Market Thinking - a view from the equity market

21/04/2017

Wednesday April 19th 2017

 

  • The contrarian trades from early this year continue to work. The dollar is down, bonds are up, commodities are flat to down. Emerging markets have been some of the best performing equities. The reflation trade has all but unwound.
  • Much of this reflects simple mean reversion on prices and a year-end group think, that while intuitively correct, this was already priced in. With politics confusing in the US and unnerving in Europe, attention is shifting to Asia, looking for yield especially.
  • Meanwhile, medium term trends on energy supply and trade routes are redefining globalism. Rather than everything adopting or adapting to a US model, it is going to mean interconnected but culturally different markets.

 

Ahead of the Easter break, most markets were flattening any bets, leaving geopolitics and the currency markets to generate most of the noise. Concerns over escalation in North Korea pushed Treasury yields down and gold up and would ‘normally’ have strengthened the dollar. However, comments by President Trump that the dollar was too strong helped push the yen back below 109 and sterling above 1.25 causing their equity markets to weaken. However, both currencies appear to have backed away from technical resistance. Oil similarly rallied and now appears to be fading.

North Korea, Turkey and France are all on the agenda this week. The US has seemingly made North Korea ‘China’s problem’ and the show of strength in Syria, Afghanistan and now the battle fleet sailing towards Korea seem to all be part of a shift in the perceived US stance of isolationism. The referendum in Turkey meanwhile has pushed that country further away from secularism and western democratic principles, which will likely only heighten tension with Europe, especially as the migration waves show no sign of slowing. On top of all that we have the first round of the French Election this weekend and while we still cling to the belief that Mr. Macron will ultimately triumph, markets are getting nervous about the prospect of a Melenchon/Le Pen second round with no middle ground candidate. This could be particularly meaningful for the single currency as both of these candidates have expressed a desire to take France out of the euro and as discussed last week, my view would be that markets, especially sovereign bonds, are likely to ‘short first and ask questions later’. As such, I think it is the future of the euro rather than the European Union that is the main concern here for markets.

I believe it is fair to say that as we approach the first 100 days of the Trump Presidency that the US policy picture is now perhaps more confused than ever. Having said that he would not intervene in Syria, that North Atlantic Treaty Organization (NATO) was irrelevant and that America would not be the world’s policeman, President Trump appears to have reversed position on all of those statements to the consternation of many of his more high profile core supporters, but the apparent approval of some of his key detractors. From a markets point of view, the easing of rhetoric on trade sanctions and tariffs is welcome, including this week the omission of any announcement that China was a currency manipulator, something candidate Trump had declared he would announce as soon as he was elected. To be fair this latter point should not have been much of a surprise, since as we noted three months ago, the rules the US has established to make such a declaration (and hence bring in tariffs) were such that it would be almost impossible to declare China a currency manipulator. This was one of the reasons that we identified emerging markets and Asia as a good contrarian bet at the beginning of the year, the consensus for a strong dollar and tariffs back then had led to an attractive relative valuation gap with the US when the reality looked far from certain.

Indeed, the so called ‘reflation’ trade has unwound quite noticeably since the derivatives expiry in March, particularly for long bonds, with the 10 year breaking back below the 2.3% level that looked like a floor – and a long way off the 3% level that so many were predicting only a month or so ago.  There is now a growing feeling that this is actually turning into a conventional Republican presidency and that represents a threat to the prospects of tax cuts over and above perhaps the repatriation deal for offshore profits.

With some of the macro drivers appearing to fade and valuations looking quite rich, there is increasing interest from international investors in emerging markets and notably Asia, not least because (as we never tire of saying) Asia provides around 30% of all dividends paid globally but is probably less than 5% of global portfolios. As we at AXA IM Framlington Equities are active equity investors, we obviously continue to believe that it is better to select a portfolio of stocks that not only have a good yield, but also where that yield is growing. However, to illustrate the broader point it is perhaps worth looking at the index shown in chart 1, the Shanghai Stock Exchange Dividend Index. This index has been going since 2005 and features 50 stocks determined to have high and stable cash dividend distribution records. We can see that earlier this month it broke out to make a new 12 month high and is showing positive momentum.

Chart 1: Chinese dividends

Source: Bloomberg, AXA IM, April 2017

 

Elsewhere when looking for yield outside the US , it was interesting to read an article in the Wall Street Journal this week pointing out that the a number of ETFs for emerging market bonds, had under-performed the benchmark over the last five years, highlighting some of the problems that benchmarks present in emerging markets. Lower liquidity levels and higher trading costs are part of the problem, as well as idiosyncratic risk from smaller sovereigns. These issues are not unknown, rather like the fact that while US equity indices are regularly top quartile performers (i.e. if measured against the full universe of active funds the index frequently comes in the top quartile), equity indices in emerging markets are often third or fourth quartile, offering opportunity for alpha. This means that the constant refrain that active managers can’t beat the benchmark, which is based largely on US markets, might not be quite so relevant in emerging markets. Indeed we would argue that it isn’t.

While on the subject of ETFs, there was an interesting point raised in the quarterly note by UK based hedge fund, Horseman Partners. The ETF boom has been so strong, notably in the US that ETF and ETF related funds can in many circumstances represent a significant, in some cases almost a majority of shareholdings for some companies. To put on our ‘market mechanics’ hat again for a moment, this could very well represent a ‘Minsky Moment’ where the suppression of volatility (and hence a particular measure of risk) stores up greater instability for later. In the example that Horseman give, Simon Properties, which is the largest property stock in the US, has apparently in excess of 50% of shareholders that are passive/ETF related. The problem, as Russell Clarke at Horseman puts it is that these are mainly REIT ETFs such that if there is an asset allocation switch from REITs the individual stocks are all offer and no bid. If, as he suspects, there is an unwind in REITs due to the poor performance of US retail malls in particular, then this rush to passive could unwind quite badly. As ever, it is the liquidity risk that is being underestimated.

President Trump’s announcements on the dollar appeared to take the markets by surprise last week, although they have yet to damage the long term trend. Perhaps this reflected the fact that most people believe that a strong dollar is actually in the US interests. This was a point made at a lunch last week with Richard Fisher, former head of the Dallas Fed and a recently retired member of the Federal Reserve (Fed) board. He noted that with a current account deficit, America benefits from cheaper imports and thus a stronger dollar. He even suggested it was as high as 82% of the population that benefits. Certainly the people who voted for President Trump tend to do better when imports are cheaper – even if exports are less competitive, except of course in the notable big (largely commodity) export industries who globally lobby their governments for competitive devaluation. As with much that is unclear in the US policy realm at the moment, in my opinion it is difficult to know if President Trump really is a mercantilist.

Richard Fisher also pointed out that the reason that the Fed has not run down its balance sheet very far is simply one of practicality, nothing was maturing. He noted that around US$1.3trillion of balance sheet rolls off over the next three years and it is unlikely that there will be any more quantitative easing (QE), given the attitude of Congress to the matter. While noting that the political ‘threat’ to the Fed had eased considerably he also pointed out that in a pre-inauguration meeting with President elect Trump he was asked about ‘practical bankers’ to join the board of the Fed. There was a general feeling that it is/was too academic in its approach. This would be consistent with a desire to shrink the balance sheet without distorting the markets too much. Experienced money and bond market operatives are needed now.

Finally, some news on activity around the New Silk Road, something that is key for this region. I forgot to mention last week that the first export train from London to Yiwu in China left on April 10th 2017, carrying such top British exports as drugs, baby products and whisky and is expected to take around three  weeks to complete its 12,000 mile journey. As we highlighted when the first westbound train left China back in January, this is considerably quicker than by ship and with a better carbon footprint than either sea or air. It also takes out various geopolitical ‘pinch points’ from the Chinese point of view, notably the Suez Canal, the Straits of Hormuz or the Malacca Straits. This is not a coincidence; indeed I believe it is one of the primary drivers for building the network, to reduce the vulnerability of Chinese trade to potential naval interference. This is clearly the case with the newly (finally) opened China Myanmar pipeline that began flowing last week, taking oil to Kunming in western China without going through the Malacca Straits.

One aspect that has been somewhat overlooked with all the discussion about the US as an exporter of oil is that recently it has also become a major exporter of gas, as illustrated by Chart 2.

Chart 2: US becomes a major player in the gas markets

Source: Bloomberg AXA IM, April 2017

 

The chart shows billions of cubic feet of liquefied natural gas (LNG) exports which have leapt this year following the moves by US company Cheniere to turn its LNG import terminals to LNG export terminals. The arrival of this new source of gas is a boost for Europe as it will keep down prices from the likes of Gazprom or the Norwegians, particularly as gas stocks are currently low. Indeed, as we discussed recently, the competition to supply gas into Europe and Asia has been intensifying with the Israel pipeline deal announced last week and ongoing discussions and plans for Syria to bring gas from either Qatar or Iran (depending on who controls Syria). Whether any of that gas would go via President Erdogan’s new Turkey is yet another complication. The US LNG shipments are playing a major role in that arbitrage.

The US is already the world’s largest supplier of liquid propane gas (LPG), which is loaded into very large gas carriers (VLGCs) and shipped globally. Traditionally a lot has simply gone to Latin America, but the opening of the new, wider, Panama Canal cuts 7000 miles off the voyage to Asia.  Alternatively they can take the more ‘traditional’ route across the Atlantic. For those that like this sort of thing, Bloomberg tracks the cargoes. Here we can see a daily plot of a VLGC shipping gas to Pakistan.

Chart 3: Plot of a gas cargo going from US to Pakistan

Source: Bloomberg AXA IM, April 2017

 

This then changes the dynamics of energy and shipping. The US is now exporting through the Suez Canal rather than importing and obviously now can compete directly in the LNG market with Russia, Qatar, Australia and Norway into Europe and Asia. The dynamics of political power tend to reflect the dynamics of motive power. The shift for the US to being an importer to an exporter of oil and gas will continue to have important repercussions for how America interacts with the rest of the world, while the excess supply brought on by its technology looks to be great for consumers globally and rather less exciting for producers, especially those with little other industry and with high social budgets.

To conclude. With the US equity market at the top of its valuation range, long bonds similarly and a potentially increased threat of a euro breakdown of some sort over the next few months,  particularly for bonds, Asia, in terms of both bonds and equities, looks increasingly attractive to medium and long term investors. However, perhaps not surprisingly given our biases we believe that the nature of the markets and the benchmarks mean that this is more of an active management issue. Meanwhile the confusion over US policy does not mean we should lose sight of some of the important longer term interactions on trade that will progress regardless of ‘trade deals’. These apply particularly to the US exporting LNG to the world but also to the impact of China securing its overland trade routes and reducing its exposure to strategic pinch points for its imports. One Belt One Road and US LNG exports are both national policies that will have meaningful impacts on the rest of the world. A different form of globalisation is coming.

Regards,

Mark

 

Mark Tinker

Head of AXA IM Framlington Equities Asia

 

-       ENDS  -

 

Notes to Editors

All data sourced by AXA IM as at Wednesday 19th April 2017.

 

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