Market Thinking - a view from the equity market - commentary from Mark Tinker, AXA IM

07/03/2017

Tuesday March 7th 2017

 

  • “Everything is going up”, long bonds, equities, commodities and the dollar ($) are all higher year to date – only Vix is lower. Risk managers should be equally concerned about what is doing well, not just what is doing badly.
  • Flow is strong, but equity valuations are stretching (especially in the US) and institutional managers are looking to hedge some tail risk, especially with a big political season coming up.
  • The March options expiry (due on Friday 17) has a history of producing sharp market moves and may yet prove to do so again.

 

I was in Tokyo last week where the market was up, but generally Asian markets were flat to down as the month ended. Interesting however to note that Hong Kong is up more than the S&P500 and is one of the best performing markets year to date. This partly reflects a steady reduction in the A share/ H share premium as shown in the chart - helped we believe by a significant uptick in southbound flows through the stock connect with China. This premium is now back to the levels below 20%, last seen at the end of 2014 – just as the mainland market bubble took off – peaking at a 59% premium in July 2015.

 

Chart 1: A share premium to H Share continues to decline

Source: Bloomberg, AXA IM March 2017

Emerging markets and Pacific ex Japan had a rocky end to 2016 in the wake of concerns over global trade but what we referred to as ‘contrarian beta’ plays at the start of this year and have had a strong year to date. Indeed they are the top performing regions in US dollar terms and only just lagging behind the US in local currency terms as well. Similarly euro and Japanese small cap stocks have had a good start to 2017 especially after a very bad Q4 and growth has started to outperform value once more. From both a stock picking and an asset allocation point of view as well, it is notable that the 52 week rolling correlation between the US and other markets has been falling steadily so far this year, probably reflecting diverging monetary policies. Also in terms of flows, we note that while last year’s flows into bond funds and ETFs were more than 10 times equity – this year they are the same YTD. This is not the great rotation yet, but is nevertheless interesting.

Here in Asia it was interesting to observe that in addition to the closing of the A Share vs H Share gap, in China, defensive stocks have tended to outperform cyclicals. So far this year in Hong Kong it has been the other way around - cyclicals have heavily outperformed defensives - a trend that appears quite widespread across other geographies (save Europe). However, as noted before, I think this has as much to do with closing out underweight positions in financials and commodities than a genuine belief in a reflation trade. While commodities are still up on the year, iron ore, coal and even copper are well off the policy inspired peaks (Chinese tightening of supply) and for all the excitement in some quarters about oil, the best we can say is that it has moved ‘aggressively sideways’. To my mind this remains about supply rather than demand.

In equities, there are concerns that exuberance is building and the State of the Union speech last Tuesday by President Trump was greeted with excitement by many, simply because it was ‘Presidential’ - which probably translates as ‘didn’t say anything unexpected’. The ETF markets had a record day, pushing the S&P higher, with financial ETFs in the lead as investors focussed on the notion of an easier fiscal policy and tighter monetary policy. The dollar was also stronger against most currencies which had the effect of pushing up most other western bond and equity markets (local currency falls, asset price rises by similar amount to preserve dollar value). Generally earnings revisions are positive, which tends to drive asset allocation models into equities, while inflation is actually remarkably stable. In fact, once we strip out volatile commodity and energy prices underlying inflation is basically unchanged from a year ago - when of course we were all told to fear deflation and collapsing demand and now it is booming demand and inflation. Neither looks particularly likely in my view and perhaps not surprisingly US bonds have failed to collapse, holding at just under 2.5%.

In particular the markets seemed to believe that the speech had reduced the prospect of border adjustment tax and punitive tariffs – something that we have noted before is one of the highest concerns for many people out here in Asia. This would indeed be positive, but we would remind people that part of the trade-off may be an end to being able to retain profits offshore and an acceleration of the repatriation of accumulated profits. While this may be good for the US economy, we remain concerned about too rapid a draining of the pools of offshore US dollar liquidity that this would represent. We continue to watch the tightening of US Libor rates (now over 110bps) and the general tightening of offshore dollar liquidity, which are arguably far more important than the headline rates from the Federal Reserve.

In its bullish mind-set, the markets last week decided that a rise in Fed rates in March was not only likely but also desirable – a rapid reversal of opinion compared to a month ago. Thus ‘higher rates, but for the right reasons’ was the rallying cry (literally). Such upward spikes tend to make investors nervous – although as yet the usual sentiment benchmarks are not showing a meaningful rise in bullishness. The AAII Bull minus Bear ratio tends to go between 20 and 40 and is currently around 25 for example, while the Vix remains low.  With the March options expiry (historically always a significant one for market action) coming up on March 17, we may find some precautionary buying of Vix – after all the next three months will cover some significant political event risk. In Europe we know there is the likely evocation of Article 50 in the UK before the end of the month, while there is also a big election/referendum season coming, with the Netherlands first then France,  Germany and likely Italy. France and Italy yields rallied in February despite concern over politics, as did Eurostoxx. These were almost certainly a function of a weaker Euro – DXY was stronger in February, not least as rhetoric shifts to a rate rise in March not June. This is because the rest of the world looks stronger – remember the point is that the Fed is setting policy for the whole dollar zone – not just the US. Stronger PMIs everywhere speed up ‘normalisation’ – except in Europe, which is still seen by the ECB as too fragile. One outlier perhaps in the political calendar is Turkey –with a referendum on extending Erdogan’s power coming up in April. This is already starting to lead to tensions with Germany and has obvious implications for refugee flow and thus is arguably more important for Europe than say the Netherlands or even Italy.

While we are becoming a bit more nervous, note that US Libor is now 1.10 – up from 62bps last year, while the US 2 year bond rates are back to pre-global financial crisis (GFC) levels. US monetary policy is already re-setting in the markets, even if there has yet to be an official move this year.

 

US money rates and short term bond yields rising

Source: Bloomberg.  AXA IM March 2017

The prospect of no easing on offshore dollars means we remain concerned about leveraged products – if the border tax doesn’t happen (a good thing being discounted now) then there is a higher chance that the deferring of offshore profits tax is cancelled – this means a faster repatriation of all that offshore dollar cash, putting squeeze on dollar funding. Meanwhile, the US debt ceiling holiday expires on March 15. We have that to worry about now.

The first quarter continued to be disrupted by travel and so it was that my colleague Simon Weston and I found ourselves up in Tokyo on a combination of research and meeting potential clients. As a regular visitor to Tokyo over the years, I made a particular effort this time to get away from the standard business and conference venues (which actually made sense considering the Grand Hyatt in Tokyo actually caught fire while we were staying there!). My overriding impression is that while Tokyo is notionally a major global city, it still really doesn’t feel like it. It doesn’t have the buzz of London nor the San Gimignano feel of New York, Hong Kong or Pudong in Shanghai. It feels low rise and surprisingly subdued. Partly of course that reflects the (not insignificant) issue of earthquakes – and we certainly experienced several tremors – but mainly it is because Tokyo is so spread out so that it feels much more like Los Angeles  than New York or even Chicago. Also Tokyo feels to be in one of its periodic retreats from engagement with the rest of the world. The Japanese authorities are offering subsidies to airlines and train companies to ferry foreigners to the regions outside Tokyo to encourage speaking of English ahead of the 2020 Olympics, but so far it doesn’t seem to be working very well. All the announcements at the domestic air terminals were in Japanese and virtually none of the ‘officials’ from the taxi stand to the bus ticket sales spoke any English. This is not to excuse my regrettable lack of Japanese, rather to contrast with other Asia – including China – where English is very much the language of international communication. Perhaps because of change everywhere else, Japan feels very mono-cultural. Other ‘surprises’ include the near impossibility of getting anything to eat after 2pm or finding any sort of ‘bar’ open before 6pm – outside of the hotels that is, but then that one caught fire as I mentioned earlier.  There were some achingly cool people under 30 and a thriving youth scene, but the over 50s seemed as stuck in the late 20th century as ever. Having said that, everyone was unfailingly polite and I was pleased to note that, once you find a restaurant open, the quality remains very high indeed.

While everything is meticulously done, the productivity is not high, from the lengthy security queues at the airport (Shanghai standards of one small tray at a time) to the three people employed to wave lighted sticks to warn you that the obviously fenced off piece of pavement under repair is, well, closed. We came away with the conclusion that, while investors may view Japan as a warrant on global growth, there is no guarantee that many of the companies that we met will benefit from this in terms of higher profitability. Some will of course, and that after all is the essence of stock picking.

Finally the SNAP IPO last week did little to downgrade the list of red flags on markets – from valuation to liquidity to something of a ‘buy everything’ mentality that is the opposite of where we were only 12 months ago. The problem here of course is that Alan Greenspan’s irrational exuberance speech came in 1996 – four year and several thousand points from the peak.  But back to SNAP for a moment, the company had been through nine rounds of pre-IPO financing to raise around $2.7bn, the bulk of which came only last May and served usefully to set the reference price for the IPO. Once diluted for performance shares and options the management and VCs have effectively sold around 14% of the company for a handy $3.4bn, but this is very different from saying that the stock is ‘valued’ at $24bn. The remaining shares (unless used for acquisition) are little more than a warrant on that publicly listed 14%.

Regards,

Mark

 

Mark Tinker

Head of AXA IM Framlington Equities Asia

 

-       ENDS  -

 

Notes to Editors

All data sourced by AXA IM as at Tuesday 7th March 2017

 

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