Market Thinking - a view from the equity market - commentary from Mark Tinker, AXA IM
- The UK General Election has produced more rather than less uncertainty, although from a market perspective the lack of ability to pass any new legislation may actually be a good thing. Once the political noise dies down, markets will focus attention back on Brexit
- Meanwhile, for the rest of the world, president Trump’s foreign policies are quietly delivering future profitability to assorted US companies in financial services, infrastructure and construction, defence and energy
- Economic pessimists on Asia are having to reassess profitability as earnings continue to beat expectations, driving de-coupling from global markets and offering potential upside for the region.
The ‘snap’ General Election in the UK – which has actually led to one of the longest ever election campaigns – was tragically overshadowed by terrorist atrocity and the voters’ focus shifted away from Brexit (which it was ostensibly about) to security and, it seems the attraction of free tuition fees for students which appears to have swung a lot of marginal seats to Labour. Markets had already been somewhat spooked by an apparent late swing in the polls towards an ultra left Labour party, much as they upped the risk premium in France at the prospect of Mr Melenchon winning the first round of the French Presidential Elections. As such there might ironically be something of a relief bounce over the next few days. Positioning was likely modest however, having learned from last year when the US presidential election was also seen by many as ‘her’s to lose’, investors moved largely to the sidelines. Now that we know the result, which delivered no overall majority for the Conservatives and a hung Parliament, politicians, if not markets are in shock (again). Prime Minister (PM) May will have lost significant credibility over this and the ‘inner circle’ who will in my view be blamed for putting in ‘unnecessary’ details on unpopular austerity measures when the opposition were always likely to be offering free stuff for everyone paid for by the ‘magic money tree’, will have to go straight away. The market might show some relief that at least it’s not a hard left government but will be concerned about the weakened ‘mandate’ of the PM. She may stay longer, but focus will undoubtedly shift to her likely successor, principally in light of their stance on Brexit, although it is important to note that Brexit will be negotiated by government, even a minority one, not parliament. Nevertheless, this will maintain the uncertainty premium over UK assets for a while yet. However, it is important to remember that trade does not need a trade agreement and that far from being ‘the worst of all worlds’, trading under the World Trade Organisation (WTO) rules in the light of no agreement with the European Union (EU) would not be an intolerable burden. More interesting might be the implications of the UK being outside of the customs union and thus without some of the significant external tariffs that the EU chooses to impose, particularly on agricultural products that Britain imports.
In the previous note we discussed president Trump’s recent foreign tour, highlighting a number of the interesting policy initiatives that had crept through almost unseen, notably the moves to allow China to import US liquefied natural gas (LNG) and the agreement to allow US banks such as JP Morgan and Citi to underwrite and settle Chinese onshore bonds, as well as US rating agencies to rate them. While the short term noise from the commentariat was about ‘failures’ on areas such as steel and aluminium, the long term strategic ‘wins’ for both the US and China in financial services and energy should not be under-estimated. The construction and infrastructure stories got a boost too, with the US backing the Chinese ‘One Belt One Road’ initiative looking for machinery sales and construction contracts no doubt and the Chinese suggesting they may well invest some of their infrastructure billions into the US. The Saudis as well are proposing to cooperate with US private equity firms such as Blackstone to spend some of their Aramco cash (raised with the help of US investment banks) on US infrastructure projects. Meanwhile US defence industry got a further boost from the stop-over in the Middle East (although as is often the case the big announcements on spending can be repeats of already announced expenditure).
All of this of course is consistent with what Trump’s advisers on security and economics – H.R. McMaster and Gary Cohn – wrote in a recent Wall Street Journal article about the world no longer being a global community. The key quote, which has the ‘Davoisie spitting feathers’ is that “The president embarked on his first foreign trip with a clear-eyed outlook that the world is not a “global community” but an arena where nations, nongovernmental actors and businesses engage and compete for advantage. We bring to this forum unmatched military, political, economic, cultural and moral strength.” This in my view undermines the globalist narrative embedded in the post war Bretton Woods institutions of the International Monetary Fund (IMF), the World Bank and the WTO, the OECD, the G7, the United Nations (UN) and all the rest. It is also entirely consistent with the announcement that the US would seek to renegotiate the agreement that president Obama signed up to on climate change in Paris. Their worldview is being not only shaken up, but ruptured and, not surprisingly they are not happy. However, as Cohn and McMaster put it “Rather than deny this elemental nature of international affairs, we embrace it.” The globalist world view is being ‘Uber-ed’ in that a small group of controlling vested interests (the Davos set) are being disrupted by a new platform (the Trump White House) that is offering end users an alternative infrastructure. Like taxis, the new model may be the same quality but cheaper like London or better quality but slightly more expensive like Hong Kong and as we are seeing in both cities, the vested interests are trying to use the legal system to preserve their monopoly. I believe Cohn and McMaster are effectively acknowledging that the genie is out of the bottle, to continue the analogy, you might be able to close down Uber, but it will only be replaced by Lyft or Didi.
As investors I believe we need to take a similar approach and rather than deny the elemental nature of the Trump Administration and its policies we should, if not exactly embrace them, at least recognise that this is the world we are now living in. Rather like economists who used to predict interest rates on the back of what they personally would do, rather than what the Federal Reserve (Fed), or the Bank of England was actually likely to do, predicting US foreign policy on the basis of what you think the Trump Administration ‘ought to do’ (in this case almost entirely follow the Davos, Bretton Woods, Washington Consensus playbook) will likely not help investors navigate the most likely actual scenario. It is like telling London commuters that have got used to Uber that they should be happy to pay two to three times as much for a taxi or Hong Kong users that they shouldn’t have the choice to pay a little more for a better quality experience. It seems America is now going to act in the interests of America, not the interests of Davos man.
Meanwhile, this week we saw another interesting fall-out from the Middle East tour, the move to isolate Qatar by other Gulf States on account of its funding for terrorism. There are naturally questions about the amount of direct involvement the US Administration had in this (though it is worth noting that the US is now a competitor with Qatar in the LNG business) but what is not in doubt is that attacking the sources of funding is a key part of the process of dealing with terrorists. Even if Qatar is indeed shown to be a source of funding, it is clearly not the only one, but the process has begun. The local markets have obviously been hit and short term, the airlines are the most obvious winners/losers and should things persist there will obviously be questions over divestment from the Sovereign Wealth Fund – as well as a key question about the 2022 World Cup! Also the US LNG producers won’t be unhappy about these events.
At our regular monthly meeting for our global equity management teams, my eye was drawn to the following chart, highlighting the collapse in correlations between the US and other markets over the last 12 months. Is this the long awaited ‘conscious uncoupling’ as the phrase goes?
Chart 1: Correlations falling rapidly – are we finally de-coupling?
Source: AXA IM, June 2017
Obviously I focussed on the drop in the Asia Pacific Ex Japan correlation from almost 90% to around 40% - not quite as low as 2014, but close. We can interpret this in one of two ways – either the correlation is just about to snap right back again, or else the longer term fundamentals are asserting themselves and we are finally seeing a de-coupling of Asia Pacific from the US. The latter certainly makes intuitive sense. US interest rate policy is much less important than it used to be in Asia Pacific, not least due to the increasing role of China, but also this year the runaway winners in Asia in terms of local currency performance have been India and South Korea, both of which are seeing multiples being driven higher very much by local rather than global factors. Meanwhile corporate profitability in Asia Pacific remains strong and it is dependent on neither the US interest rate nor the US non-farm payrolls. Balance sheets are sound and cash distribution is high. From an asset allocation perspective, this ought to be a win/win for diversification; either the correlation drops further, justifying diversification into Asia Pacific, or it rises from here and there is no loss from diversifying from US to Asia Pacific. Heads you win and tails you don’t lose. Correlation of course says little about direction, Asia Pacific could go down while the US goes up, but earnings, valuation and relative growth would argue against that. We also need to remember that there is more to risk measurement than volatility and correlation with a benchmark.
The correlation between the US and emerging markets (EM) has fallen even further and this partly reflects the influence of Asia, but also I would argue the increasing fall in correlation within emerging markets themselves. This is nicely illustrated in my opinion by the following info-graphic from Charles Schwab which I picked up on thanks to one of my Linkedin contacts posting it (thanks Daniel). As the title on the linked website puts it “Emerging Markets are not all created equal”
Chart 2: Emerging market drivers increasingly diverse
Source: Charles Schwab Corporation, 2017
We can argue about the Charles Scwab interpretations of sensitivity for various countries, (for example as noted above much of Asia is increasingly sensitive to what is happening in China) but in my view this graphic helps illustrate two important points for investors. Firstly the diversity of drivers and sensitivities of countries within the overall group known as emerging markets and secondly the fact that we can debate these sensitivities is partly a result of the fact that they are changing. This is (yet another) important point to consider in the active versus passive debate. Investors in an emerging market benchmark, be it equity or debt need to recognise the two factors outlined above and ask questions such as “how is your benchmark weighted in EM? Does it include areas you want/don’t want to be exposed to? Does it allow for the changing economic dynamics represented in this chart?” And so on.
One aspect of active management of course is governance and bottom up analysis. As we discussed in the last note, the problems of market cap weighted indices for equities pushing capital to the biggest companies are in certain ways as nothing compared to the issue weightings in credit markets. This is particularly an issue with tracker or indeed quantitative funds which claim they do not need research if there is a problem with the published numbers, something that remains an important issue in emerging markets and certainly here in Asia. This “G” for governance I think can sometimes be the overlooked element of ESG analysis, but it is a key part of portfolio risk management in our view. Computers can screen for red flags on published data, but they can only work with what’s in the database and obviously have limited look ahead or forecast data.
By way of illustration, this week saw the Sohn conference here in Hong Kong and noted short seller Carson Block of Muddy Waters Research caused something of a panic in Hong Kong markets when he announced that he would be revealing his next big short and that it would be a Hong Kong stock. A list of around 30 or more stocks all moved close to limit down as local speculators tried to work out the name involved. Asia has a number of governance issues that would set up red flags for investors, such as relatively opaque ownership structures, the predominance of single family majority shareholders (and the risk of related transactions), somewhat inconsistent tax treatments, lack of visibility on cash flows and so on. All of course are further reasons we would argue for careful active management. Carson Block has scored two direct hits in this particular game of battleships in the last few years. In 2011 he correctly identified the inconsistences in Sino-Forest Corporation, a widely held timber stock that turned out to have only a small fraction of the land (and trees) that it claimed and last year he suggested that Huishan Dairy, a relatively new listing was essentially worth zero. As such, the media here were hanging on his every word for ‘this year’s stock’. It is not for me to comment on the accuracy of this year’s pronouncements, not least because we have not yet seen the detailed report, beyond noting that while two huge hits in five years is excellent, it doesn’t guarantee a hit every year as this article points out (both stocks mentioned in that report are significantly higher today for example). However, what it does illustrate in my view is that data needs analysis before it becomes information. A screen is a starting point for your credit risk analysis (as a credit or an equity investor), not a substitute for it.
Much travel ahead for the rest of the month, speaking at conferences in the UK, Thailand and Australia, but will hopefully be able to keep up a few updates as we approach the end of the second quarter, where did that go?
Head of AXA IM Framlington Equities Asia
Notes to Editors
All data sourced by AXA IM as at Friday June 9th 2017.
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