A global slowdown in 2019 – is it already in the price?

A global slowdown in 2019 – is it already in the price?

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Macro Letter – No 106 – 07-12-2018

A global slowdown in 2019 – is it already in the price?

  • US stocks have given back all of their 2018 gains
  • Several developed and emerging stock markets are already in bear-market territory
  • US/China trade tensions have eased, a ‘No’ deal Brexit is priced in
  • An opportunity to re-balance global portfolios is nigh

The recent shakeout in US stocks has acted as a wake-up call for investors. However, a look beyond the US finds equity markets that are far less buoyant despite no significant tightening of monetary conditions. In fact a number of emerging markets, especially some which loosely peg themselves to the US$, have reacted more violently to Federal Reserve tightening than companies in the US. I discussed this previously in Macro Letter – No 96 – 04-05-2018 – Is the US exporting a recession?

In the wake of the financial crisis, European lacklustre growth saw interest rates lowered to a much greater degree than in the US. Shorter maturity German Bund yields have remained negative for a protracted period (7yr currently -0.05%) and Swiss Confederation bonds have plumbed negative yields never seen before (10yr currently -0.17%, but off their July 2016 lows of -0.65%). Japan, whose stock market peaked in 1989, remains in an interest rate wilderness (although a possible end to yield curve control may have injected some life into the market recently) . The BoJ balance-sheet is bloated, yet officials are still gorging on a diet of QQE policy. China, the second great engine of world GDP growth, continues to moderate its rate of expansion as it transitions away from primary industry and towards a more balanced, consumer-centric economic trajectory. From a peak of 14% in 2007 the rate has slowed to 6.5% and is forecast to decline further:-

china-gdp-growth-annual 1988 - 2018

Source: Trading Economics, China, National Bureau of Statistics

2019 has not been kind to emerging market stocks either. The MSCI Emerging Markets (MSCIEF) is down 27% from its January peak of 1279, but it has been in a technical bear market since 2008. The all-time high was recorded in November 2007 at 1345.

MSCI EM - 2004 - 2018

Source: MSCI, Investing.com

A star in this murky firmament is the Brazilian Bovespa Index made new all-time high of 89,820 this week.

brazil-stock-market 2013 to 2018

Source: Trading Economics

The German DAX Index, which made an all-time high of 13,597 in January, lurched through the 10,880 level yesterday. It is now officially in a bear-market making a low of 10,782. 10yr German Bund yields have also reacted to the threat to growth, falling from 58bp in early October to test 22bp yesterday; they are down from 81bp in February. The recent weakness in stocks and flight to quality in Bunds may have been reinforced by excessively expansionary Italian budget proposals and the continuing sorry saga of Brexit negotiations. A ‘No’ deal on Brexit will hit German exporters hard. Here is the DAX Index over the last year: –

germany-stock-market 1yr

Source: Trading Economics

I believe the recent decoupling in the correlation between the US and other stock markets is likely to reverse if the US stock market breaks lower. Ironically, China, President Trump’s nemesis, may manage to avoid the contagion. They have a command economy model and control the levers of state by government fiat and through currency reserve management. The RMB is still subject to stringent currency controls. The recent G20 meeting heralded a détente in the US/China trade war; ‘A deal to discuss a deal,’ as one of my fellow commentators put it on Monday.

If China manages to avoid the worst ravages of a developed market downturn, it will support its near neighbours. Vietnam should certainly benefit, especially since Chinese policy continues to favour re-balancing towards domestic consumption. Other countries such as Malaysia, should also weather the coming downturn. Twin-deficit countries such as India, which has high levels of exports to the EU, and Indonesia, which has higher levels of foreign currency debt, may fare less well.

Evidence of China’s capacity to consume is revealed in recent internet sales data (remember China has more than 748mln internet users versus the US with 245mln). The chart below shows the growth of web-sales on Singles Day (11th November) which is China’s equivalent of Cyber Monday in the US: –

China Singles day sales Alibaba

Source: Digital Commerce, Alibaba Group

China has some way to go before it can challenge the US for the title of ‘consumer of last resort’ but the official policy of re-balancing the Chinese economy towards domestic consumption appears to be working.

Here is a comparison with the other major internet sales days: –

Websales comparison

Source: Digital Commerce, Adobe Digital Insights, company reports, Internet Retailer

Conclusion and Investment Opportunity

Emerging market equities are traditionally more volatile than those of developed markets, hence the, arguably fallacious, argument for having a reduced weighting, however, those emerging market countries which are blessed with good demographics and higher structural rates of economic growth should perform more strongly in the long run.

A global slowdown may not be entirely priced into equity markets yet, but fear of US protectionist trade policies and a disappointing or protracted resolution to the Brexit question probably are. In financial markets the expression ‘buy the rumour sell that fact’ is often quoted. From a technical perspective, I remain patient, awaiting confirmation, but a re-balancing of stock exposure, from the US to a carefully selected group of emerging markets, is beginning to look increasingly attractive from a value perspective.

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The Self-righting Ship – Debt, Inflation and the Credit Cycle

The Self-righting Ship – Debt, Inflation and the Credit Cycle

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Macro Letter – No 105 – 23-11-18

The Self-righting Ship – Debt, Inflation and the Credit Cycle

recovery_saltaire

Source: Stromness Lifeboat

  • Rising bond yields may already have tempered economic growth
  • Global stocks are in a corrective phase but not a bear-market
  • With oil prices under pressure inflation expectations have moderated

The first self-righting vessel was a life-boat, designed in 1789. It needed to be able to weather the most extreme conditions and its eventual introduction (in the 1840’s) transformed the business of recuse at sea forever. The current level of debt, especially in the developed economies, seems to be acting rather like the self-righting ship. As economic growth accelerates and labour markets tighten, central banks gradually tighten monetary conditions in expectation of inflation. As short-term rates increase, bond yields follow, but, unlike the pattern seen in the higher interest rate era of the 1970’s and 1980’s, the effect of higher bond yields quickly leads to a tempering of credit demand.

Some commentators will rightly observe that this phenomenon has always existed, but, at the risk of saying this time it’s different, the level at which higher bond yields act as a break on credit expansion are much lower today in most developed markets.

When in doubt, look to Japan

For central bankers, Japan is the petri dish in which all unconventional monetary policies are tested. Even today, QQE – Quantitative and Qualitative Easing – is only seriously being undertaken in Japan. The Qualitative element, involving the provision of permanent capital by the Bank of Japan (BoJ) through their purchases of common stocks (at present, still, indirectly via ETFs), remains avant garde even by the unorthodox standards of our times.

Recently the BoJ has hinted that it may abandon another of its unconventional monetary policies – yield curve control. This is the operation whereby the bank maintains rates for 10yr maturity JGBs in a range of between zero and 10 basis point – the range is implied rather than disclosed – by the purchase of a large percentage of all new Japanese Treasury issuance, they also intervene in the secondary market. During the past two decades, any attempt, on the part of the BoJ, to reverse monetary easing has prompted a rise in the value of the Yen and a downturn in economic growth, this time, however, might be different – did I use that most dangerous of terms again? It is a long time since Japanese banks were able to function in a normal manner, by which I mean borrowing short and lending long. The yield curve is almost flat and any JGBs with maturities shorter than 10 years tend to trade with negative yields in the secondary market.

Japanese banks were not heavily involved in the boom of the mid-2000’s and therefore weathered the 2008 crisis relatively well. Investing abroad has been challenging due to the continuous rise in the value of the Yen, but during the last few years the Japanese currency has begun to trade in a broad range rather than appreciating inexorably.

In the non-financial sector a number of heavily indebted companies continue to limp on, living beyond their useful life on a debt-fuelled last hurrah. Elsewhere, however, Japan has a number of world class companies trading at reasonable multiples to earnings. If the BoJ allows rates to rise the zombie corporations will finally exit the gene pool and new entrepreneurs will be able to fill the gap created in the marketplace more cheaply and to the benefit of the beleaguered Japanese consumer. My optimism about a sea-change at the BoJ may well prove misplaced. Forsaking an inflation target and offering Japanese savers positive real-interest rates is an heretically old-fashioned idea.

Whilst for Japan, total debt consists mainly of government obligations, for the rest of the developed world, the distribution is broader. Corporate and consumer borrowing forms a much larger share of the total sum. Giving the historically low level of interest rates in most developed economies today, even a moderate rise in interest rates has an immediate impact. Whereas, in the 1990’s, an increase from 5% to 10% mortgage rates represented a doubling payments by the mortgagee, today a move from 2% to 4% has the same impact.

The US stock market as bellwether for global growth

Last month US stocks suffered a sharp correction. The rise had been driven by technology and it was fears of a slowdown in the technology sector that precipitated the rout. Part of the concern also related to US T-Bonds as they breached 3% yields – a level German Bund investors can only dream of. Elsewhere stock markets have been in corrective (0 – 20%) or bear-market (20% or more) territory for some time. I wrote about this decoupling in Macro Letter – No 101 – 31-08-2018 – Divergent – the breakdown of stock market correlations, temp or perm? Now the divergence might be about to reverse. US stocks have yet to correct, whilst China and its vassals have already reacted to the change in global growth expectations. Globally, stocks have performed well for almost a decade: –

MSCI World

Source: MSCI and Yardeni

The next decade may see a prolonged period of range trading. After 10 years, during which momentum investing has paid handsomely, value investing may be the way to navigate the next.

Along with stocks, oil prices have fallen, despite geopolitical tensions. The Baker Hughes rig count reached 888 this week, the highest since early 2015. With WTI still above $60/bbl, the number of active rigs is likely to continue growing.

US 10yr bond yields have already moderated (down to 3.06% versus their high of 3.26%) and stocks have regained some composure after the sudden repricing of last month. The ship has self-righted for the present but the forecast remains turbulent.     

How are Chinese stocks responding to tariffs with the US and a slowdown in Asian growth?

How are Chinese stocks responding to tariffs with the US and a slowdown in Asian growth?

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Macro Letter – No 104 – 09-11-2018

How are Chinese stocks responding to tariffs with the US and a slowdown in Asian growth?

  • Despite US tariffs, China’s September trade balance with the US reached a record high
  • A number of China’s Asian neighbours have seen a deceleration in growth
  • The Shanghai Composite has fallen more than 50% since 2015, the PE ratio is 7.2
  • Government bond yields have eased and the currency is lower against a rising US$

During 2018 Chinese financial markets have been on the move. 10yr bond yields rose from all-time lows throughout 2017 but have since declined: –

China bonds 2006-2018

Source: Trading Economics, PRC Ministry of Finance

Despite this easing of monetary conditions the negative impact US tariffs, continues to weigh on the Chinese stock market: –

China shanghai index 1990-2018

Source: Trading Economics, OTC, CFD

Despite being a leader in frontier technologies such as e-commerce (China has 733mln internet users compared with 391mln in India, 413mln in the EU and a mere 246mln in the US) the recent decline in tech giants Alibaba (BABA) and Tencent (TCEHY) have added to financial market woes. However, as the chart above shows, Chinese stocks have been in a bear-market since 2015. Some of its Asian neighbours have followed a similar trajectory as their economies have slowed in response to a US$ strength and US trade policy.

The notionally pegged Chinese currency has also weakened against the US$, testing it lowest levels in almost a decade: –

China currency 2008-2018

Source: Trading Economics

Meanwhile, President Xi has now announced plans to rebalance China’s economy towards consumption, turning it into an importing superpower. Surely something has to give.

The IMF expects Chinese GDP to grow at 6.6% in 2018. They continue to point to signs of economic progress: –

The country now accounts for one-third of global growth. Over 800 million people have been lifted out of poverty and the country has achieved upper middle-income status. China’s per capita GDP continues to converge to that of the United States, albeit at a more moderate pace in the last few years.

The authors go on to predict that the country may become the world’s largest economy by 2030. However, there are headwinds: –

Despite the sharp rebound in nominal GDP and industrial profits, total nonfinancial sector debt still rose significantly faster than nominal GDP growth in 2017. While the corporate debt to GDP ratio has stabilized, government and especially household debt is rising, driven by continued strong off-budget investment spending and a rapid increase in mortgage and consumer loans.

It is debt that concerns Carnegie Endowment’s Michael Pettis – Beijing’s Three Options: Unemployment, Debt, or Wealth Transfers – as the title suggests he envisages three paths to adjustment.

Raise investment. Beijing can engineer an increase in public-sector investment. In theory, private-sector investment can also be expanded, but in practice Chinese private-sector actors have been reluctant to increase investment, and it is hard to imagine that they would do so now in response to a forced contraction in China’s current account surplus.

Reduce savings by letting unemployment rise. Given that the contraction in China’s current account surplus is likely to be driven by a drop in exports, Beijing can allow unemployment to rise, which would automatically reduce the country’s savings rate.

Reduce savings by allowing debt to rise. Beijing can increase consumption by engineering a surge in consumer debt. A rising consumption share, of course, would mean a declining savings share.

Reduce savings by boosting Chinese household consumption. Beijing can boost the consumption share by increasing the share of GDP retained by ordinary Chinese households, those most likely to consume a large share of their increased income. Obviously, this would mean reducing the share of some low-consuming group—the rich, private businesses, state-owned enterprises (SOEs), or central or local governments.

Although fiscal stimulus appears to be rebounding it is a short-term solution. There have been many example of non-productive public investment: as a longer-term policy, this route is untenable: –

If Beijing does not rein in credit growth in time, it will be forced to do so once debt levels reach the point at which debt can no longer rise fast enough to maintain the country’s targeted economic growth rate. This adjustment can happen quickly, in the form of a debt crisis. Or (what I think is far more likely, at least for now) it can happen slowly, in the form of what is subsequently called a lost decade (or decades) of slow growth, similar to what Japan experienced after 1990.

Increased unemployment is a dangerous route to take, debt levels are already stretched, which leaves wealth transfers to the private sector.

A forced contraction in China’s current account surplus must be counteracted by either an increase in unemployment, an increase in the debt, or wealth transfers to Chines consumers (rather than savers).

Looking ahead Chinese growth is likely to slow. Here is Focus Economics – China Economic Outlook for October: –

China Economic Outlook

Available data suggests that economic growth decelerated in the third quarter, mainly due to lackluster infrastructure investment and negative spillovers from financial deleveraging. Surprisingly, export growth remained robust in Q3 despite the ongoing trade war between China and the United States. The September PMI survey, however, revealed that external demand is softening, which suggests export figures are likely to worsen in the next few months. In response, the government has reverted to old tactics, boosting lending and increasing fiscal stimulus. Although these initiatives are effective in supporting the economy in the short-term, they threaten the effort made in previous years to reshape the country’s economic model and allow the country to avoid the “middle income trap”.

China Economic Growth

Looking ahead, economic growth is expected to decelerate. This reflects China’s more mature economic cycle and the impact of previous economic reforms, as well as the tit-for-tat trade war with the United States and the cooling housing market. However, a looser fiscal stance and a more accommodative monetary policy should cushion the slowdown. FocusEconomics panelists see the economy growing 6.3% in 2019, which is unchanged from last month’s forecast. In 2020 the economy is seen expanding 6.1%.

Countering this view Peterson Economics – Who Thinks China’s Growth Is Slowing? Suggests that China may be holding up much better than imagined: –

A widespread consensus has developed around the view that China’s economic growth is slowing and that the leadership in Beijing will have no choice but to capitulate in the tariff war with President Donald Trump to avoid a further slowdown. Leading US news organizations (here and here) have sounded this theme as a kind of late summer siren song to lull people into thinking that Trump’s confrontational approach is bound to succeed at some point. The reality is that, as has been the case for the last few years, the case for China’s imminent economic difficulties is overblown.

The most widely cited piece of evidence for the new conventional wisdom, for example, is that fixed asset investment is slowing dramatically. Unfortunately, this assessment is based on a monthly data series released by China’s National Bureau of Statistics (NBS), which is currently revising the method used to calculate fixed asset investment. The method that was used so far involved considerable double counting, which the authorities are paring back. The slowing growth of this metric, thus, tells us nothing, and assessments based on existing data are no longer meaningful. 

There are three sources of growth in any economy: consumption, investment, and net exports. The problem is that data on China’s fixed asset investment, which include the value of sales of land and other assets, have increasingly overstated the expansion of the economy’s productive capacity.  Nonetheless, financial analysts and others have relied on this series because it is the only high-frequency data available on investment.  China’s data on gross domestic capital formation, which accurately measures the expansion of productive capacity, are available only on an annual basis and with a lag of five months.

According to NBS data, fixed asset investment grew by only 5.5 percent in the first seven months of 2018, the lowest in decades. In the first half of the year (January to June), fixed asset investment grew by 6 percent. But the price index for fixed asset investment rose by 5.7 percent, implying that real investment barely grew.  This, however, is inconsistent with the more reliable NBS data, which show the expansion of capital formation, properly measured, accounted for about one-third of the 6.8 percent of China’s GDP growth.

When the NBS releases final data for 2018 (probably in about nine months), we are likely to learn that the growth of capital formation, properly measured, exceeded the growth of fixed asset investment, just as it did in 2017.

The full article is in three parts – part 2 – taking a closer look at domestic consumption – is here and part 3 – charting the steady rise in imports – is here.

Conclusions and Investment Opportunities

According to analysis from Star Capital (28-9-2018) the PE ratio for Chinese Stocks was just 7.2 times – the second cheapest of the 40 stock markets they monitor – although its CAPE ratio was a more exalted 15.7. Since June 2015 the Shanghai Composite Index have fallen by 53%, peak to trough, whilst since January it has retraced 32% to its low last month. The downtrend has yet to reverse, but, as the second chart above shows, we are testing a support line taken from the lows of 2005 and 2014.

The Q2 2018 Monetary Policy Report the PBoC revealed a moderation in the rate of growth of loans to households to 18.8%, other areas of lending continue to expand rapidly. M2 growth has been steady at around 8%. I believe they will allow interest rates to remain unchanged at 4.35%, or reduce them should the need arise. Last month PBoC foreign exchange reserves fell slightly (-$34bln) but they remain above $3trln: enough to moderate the RMBs decline. China’s real broad effective exchange rate (trade-weighted) is still in a broad, multi-year uptrend due to its soft peg to the US$. Here is the chart since 2006: –

fredgraph (4)

Source: Federal Reserve Bank of St Louis

I expect China to reach a trade deal with the US within the next year. The recent slowdown in growth rate of debt formation by households will reverse: and the Shanghai Composite Index will form a base. The RMB may weaken further as the US continues to raise interest rates. Provided the US stock market maintains its nerve, an opportunity to buy Chinese stocks may emerge in the next few months. It may not yet be time to buy but there is little benefit in remaining short.

Not waving but drowning – Stocks, debt and inflation?

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Macro Letter – No 103 – 26-10-2018

Not waving but drowning – Stocks, debt and inflation?

  • The US stock market is close to being in a corrective phase -10% off its highs
  • Global debt has passed $63trln – well above the levels on 2007
  • Interest rates are still historically low, especially given the point in the economic cycle
  • Predictions of a bear-market may be premature, but the headwinds are building

The recent decline in the US stock market, after the longest bull-market in history, has prompted many commentators to focus on the negative factors which could sow the seeds of the next recession. Among the main concerns is the inexorable rise in debt since the great financial recession (GFR) of 2008. According to May 2018 data from the IMF, global debt now stands at $63trln, with emerging economy debt expansion, over the last decade, more than offsetting the marking time among developed nations. The IMF – Global Debt Database: Methodology and Sources WP/18/111 – looks at the topic in more detail.

The title of this week’s Macro letter comes from the poet Stevie Smith: –

I was much further out than you thought

And not waving but drowning.

It seems an appropriate metaphor for valuation and leverage in asset markets. In 2013 Thomas Pickety published ‘Capital in the 21st Century’ in which he observed that income inequality was rising due to the higher return on unearned income relative to labour. He and his co-authors gathering together one of the longest historical data-set on interest rates and wages – an incredible achievement. Their conclusion was that the average return on capital had been roughly 5% over the very long run.

This is not the place to argue about the pros and cons of Pickety’s conclusions, suffice to say that, during the last 50 years, inflation indices have tended to understate what most of us regard as our own personal inflation rate, whilst the yield offered by government bonds has been insufficient to match the increase in our cost of living. The real rate of return on capital has diminished in the inflationary, modern era. Looked at from another perspective, our current fiat money and taxation system encourages borrowing rather than lending, both by households, corporates, for whom repayment is still an objective: and governments, for whom it is not.

Financial innovation and deregulation has helped to oil the wheels of industry, making it easier to service or reschedule debt today than in the past. The depth of secondary capital markets has made it easier to raise debt (and indeed equity) capital than at any time in history. These financial markets are underpinned by central banks which control interest rates. Since the GFR interest rates have been held at exceptionally low levels, helping to stimulate credit growth, however, that which is not seen, as Bastiat might have put it, is the effect that this credit expansion has had on the global economy. It has led to a vast misallocation of capital. Companies which would, in an unencumbered interest rate environment, have been forced into liquidation, are still able to borrow and continue operating; their inferior products flood the market place crowding out the market for new innovative products. New companies are confronted by unfair competition from incumbent firms. Where there should be a gap in the market, it simply does not exist. At a national and international level, productivity slows and the trend rate of GDP growth declines.

We are too far out at sea and have been for decades. Markets are never permitted to clear, during economic downturns, because the short-term pain of recessions is alleviated by the rapid lowering of official interest rates, prolonging the misallocation of capital and encouraging new borrowing via debt – often simply to retire equity capital and increase leverage. The price of money should be a determinant of the value of an investment, but when interest rates are held at an artificially low rate for a protracted period, the outcome is massively sub-optimal. Equity is replaced by debt, leverage increases, zombie companies limp on and, notwithstanding the number of technology start-ups seen during the past decade, innovation is crushed before it has even begun.

In an unencumbered market with near price stability, as was the case prior to the recent inflationary, fiat currency era, I suspect, the rate of return on capital would be approximately 5%. On that point, Pickety and I are in general agreement. Today, markets are as far from unencumbered as they have been at any time since the breakdown of the Bretton Woods agreement in 1971.

Wither the stock market?

With US 10yr bond yields now above 3%, stocks are becoming less attractive, but until real-yields on bonds reach at least 3% they still offer little value – US CPI was at 2.9% as recently as August. Meanwhile higher oil prices, import tariffs and wage inflation all bode ill for US inflation. Nonetheless, demand for US Treasuries remains robust while real-yields, even using the 2.3% CPI data for September, are still exceptionally low by historic standards. See the chart below which traces the US CPI (LHS) and US 10yr yields (RHS) since 1971. Equities remain a better bet from a total return perspective: –

united-states-inflation-cpi 1970 to 2018

Source: Trading Economics

What could change sentiment, among other factors, is a dramatic rise in the US$, an escalation in the trade-war with China, or a further increase in the price of oil. From a technical perspective the recent weakness in stocks looks likely to continue. A test of the February lows may be seen before the year has run its course. Already around ¾ of the stocks in the S&P 500 have suffered a 10% plus correction – this decline is broad-based.

Many international markets have already moved into bear territory (declining more than 20% from their highs) but the expression, ‘when the US sneezes the world catches a cold,’ implies that these markets may fall less steeply, in a US stock downturn, but they will be hard-pressed to ignore the direction of the US equity market.

Conclusions and investment opportunities

Rumours abound of another US tax cut. Federal Reserve Chairman, Powell, has been openly criticised by President Trump; whilst this may not cause the FOMC to reverse their tightening, they will want to avoid going down in history as the committee that precipitated an end to Federal Reserve independence.

There is a greater than 50% chance that the S&P 500 will decline further. Wednesday’s low was 2652. The largest one month correction this year is still that which occurred in February (303 points). We are not far away, however, a move below 2637 will fuel fears. I believe it is a breakdown through the February low, of 2533, which will prompt a more aggressive global move out of risk assets. The narrower Dow Jones Industrials has actually broken to new lows for the year and the NASDAQ suffered its largest one day decline in seven years this week.

A close below 2352 for the S&P 500 would constitute a 20% correction – a technical bear-market. If the market retraces to the 2016 low (1810) the correction will be 38% – did someone say, ‘Fibonacci’ – if we reach that point the US Treasury yield curve will probably be close to an inversion: and from a very low level of absolute rates. Last week the FRBSF – The Slope of the Yield Curve and the Near-Term Outlook – analysed the recession predicting power of the shape of the yield curve, they appear unconcerned at present, but then the current slope is more than 80bp positive.

If the stock correction reaches the 2016 lows, a rapid reversal of Federal Reserve policy will be required to avoid accusations that the Fed deliberately engineered the disaster. I envisage the Fed calling upon other central banks to render assistance via another concert party of quantitative, perhaps backed up by qualitative, easing.

At this point, I believe the US stock market is consolidating, an immanent crash is not on the horizon. The GFR is still too fresh in our collective minds for history to repeat. Longer term, however, the situation looks dire – history may not repeat but it tends to rhyme. Among the principal problems back in 2008 was an excess of debt, today the level of indebtedness is even greater…

We are much further out than we thought,

And not waving but drowning.

UK Financial Services – Opportunities and Threats Post-Brexit – Short-term Pain, Long-term Gain?

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Macro Letter – No 102 – 28-09-2018

UK Financial Services – Opportunities and Threats Post-Brexit – Short-term Pain, Long-term Gain?

  • A Brexit deal is still no closer, but trade will not cease even if the March deadline passes
  • In the short-term UK and EU economic growth will suffer
  • Medium-term new arrangements will hold back capital investment
  • Long-term, there are a host of opportunities, in time they will eclipse the threats

In a departure from the my usual format this Macro Letter is the transcript of a speech I gave earlier this week at the UK law firm, Collyer Bristow; Thomas Carlisle may have dubbed Economics ‘the dismal science,’ but I remain an optimist.

Setting aside the vexed question of whether Brexit will be hard, soft or stalled, the impact on financial services (and, indeed, the majority of UK trade in goods and services) will be dramatic.

Financial markets (and businesses in general) loathe uncertainty. Ever since the referendum result, investment decisions have been postponed or cancelled. When investment is being made it is generally tentative and defensive. Exporters and importers alike are striving to develop alternative strategies to maintain and protect their franchises.

As a long-term economic commentator, I try to look beyond the immediate impact of events, since near-term expectations are usually reflected in the valuation of an asset or currency. Brexit, however, is a particular challenge, not only due to near-term uncertainty but because policy decisions taken now and in the wake of the March 2019 deadline could set the UK economy on an unusually wide array of possible trajectories.

Near-term

To begin an analysis of the impact post-Brexit on financial services, there are several near-term threats; here are a selection: –

  1. House Prices

Earlier this month Mark Carney, the Governor of the Bank of England, warned cabinet ministers that a ‘no-deal’ on Brexit could see house prices decline by as much as one third and a rapid rise in defaults. The subsequent impact on financial institutions balance sheets and the inevitable curtailment of bank lending could be severe. Jacob Rees-Mogg even dubbed him, ‘The High Priest of Project Fear.’

  1. Passporting

Assuming no deal is agreed, the access which financial services providers in the UK have had to the EU27 will not be available after March 2019. Many existing contracts and licensing agreements will need to be rewritten.

  1. Regulatory equivalence

Divergence between the regulatory regime in the UK and Europe remains a distinct risk. The types of legal issues surrounding, for example, ISDA Master agreements (Deutsche Bank AG v Comune di Savona) will inevitably become more widespread.

  1. Systemic Risks to the Euro

The ECB is vocal in its mission to maintain control over the clearing and settlement of Euro denominated transactions. Many financial services activities which currently take place in the UK may need to be transferred to another EU country.

In the near-term, these types of factors will reduce trade and economic growth, both in the UK and, to a lesser degree, in Europe. In May 2017 I wrote an essay entitled ‘Hard Brexit Maths – Walking Away’ in which I estimated the negative impact a no-deal Brexit would have on the EU. The UK’s NIESR estimated the bill for a Hard Brexit to the UK at EUR66bln/annum. I guesstimated the cost of Hard Brexit to the EU at EUR 62bln/annum. Both forecasts will probably prove inaccurate.

The reduced free movement of workers from the EU is another significant factor. It will lead to a rise in a toxic combination of skill shortages (due to new immigration controls) and unemployment, as companies are forced to conserve capital to weather the inevitable economic slowdown.

There are, however, several near-term opportunities, here are a small selection: –

  1. Sterling weakness

The currency has already weakened. Whilst this may be inflationary it makes UK exports more competitive. Whether the UK can take advantage of currency weakness remains to be seen, history is not on our side in this respect.

  1. A US boom

Aided by a lavish tax cut, the US economy is growing faster than at any-time since the financial crisis, underpinning its currency. Its trade deficit is growing despite tariff barriers.

  1. US Trade policy

The Trump administration appears to have focused its ire on trade surplus countries, of which Germany is the largest European example. The UK is not under the White House microscope to the same degree.

Seizing the opportunity presented by these financial and geopolitical shifts is easier to speak of than to grasp. Nonetheless, just this month Absa Bank of South Africa (recently spun-off from Barclays) announced plans to open a London office to capitalise on post-Brexit opportunities connected with the fast-growing economies of Africa.

Medium-term

The medium-term risks will mostly be borne out of inertia. Until the shape of Brexit is clear, decisions will continue to be postponed. Once Brexit occurs there will be inevitable technical problems, stemming from systems issues and new procedures. Growth will slow further, business operating costs will need to be cut, employment in financial services (and elsewhere) will decline at exactly the moment when greater investment should be undertaken.

But, new trade deals will be negotiated, not just with Europe and the US, but also with the countries of the British Commonwealth, notably (but not just) India. Many of these countries are among the fastest growing economies in the world, often imbued with benign demographics. Here is a rapidly expanding working age population in need of capital investment and financial services. Ruth Lea, Chief Economist at Arbuthnot Latham has commentated on this subject at length during the last two years. In April she wrote: –

Commonwealth countries, taken together, have buoyant economic prospects and their share of global output continues to increase (especially in PPP terms). The EU28 share, in contrast continues to decline.

UK exports to the top eight Commonwealth countries rose by over 31% between 2006 and 2016, but total exports rose by 40%. And the share of UK exports going to the top eight Commonwealth countries fell from 7.5% in 2006 to 7.0% in 2016…

There is little doubt that Commonwealth countries have the potential to be significant growth markets for the UK’s exports, given their favourable growth prospects and demographics. This is all the more likely given the probability of trade deals with individual Commonwealth countries after Brexit.

Long-term

David Riccardo defined the law of comparative advantage just over two hundred years ago. Perhaps one of the best examples of the continuance of the phenomenon is Switzerland, which has seen its currency appreciate against the US$ by approximately 3% per year, every year since fiat currencies were freed from their shackles after the collapse of the Bretton Woods agreement in 1971. Here is a chart of the US$/CHF exchange rate over the period: –

USDCHF 1970 to 2018

Source: fxtop.com

The Swiss turned to pharmaceuticals and other value-added businesses. The success of this strategy, despite a constantly appreciating currency, has spawned an entire industrial region – the Rhone-Alp economic area, which incorporates German, French, Italian and Austrian companies bordering Switzerland. This region is among the most economically productive in the EU.

The UK has an opportunity, post-Brexit, to focus on economic growth. As a trading nation, we should concentrate our efforts on re-forging links with the fast-growing countries of the Commonwealth, where the advantages of a common language and legal system favour the UK over other developed nations.

An example of this opportunity is in education. We have a world class reputation for education and training. Combine this redoubtable capability with the abundance of new technologies, which permit the delivery of content globally via the internet, and we can provide the full gamut of instruction, ranging from primary to tertiary and professional via a combination of video content, on-line examination and tailored digital collateral.

A recent MOOC (Mass Open On-line Course) In which I enrolled, attracted students from across the world. The course was dedicated to finance and among the students with whom I interacted was a Masi tribesman from Kenya who hoped to develop micro-finance solutions for the local farming community. The world is our veritable oyster.

Conclusion – The Bigger Picture

The economies of the developed world are growing more slowly than those of developing nations. Providing goods and services to the fastest growing economies makes economic sense. Many of the largest companies listed on the UK stock market have been oriented to take advantage of this dynamic for decades. Brexit is proving to be cathartic, we should embrace change: the sooner the better.

The Austrian economist, Joseph Schumpter, described the cycle of economic development as including a period of ‘creative destruction’. Brexit could be an extreme version of this process. The patterns of trade which have developed since the end of WW2 have been concerned with promoting cohesion between European nations, but, as Hyman Minsky famously noted, ‘stability creates the seeds of instability.’ I believe the political polarisation seen in Europe and elsewhere is a reaction against the success of the global financial and economic system and the institutions and alliances created to insure its success. We are entering an era of change and Brexit is but one personification of a growing trend. Technology has shrunk the world, empowered the individual and (in the process) undermined the influence of nation states and international institutions. Individual freedom is ascendant but with freedom comes responsibility.

One of the greatest challenges facing the UK and other developed nations, in the long run, is the provision of pensions and health insurance to an increasingly ageing population. Many of the financial products required by these ageing consumers are ones in which the UK is a world leader. The developing world is rapidly growing richer too. Their citizens will require these self-same products and services. Brexit is an opportunity to look forward rather than back. If we embrace change we will thrive, if not change will occur regardless. Post-Brexit there will be considerably pain but, if we manage to learn from history, there can also be long-term gain.

Divergent – the breakdown of stock market correlations, temp or perm?

Divergent – the breakdown of stock market correlations, temp or perm?

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Macro Letter – No 101 – 31-08-2018

Divergent – the breakdown of stock market correlations, temp or perm?

  • Emerging market stocks have stabilised, helped by the strength of US equities
  • Rising emerging market bond yields are beginning to attract investor attention
  • US tariffs and domestic tax cuts support US economic growth
  • US$ strength is dampening US inflation, doing the work of the Federal Reserve

To begin delving into the recent out-performance of the US stock market relative to its international peers, we need to reflect on the global fiscal and monetary response to the last crisis. After the great financial recession of 2008/2009, the main driver of stock market performance was the combined reduction of interest rates by the world’s largest central banks. When rate cuts failed to stimulate sufficient economic growth – and conscious of the failure of monetary largesse to stimulate the Japanese economy – the Federal Reserve embarked on successive rounds of ‘experimental’ quantitative easing. The US government also played its part, introducing the Troubled Asset Relief Program – TARP. Despite these substantial interventions, the velocity of circulation of money supply plummeted: and, although it had met elements of its dual-mandate (stable prices and full employment), the Fed remained concerned that whilst unemployment declined, average earnings stubbornly refused to rise.

Eventually the US economy began to grow and, after almost a decade, the Federal Reserve, cautiously attempted to reverse the temporary, emergency measures it had been forced to adopt. It was helped by the election of a new president who, during his election campaign, had pledged to cut taxes and impose tariffs on imported goods which he believed were being dumped on the US market.

Europe and Japan, meanwhile, struggled to gain economic traction, the overhang of debt more than offsetting the even lower level of interest rates in these markets. Emerging markets, which had recovered from the crisis of 1998 but adopted fiscal rectitude in the process, now resorted to debt in order to maintain growth. They had room to manoeuvre, having deleveraged for more than a decade, but the spectre of a trade war with the US has made them vulnerable to any strengthening of the reserve currency. They need to raise interest rates, by more than is required to control domestic inflation, in order to defend against capital flight.

In light of these developments, the recent divergence between developed and emerging markets – and especially the outperformance of US stocks – is understandable. US rates are rising, elsewhere in developed markets they are generally not; added to which, US tariffs are biting, especially in mercantilist economies which have relied, for so many years, on exporting to the ‘buyer of last resort’ – namely the US. Nonetheless, the chart below shows that divergence has occurred quite frequently over the past 15 years, this phenomenon is likely to be temporary: –

MSCI Developed vs MSCI EM 24-8-2018 Yardeni Research

Source: MSCI, Yardeni Research

Another factor is at work, which benefits US stocks, the outperformance of the technology sector. As finance costs have fallen, to levels never witnessed in recorded history, it has become easier for zombie companies to survive, crowding out more favourable investment opportunities, but it has also allowed, technology companies, with no expectation of near-term positive earnings, to continue raising capital and servicing their debts for far longer than during the tech-bubble of the 1990’s; added to which, the most successful technology companies, which evolved in the aftermath of the bursting of the tech bubble, have come to dominate their niches, often, globally. Cheap capital has helped prolong their market dominance.

Finally, capital flows have played a significant part. As emerging market stocks came under pressure, international asset managers were quick to redeem. These assets, repatriated most often to the US, need to be reallocated: US stocks have been an obvious destination, supported by a business-friendly administration, tax cuts and tariff barriers to international competition. These factors may be short-term but so is the stock holding period of the average investment manager.

Among the most important questions to consider looking ahead over the next five years are these: –

  1. Will US tariffs start to have a negative impact on US inflation, economic growth and employment?
  2. Will the US$ continue to rise? And, if so, will commodity prices suffer, forcing the Federal Reserve to reverse its tightening as import price inflation collapses?
  3. Will the collapse in the value of the Turkish Lira and the Argentine Peso prompt further competitive devaluation of other emerging market currencies?

In answer to the first question, I believe it will take a considerable amount of time for employment and economic growth to be affected, provided that consumer and business confidence remains strong. Inflation will rise unless the US$ rises faster.

Which brings us to the second question. With higher interest rates and broad-based economic growth, primed by a tax cut and tariffs barriers, I expect the US$ to be well supported. Unemployment maybe at a record low, but the quality of employment remains poor. The Gig economy offers workers flexibility, but at the cost of earning potential. Inflation in raw materials will continued to be tempered by a lack of purchasing power among the vastly expanded ranks of the temporarily and cheaply employed.

Switching to the question of contagion. I believe the ramifications of the recent collapse in the value of the Turkish Lira will spread, but only to vulnerable countries; trade deficit countries will be the beneficiaries as import prices fall (see the table at the end of this letter for a recent snapshot of the impact since mid-July).

At a recent symposium hosted by Aberdeen Standard Asset Management – Emerging Markets: increasing or decreasing risks? they polled delegates about the prospects for emerging markets, these were their findings: –

83% believe risks in EMs are increasing; 17% believe they are decreasing

46% consider rising U.S. interest rates/rising U.S. dollar to be the greatest risk for EMs over the next 12 months; 25% say a slowdown in China is the biggest threat

50% believe Asia offers the best EM opportunities over the next 12 months; 20% consider Latin America to have the greatest potential

64% believe EM bonds offer the best risk-adjusted returns over the next three years; 36% voted for EM equities.

The increase in EM bond yields may be encouraging investors back into fixed income, but as I wrote recently in Macro Letter – No 99 – 22-06-2018 – Where in the world? Hunting for value in the bond market there are a limited number of markets where the 10yr yield offers more than 2% above the base rate and the real-yield is greater than 1.5%. That Turkey has now joined there ranks, with a base rate of 17.75%, inflation at 15.85% and a 10yr government bond yield of 21.03%, should not be regarded as a recommendation to invest. Here is a table looking at the way yields have evolved over the past two months, for a selection of emerging markets, sorted by largest increase in real-yield (for the purposes of this table I’ve ignored the shape of the yield curve): –

EM Real Yield change June to August 2018

Source: Investing.com

Turkish bonds may begin to look good value from a real-yield perspective, but their new government’s approach to the imposition of US tariffs has not been constructive for financial markets: now, sanctions have ensued. With more than half of all Turkish borrowing denominated in foreign currencies, the fortunes of the Lira are unlikely to rebound, bond yields may well rise further too, but Argentina, with inflation at 31% and 10yr (actually it’s a 9yr benchmark bond) yielding 18% there may be cause for hope.

Emerging market currencies have been mixed since July. The Turkish Lira is down another 28%, the Argentinian Peso by 12%, Brazilian Real shed 6.3% and the South African Rand is 5.7% weaker, however the Indonesian Rupiah has declined by just 1.6%. The table below is updated from Macro Letter 100 – 13-07-2018 – Canary in the coal-mine – Emerging market contagion. It shows the performance of currencies and stocks in the period January to mid-July and from mid-July to the 28th August, the countries are arranged by size of economy, largest to smallest: –

EM FX and stocks Jan-Jul and Jul-Aug 2018

Source: Investing.com

It is not unusual to see an emerging stock market rise in response to a collapse in its domestic currency, especially where the country runs a trade surplus with developed countries, but, as the US closes its doors to imports and growth in Europe and Japan stalls, fear could spread. Capital flight may hasten a ‘sudden stop’ sending some of the most vulnerable emerging markets into a sharp and painful recession.

Conclusions and Investment Opportunities

My prediction of six weeks ago was that Turkey would be the market to watch. Contagion has been evident in the wake of the decline of the Lira and the rise in bond yields, but it has not been widespread. Those countries with twin deficits remain vulnerable. In terms of stock markets Indonesia looks remarkably expensive by many measures, India is not far behind. Russia – and to a lesser extent Turkey – continues to appear cheap… ‘The markets can remain irrational longer than I can remain solvent,’ as Keynes once said.

Emerging market bonds may recover if the Federal Reserve tightening cycle is truncated. This will only occur if the pace of US economic growth slows in 2019 and 2020. Another possibility is that the Trump administration manage to achieve their goal, of fairer trading arrangements with China, Europe and beyond, then the impact of tariffs on emerging market economies may be relatively short-lived. The price action in global stock markets have been divergent recently, but the worst of the contagion may be past. Mexico and the US have made progress on replacing NAFTA. Other countries may acquiesce to the new Trumpian compact.

The bull market in US stocks is now the longest ever recorded, it would be incautious to recommend stocks except for the very long-run at this stage in the cycle. In the near-term emerging market volatility should diminish and over-sold markets are likely to rebound. Medium-term, those countries hardest hit by the recent crisis will languish until the inflationary effects of currency depreciations have fed through. In the Long Run, a number of emerging markets, Turkey included, offer value: they have demographics on their side.