant bank and asset management company). Among a fascinating series of facts he pointed out that prior to the recent attempt at a crackdown, Chinese trading of bitcoin peaked at an extra-ordinary 95% of the total global volume because of active automatic arbitrage trading. That obviously collapsed after the crackdown, although as he admitted that means it has largely gone over the counter. The mining of bitcoin is also dominated by China, with around 75% of the mining pools, followed by the US with 15. Currently revenue exceeds $13m per day, of which 60% or more is in China. As I have commented before, the real significance of the initial coin offering (ICO) market which led to the Chinese authority crackdown in my view is the focus it puts onto the blockchain, which has the potential to be as disruptive to services as the internet was to traditional retail. Having said that, if bitcoin as a digital currency which is largely ‘manufactured’ in China starts to push consumers away from traditional dollar based payment systems, then the concerns that the US already has about countries trading energy in RMB will only magnify.

To conclude. As we see the first anniversary of President Trump, we find him in our backyard here in Asia, where his bi-lateral approach to trade and geo-politics is likely to result in a big boost to US trade – notably energy and armaments – as well as hopefully a ratcheting down of the tensions that have built up in the Korean peninsula. To a dollar based investor, the Trump rally has seen a total return on the S&P of 22%, but on the emerging market ETF (EEM) it is 26%, the Hang Seng 31%, the Dax 34% and the Italian market 47%. Much of this has been a decline in the various risk premia that so obsessed the macro traders this time a year ago, but it has also been a function of strong profitability – for example our Asia dividend strategy is still yielding close to 4% despite capital gains in excess of 20% because dividends have been rising strongly. A lot of this profitability reflects operational leverage as sales pick up against a high fixed cost base, but we should not under-estimate the role of China in taking out excess capacity. For the last quarter century China has expanded its economy by expanding capacity and thus exporting disinflation. While on the one hand, investors will applaud moves to restore profitability they should recognise that shifting supply versus demand will inevitably shift pricing power. For fixed income investors in particular they should perhaps be careful what they wish for.

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All data sourced by AXA IM as at Wednesday 8th 2017. 

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