Mark Tinker

Mark Tinker, Head of Framlington Equities Asia, comments on US and Asian Markets.

While all the talk is of trade tensions, what we are seeing in the markets at the moment are the natural consequences of tightening US monetary conditions, both onshore and particularly offshore.

Anyone who has borrowed USD has been scrambling to pay them back, causing distressed selling of assets and forced  purchase of USD. The traders are as negative on high yield carry currencies in Emerging Markets as they were positive six months ago, but North Asian currencies look more stable.

The US mid-terms are not the only political risk out there, markets need to be wary that politicians everywhere may be tempted to embrace populist measures that may threaten existing market structures.

We have been talking for several months now about how the whole story on Trump and trade wars has become the comfortable narrative behind the sell-off in Emerging Markets (EM), when in fact the realities are more complex and nuanced. After a week or two travelling around the region we remain convinced that this is as much if not more about liquidity than economics.

In the last note I discussed how the actions of different operators in markets could be inferred from the consensus narratives; the shorter term noise traders tend to focus on currencies and commodities as evidence of their narrative being correct. Thus a bull or bear story on China tends to be traded through commodities such as copper, or currencies like the Australian dollar. Chart 1 Shows how a trader’s view on China, usually derived from relatively high frequency data such as the Caixin PMI (shown here in purple) can flip around and be reflected in the tradeable prices such as AUD and Copper, as well as the Shanghai Composite.

Chart 1: Using China PMI to trade Equities, Currencies and Commodities

Source Bloomberg, AXA Investment Managers, September 2018

The Caixin Purchasing Managers’ Survey (PMI) tends to be preferred as it covers more private, export oriented companies and, as can be seen, traders do appear to use the survey as a basis for their views on China.  The fact thatany PMI index is a diffusion index and actually deals with the second derivative rather than the first  (i.e. not growth, but acceleration or deceleration of growth) tends to be widely misunderstood however, and thus we constantly hear comments that “a level below 50 means that the economy is shrinking”, even though this is totally incorrect (!). If an economy was growing at 6.9% and the PMI is below 50, it means that it could soon be growing at 6.7% (as actually happened in China in 2016). However, just as the non-farm payrolls tells us almost nothing about what the Fed will do next, the truth on the PMI does not matter. If traders believe that markets follow it, they will act accordingly.  So, a weaker China PMI means sell copper and sell the AUD (and of course vice versa) and having done so the story or narrative behind the move gets louder to allow the noise traders to exit their positions. Until a positive PMI flips it all around.

There are of course other drivers to currencies, (such as politics), and to commodities, (such as supply issues), but generally the narrative is framed in terms of cyclical economic demand. So a view on a weak China means to bet on a weak copper price and the view on a weaker China is then justified with reference to the weak copper price (!). Obvious risks of circularity abound. Here in the chart we can see how the Shanghai Composite is also dragged into the equation, showing a recent very high correlation with the Australian dollar. This is where it can get interesting. If, for example, the AUD is weak for a different reason, say that the attraction of carry over the USD has lessened, then there is a danger of a false reading onto the Chinese economy. The same is true of “Dr. Copper” which is held up by bond economists as being much smarter at spotting demand than the equity market (though to be fair, most bond economists think almost anything is smarter than the equity market). If there are supply or inventory issues for example then the price will not be telling us anything meaningful about Chinese or indeed global demand.

When we consider the possibility of ‘other reasons’ for market movements rather than simply weak Chinese growth, the most obvious candidate is USD  liquidity. This is something we have been discussing for over a year now, with reference to US Libor, which has essentially doubled in price over the last 12 months. Given that this is the ‘raw material’ for the majority of the world’s financial products this is obviously very important. In particular it helps explain the collapse in popularity of ‘Carry Trades’ in financial markets, principally currencies. Certainly if we look at chart 2, something appears to have begun back in February, which is picked up as a sign of distress from looking at the market indicator known as the TED spread – the spread  between 3 month Libor and 3 month Treasury Bills, as shown in this lower of the two charts.

Chart 2: US $ liquidity stress in February led to closure of many carry trades in Q2

Source Bloomberg, AXA Investment Managers, September 2018

The top chart shows the steady rise in Libor over the last 12 months while the lower chart shows the spike in the spread earlier this year indicating liquidity stress. Note that the spikes in 2016 were not stress in the same way, but rather to do with (necessary) changes to regulation of money market funds, something we discussed at the time, but were nevertheless a key driver to the longer term rise in Libor.

One obvious event that took place in the first quarter was the Trump tax cuts, and the repatriation of trade from large US multinationals. Given that most of this cash was offshore, sitting in repo markets or in money market funds, this move back onshore was less of a driver for the USD (it just swapped offshore dollar for onshore dollar) and more of a driver for tighter liquidity in offshore markets.

We also think that something else happened back in February to cause a scramble for USD liquidity, the collapse of the short volatility trade. This was something we discussed in considerable detail at the time, but to recap, the traders were all heavily exposed on a bullish China bet in the second half of last year and into late January 2018, doubtless encouraged by the Caixin PMI index shown in Chart 1. At the same time many  were also short volatility (essentially selling puts) as a way of funding their positions. This situation was made unstable by the existence of a large and popular ETF with the ticker XIV, which was an inverse of the VIX implied volatility index. As traders sold volatility and the VIX fell, so the XIV rose, gaining almost 400% over the eighteen months leading up to February this year and dragging a lot of momentum traders into the ETF. Of course when they bought XIV, the market makers to the ETF essentially went out and sold volatility, creating a virtuous circle that ultimately turned vicious.  If the VIX was the fear index, the XIV was the greed index. This not only caused the traders to flee the markets in February, but they took their liquidity with them.

Together these liquidity events helped to drive US Libor higher throughout the first quarter, from 1.7% to 2.3%. and I think it is no coincidence that two of the bigger offshore dollar carry trade currencies in Asia (Indian Rupee and Indonesian Rupiah) peaked at around this time

Which brings us to look at Chart 3, showing USD Libor, the Hong Kong Dollar, the offshore RMB and China currency reserves.

Chart 3: Tighter $ liquidity drives Chinese currencies lower

Source Bloomberg, AXA-Investment Managers September 2018

We can see that the Hong Kong Dollar, which is pegged to the USD, has simply tracked US Libor over the last 12 months, weakening as US rates rise, but my suggestion is that the CNY, or offshore Rmb has also responded. When rates spiked in February to around 2.3% this triggered Chinese companies with offshore borrowings in USD (mainly property companies) to pay back their debts and switch back to Rmb. We know this anecdotally, but we can also detect it from movements in the official reserves (shown here inverted). Of course, as already discussed, a stronger USD then acted as a catalyst to the  taking of profits by asset allocators in the EM versus Developed Market (DM) trade. This hit China and Chinese equities the hardest as they are 44% of the benchmark and when everyone wants out at the same time the hit to prices can be meaningful, but it ironically benefitted a number of countries where benchmarked investors were underweight as a general reduction in risk – i.e. move to hug the benchmark – appears to have occurred.

It hasn’t gone unnoticed for example that while the rest of MSCI Asia is off notably from its highs, the Indian markets continue to make new highs, which seems strange given that India has all the characteristics of a ‘bad’ emerging market economy in terms of current account deficits, foreign debt, political uncertainty and so on. Throw in the fact that the US has imposed tariffs on Indian goods (notably steel) and that they are an importer of oil (including from Iran) and it looks even stranger. The obvious explanations centre  around the fact that earnings are good, India is less affected by trade wars than the rest of EM, and that it is immune from the Asian tech sell-off. However, I do not find these very convincing. Instead, I see a number of issues around market mechanics that make me wary of jumping in.

At the micro level, earnings have actually been pretty good, which frankly makes a change, as their capacity to disappoint while promising great things ‘soon’ is well known to EM investors. Even then, there seems little prospect for much upside from here in terms of ratings as Indian equities are at 10 year highs in terms of valuations. Second, I suspect there has also been some rotation by benchmarked investors. As previously discussed, once the traders had left the Emerging Markets back in February the asset allocators waited until the end of Q2 before rotating out of EM into DM, tracking a stronger US dollar. This prompted a number of benchmarked investors in EM strategies to close out their long China/short India positions, picking India up from its May lows and delivering a healthy relative performance catch up. In effect, by having relatively little in terms of technology, India has ‘benefited’ from the rotation out of Asian Tech names such as Tencent and AliBaba. A somewhat pyrrhic victory, if you ask me – “we didn’t go down this year because we haven’t got any growth stocks to take profits in. “The narrative to support this benchmark flattening has largely focused around the fact that India is relatively unaffected by Trade Wars which is of course the go-to explanation for everything at the moment, but if we are to believe the bottom up data from across the region, nor are many other stocks, sectors and markets. In fact, one of the biggest potential losers under a trade war scenario is the US – which is also at new highs!

Moreover, we should note that some of this apparent ‘strength’ is largely mechanical, reflecting the recent weakness of the Rupee, which as well as a carry trade rolling over has reflected the economic weaknesses just mentioned. Thus, the Sensex, Nifty or MSCI India are not hitting new highs in USD terms. A second point that is not often mentioned is that almost a third of the rise in the market year to date has come from a single stock, Reliance, making its largest shareholder, Mukesh Ambani the richest man in Asia. Reliance accounts for around 10% (by market cap) of the various India indices and should obviously ring some alarm bells about market breadth, certainly with the experience of Tencent and AliBaba last year, where stellar share price moves made Jack Ma and Pony Ma (Ma Huateng) the first and second richest men in Asia, while Tencent became between 15% and 20% of many local indices. In some sense I am also reminded of the Macau stocks back in 2014  which were also a very crowded trade for both locals and international investors and peaked around the time of the headline that the majority owner Lui Che-Woo Chairman of Galaxy Entertainment, then at almost HKD80 was declared the second richest man in Asia, behind Li Ka Shing. A year later, the stock was at HKD20 and he (obviously) wasn’t. He is okay though, with a stock rally since then he is getting by at 17th place with %15.7bn. The title passed to Jack Ma and now it is Mukesh Ambani.

A final thought on India. With the announcement last week that Warren Buffet is buying into payments company PayTM, India is quite clearly going to be the battle ground between the US and Chinese Tech giants. Facebook, Amazon and Google are going head to head with Tencent and AliBaba with the more traditional retailers like Walmart coming in behind them. Such capital inflows are undoubtedly going to improve things for Indian consumers – building a logistics infrastructure for a start – but may well also explain some of the resilience of Indian markets.

Earlier we looked at the Australian Dollar and suggested there may be some other reason for its sell off (in which case the Shanghai Composite might perhaps not be sensible to track it) and the obvious one would be politics. With the seventh Prime Minister in ten years, perhaps not surprisingly the local Madame Tussauds are refusing to update their waxworks and if anything it highlights the reality that while in many countries there may only officially be two or three major political parties, there are serious factions within these parties, making the situation far more like a coalition government than it might seem from a distance. In a world where government policy is increasingly becoming as significant as monetary policy this could be very important, for in order to carry an official party, populist policies may be brought out to unite the factions which could have significant impact on markets. If we take Australia as an example –  and I stress I have no insight at all here –  we might find ourselves with some serious potential black swan events. To explain, let’s think up a populist campaign or two.

Were I, say, the labor leader and looking to unite the party, I might suggest the following. Declare that the release of Super-Annuation funds on retirement has made a happy hunting ground for the ‘unscrupulous financial services industry’ in a world where it’s increasingly difficult to match assets and liabilities on retirement. Then announce a new type of index linked annuity bond, government backed and only available to retail investors, offering a very respectable 3% real yields – or a return based on a rolling lagged nominal GDP. This would obviously be massively popular with pensioners and play into the anti-Bank sentiment surrounding the Royal Commission. Obviously there would be criticism of the higher interest cost, but this could be deflected by saying that it deals with a problem that existing governments are trying to keep off balance sheet, i.e. that people unable to find decent annuity income may end up dependent on the state anyway. You could also announce that you could pay for it by removing the imputation tax credit enjoyed by Australian equities. (I stress I am not saying this is a good idea, just that it may be presented as one). The UK did something similar, albeit in two stages, getting rid of dividend tax credits just as Australia adopted them. The offset was to lower corporate tax rates, but that benefited the companies more than the savers and while the relative strength of the two pension systems over 20 years later should give pause for thought,  it probably won’t. Indeed, in March the leader of the Opposition, Bill Shorten, already announced he would do this if elected. There are some interesting and quite sensible suggestions out there, but not, I would suggest in the share prices of a number of the dividend rich Australian stocks. Back in the UK, it was argued that the structure encouraged too much equity funding at the expense of corporate debt (although I personally wouldn’t see that as a bad thing) but also played on the notion that UK companies were not investing enough. This didn’t change when dividend credits were withdrawn, but it did damage the funding position of many individuals and corporates  and diverted cash into pension funds investing in low yielding bonds instead of pursuing  corporate growth in assets or dividends. Another policy to both raise revenue and apparently reduce distortion would be to phase out interest relief on mortgages. While obviously not popular, this also happened in the UK with a steady phasing out while encouraging people to save in other instruments than houses. Given the low implied yields on Australian residential property at the moment, there would not be much room for manoeuvre. Those are just a few ideas that would be plausible, populist, and yet deliver significant upheaval to many in financial services, from Banks and brokers to real estate. I am not saying they will happen, but the possibility of radical reform is certainly a long way from current prices.

To conclude, while Asia has been battered by summer storms, both literal and metaphorical, Europe and particularly the US have had a much more pleasant few months. Some are noting on the 10th anniversary of the Lehman collapse, that this for the US is now the longest bull market in history, and what a grumpy time this has been! Commentators have been calling for an imminent collapse almost constantly for the last decade, with the possible exception of January and early February this year – which should have been a warning! To my mind, the sell-off in Emerging Markets over the summer has largely been a function of tighter offshore USD liquidity, asset allocation rotation, and benchmark investor de-risking. The traditional problems of emerging markets – too much USD debt, current account deficits, fragile institutions have resurfaced, but for non-traditional Emerging Markets this is not the case, presenting value opportunities. Currently the traders are once again going after EM currencies, this time on the short side, making the carry trades look (still) very vulnerable, but with offshore USD liquidity stabilising, North Asia looks better positioned for a more positive fourth quarter.

The post Market Thinking – a view from the equity market appeared first on AdviserVoice.

Mark Tinker

Trade relationships are having to be reset

Trade tension is being blamed for what is essentially a ‘normal’ market correction. It is not irrelevant, but it is the new economy that is more important. As last year, Xi has made important concessions on access, without appearing to do so.

China’s capital markets continue to open up with a huge increase in daily stock connect quotas, a stock connect with London, the ability of foreigners to own asset management businesses and the restart of the QDII quota system all announced in the last few days.

Geo-Political Tension over Syria is also a repeat of a year ago, we have to hope it fades in a similar fashion. Meanwhile Libor is literally double the levels of last April promoting further deleveraging.

Almost exactly this time last year we were facing military tension in the Gulf and threats of a trade war in Asia, so we have something of a sense of deja vue at the moment.  In this instance I believe that we are seeing a fundamental re-set of the post WWll trading era, to recognise the role of China. A new “New World Order’ if you like.

The  market behaviour in Q2 continues to be one of de-risking and it is clear that the noise traders who came so enthusiastically into equity markets around the turn of the calendar year have gone again before the start of the new financial year, taking their leverage with them.

This may be  evident from the way that Emerging Markets, though most sensitive to the supposed cause of the correction, the threat of Trade Wars,  have actually outperformed the US equity  market over this period. It is also evident from the way that stocks owned in leveraged ETFs have been affected.

For example, when we look at the energy sector ETF, XLE, we see a rush of enthusiasm between mid-December and mid-January and a jump of almost 15% in the price before it all disappeared practically overnight in the early February volatility spike.

Naturally ERX US, the three times leveraged ETF that tracks the energy sector index was a multiple of that  – approximately plus and then minus 40%. In a similar fashion, FAS, the three times leveraged financials ETF rallied over 20% and then lost it all. Encouragingly, the last week or so has seen much greater stability across the board and most if not all sectors and markets remain sound from a technical perspective.

The other factor behind the deleveraging in the financial markets  is a simple one. Price. As we have noted many times, the cost of money as a raw material for financial products as proxied by Libor has doubled over the last 12 months. With the US yield curve all but flat out to 5 years – at 27bp the spread between libor and 5 year bonds is not far from the lows seen in the 2012 – the opportunity for simple carry and spread trades has shrunk, especially compared to the 2013-15 period where it was around 130-150bp.

Similarly the spread out to 2 years is now negative. Some people are making a lot of the notion that a flat yield curve is a lead indicator of a recession, but I would argue that those models can’t really properly take account of the unusual era of QE we have been living through.

Having said that, countries with consumer borrowing rates tied to libor will have seen (and continue to see) pressure on the disposable income/cash flow of households and companies with floating rate debt. Strong balance sheets and sensible balance sheet management are already coming into focus.

The market needs a good narrative and concern over trade wars provides something suitable, but it is not as if trade tensions between the US and China are anything new, indeed it was one of the dominant talking points of q1 last year, until calmed down by the discussions between Presidents Xi and Trump almost exactly a year ago, after which China made a number of concessions on access for US financial services and agreed to import more of the US’s latest key product, LNG.

The short history so far suggests that President Trump is using trade and the threat of sanctions, in effect America’s economic power, in order to obtain what he regards as a better deal for America in its relations with the rest of the world.

As a deal maker his opening statements will always take an aggressive position, hence the expression from a year ago that we should take him seriously, but not literally and it seems that the markets, if not necessarily many in the media, are doing just that.

The recent announcements on steel and Aluminium for example make a lot more sense when viewed as part of a coercion strategy to get Mexico and Canada, who were far more affected than China, to push through a re-negotiation of NAFTA as well as South Korea to agree a new bi-lateral agreement.

Interestingly the US has acknowledged that it may well re-join the TPP if conditions are right and made its statement on Steel and Aluminium literally a few hours after the TPP – 11 (i.e. not including the US) made a number of breakthroughs on service industry related issues at its recent summit in Peru. Indeed as I write this I hear that President Trump is calling for his economic advisers to revisit TPP.

This is about acknowledging it is no longer a unipolar world and trying to line up as many countries behind ‘your team’. It’s a grand reset. The benefits of specialisation and trade are one of the things that almost all economists agree upon, although not necessarily all politicians do and of course the upcoming US mid-term elections certainly have a role to play in all this. However, in my view much of this is about geo-politics rather than domestic politics.

For example, trade pressure from the US in turn reportedly produced trade pressure from China that appears to have brought North Korea to the meeting table, while trade pressure on Europe and others is being shaped to try and ensure that it is America, rather than China that ‘sets the rules’, not so much for the old economy of steel and aluminium, but for the new economy of fintech, cloud computing, AI, biotech and autonomous driving.

China has set out its aims to excel in these areas in its ‘Made in China 2025’ strategy but  as President Trump’s new Trade advisor Peter Navarro pointed out in an Op-ed in the media  this week,  if China “captures these industries, the US simply will not have an economic future”. This is the heart of the issue, that the  US wants the fourth industrial revolution and the  ‘internet of things’ to be American, not Chinese.

In practical terms, what the US also really wants is greater access to the Chinese Consumer and the giant US  multi-nationals who used to fight off the protectionist tendencies of US politicians are no longer doing so, recognising that they need an aggressive US trade stance to wring concessions from the Chinese. While the noise traders try and play currencies, commodities and ‘thematic stocks’ like steel and shipping, as equity investors we find that If we listen carefully we can already hear the rhetoric has shifted to tech and services. Importantly the Chinese authorities are more than aware of this and we have already seen from recent statements that the process of opening up access to certain Chinese markets will continue.

Xi’s comments this week, in my view are a classic example of this; a concession without appearing to concede. There are promises of more to be done on financial services, autos and IP protection. The latter is interesting because a big part of recent US complaints about China is the theft of Intellectual property, but this is to confuse invention with innovation.

The idea of patents is to allow those that invent something to benefit from doing so – and thus encourage invention. They should not however be used to prevent innovation, the second stage of the process whereupon a different set of actors – in this case entrepreneurs rather than inventors – take the original idea and modify it to suit consumer needs. None of these are really  concessions, they were  already happening, the high profile rhetoric has simply ensured that it continues to do so. Moreover, the concessions such as they are,  are all for the benefit of the Chinese consumer rather than the producer.

China clearly no longer feels the need to protect certain industries from competition, the classic case for emerging industries in emerging markets, but while providing access they are not necessarily going to provide instant profits for western companies. It is likely that it will be no easier for a US financial corporation to ‘break into’ China than it is for a European to break into the US. Non trade barriers outside of the WTO rules abound, as they have done for years so we should be careful about getting too carried away.

As I pointed out to some US government economists in Beijing recently, the reason why third party countries will more willingly accept Union Pay than MasterCard or Visa is the same reason they currently accept American Express; it’s the preferred choice of the consumer with the most money. As to who will benefit most from the burgeoning Chinese consumer, well we would suggest that will be the investor who picks the best companies, regardless of where they are quoted.

For investors a move to a multi polar world is actually a good thing not least  from a diversification point of view.

We are seeing increasing interest from clients globally in how, rather than why, they should invest in Chinese companies and about  how the capital markets are opening up and there was yet more positive news on that front this week from multiple directions.

Diversification works both ways of course and we saw an announcement by SAFE, who manage the Chinese foreign exchange reserves, about the restart of the QDII quota system after it had been suspended for the last three years. Essentially this is quota in US$, in this case $90bn or so, that can be invested overseas. Meanwhile the PBOC announced a Shanghai–London stock connect link would be operational by the end of the year.

In terms of inflows, this came on the same day that the PBOC announced that foreign investors would be allowed to take majority stakes in fund management, securities and life insurance companies, while the Hong Kong Exchange announced a significant expansion in the size of the daily limit for the Hong Kong Shanghai and Shenzhen stock connects. Approved by the mainland and Hong Kong regulators, the  Northbound daily quota will increase from RMB13bn to Rmb52bn and Southbound from Rmb 10.5bn to Rmb42bn.

One other interesting development over the last few weeks has been the launch of an oil futures contract in China traded in RMB. This has been discussed  before and particularly the notion that as the world’s largest importer of oil, China may ask its two biggest suppliers – Russia and Angola – to accept payments in RMB.

The fact that neither might have sufficient interest in RMB purchases could be dealt with by passing the RMB contracts through to gold, which ultimately threatens the status of the petro dollar. Be careful what you wish for as they say and those insisting on an immediate full convertibility of the RMB may find themselves worrying about the $ losing its reserve currency status and all the privilege that goes with that.

Conclusion

Recent market moves are not really about Trade tariffs, but that is not to say they are not important. In fact they are highlighting very important economic and political ‘re-setting.’  With political power consolidated, Xi is moving back to economic and financial reform.

The trade pressure from America is notionally aimed at China but is really about adjusting the post War US centric trading system to account for the emergence of China while seeking to pull the ‘rest of the world’ in behind America. The policy of made in China 2025 is the key focus of US concern, China has moved too rapidly up the value added chain for comfort as far as many western corporations are concerned and policy is being aimed at both gaining access to Chinese consumers and trying to shut increasingly sophisticated Chinese producers out of lucrative third party markets. In response China is making concessions on market access, but in my view only where they suit China.

Where there are strong domestic players established – autos and finance for example, they are increasingly allowing foreign access, recognising that competition is good for the end consumer. Just in the last week announcements about changes to the size of the Hong Kong stock connects, opening up outbound quota again, building a stock connect with London, allowing foreign ownership of asset management firm illustrates the speed and scope of the changes coming.

The winners and (losers) of this newly emerging ‘world order’ will be geographically diverse, both in their headquarters and their listings and in our view investors will be far better served by taking an active bottom up approach in constructing portfolios to capture the winners and just as important avoid the losers.

By Mark Tinker

The post Market Thinking: Trade War talk obscures a fundamental shift to a multi-polar world appeared first on AdviserVoice.

Mark Tinker

• The year has begun with a combination of momentum for last year’s thematics and some value from a recognition that despite projections a year ago, we are in a period of co-ordinated cyclical growth.
• Asia is at the heart of both and international investors are waking up to the fact that emerging market equities are as cheap relative to the US as they were post the Asian crisis of 1997, which is a world away from where we are now.
• Long term trend lines favour both EM equities and debt and most EM currencies. Asia looks particularly good in all areas. Conversely, the dollar and US Treasuries have broken their uptrends. Commodities have moved back to an uptrend while the short volatility trade remains strong – even though it is a huge potential risk.
• Higher cyclical inflation is coming but is a bigger threat to equities without pricing power than it is to bonds.

I have been fortunate enough to be invited to speak on some year ahead panels around the region by one of our major private banking ‘partners’ so have very much hit the ground running into the New Year. One thing I particularly like about the private banks is that the presentations are very much about giving advice to clients, in that they are practical, rather than simply a laundry list of forecasts. Thus nobody really cares about precise GDP forecasts or inflation projections, they want to know where they should be investing, which is a function of thematic growth stories and relative value.

As discussed here on multiple occasions, our thematic strategies (which formed the basis of much of the discussion) are global but many have a strong Asian bias and certainly an Asian, usually Chinese, catalyst. The robotics and automation theme for example really kicked off in 2014 as China became the world’s largest buyer of industrial robots, something we tie in to the stated policy of Made in China 2025. China is following the North Asia model of Japan, Korea and Taiwan in moving up the value added chain and that requires huge and ongoing investment not only in robotics but in smart factories, sensors, big data and the whole internet of things. One thing is clear, the fourth industrial revolution will have Asia at the heart of it. Similarly a digital consumer strategy is going to heavily feature the likes of Tencent and Ali-Baba as the 350 million plus middle class consumers in China channel everything through their mobile devices. The drive to lower pollution and emissions, smart energy and smart cities is also coming from Asia, while the need for a transition away from a big bank dominated financial system in China towards a more distributed capital markets system is powering a fintech revolution.

These thematic drivers come against a background of cyclical growth globally and the prospect of an unwinding – or at the very least a slowing – of non-conventional monetary policy. This is likely to be a drag on areas and investments that have benefited from this, particularly in my view the spread trade and leveraged markets that essentially used financial engineering to create artificial investment products. The notion that you could take a low yielding bond portfolio and gear it up fifteen times while presenting it as ‘low risk’ simply because it had low volatility always struck me as showing that we had learned nothing from the credit default swap (CDS) debacle. The reality is that such products rely on institutional adherence to rules based systems that define risk very narrowly as volatility and correlation and whereby capital rules proscribe what can be invested in. Equities risky, highly leveraged illiquid products not risky and so on. It’s crazy, but those are the rules. By contrast, clients of private banks view risk as the probability of losing capital and particularly here in Asia it is that ‘back to basics’ approach to investing that is a welcome change.

The year has started with a combination of both value and momentum. The momentum plays from last year such as the Asian tech stocks have continued to run, but equally some of the cyclical value plays have also bounced quite sharply. Part of this I suspect is a function of valuation; not only are Asian stocks generally seen as good value compared to their US counterparts, but cyclical stocks are particularly good relative value.  Indeed according to a chart put up by the chief strategist at the private bank, emerging market equities are as cheap against their US counterparts as they were after the Asian financial crisis in 1997. This is extra-ordinary for a number of reasons. First and most obviously Asia is in a very different economic position than it was then. Earnings are growing steadily, balance sheets are strong, real wages are rising, dividend payouts are high and payout ratios are rising. Asia currently provides between a quarter and a third of all dividends globally and yet barely features in the portfolios of most income investors. Most important of all however is that back then Chinese GDP was less than $1trillion and that since 1997, China’s GDP has grown by a multiple of 11 times. Even if we only go back 10 years rather than twenty, we see that the Hang Seng has just taken out its 2007 high, meaning that, in rolling news speak, it is “hitting a new record all time high”. However, this shouldn’t be too surprising (as I pointed out on CNBC this week) given that the earnings base for the Hang Seng is over 60% higher than it was back then.

With that sort of long term perspective in mind, I jotted down a few of my own New Year resolutions for long term investors.

1. Recognise what type of investor you are. If you are not capital constrained or driven by asset liability management don’t mimic people who are. The very biggest institutional investors may not ‘know’ anything you don’t.
2. If you are a long term investor, recognise that patient capital gets returns from being patient, try and separate the signal from the noise.
3. For a long term investor volatility is your friend, it’s a risk you can take to get a return. Traders avoid it, but you don’t have to.
4. Diversification is good in a portfolio, but don’t make a bad investment simply because it is not historically correlated. There is little need to take credit risk.
5. Be wary of products that take/impose liquidity risk or use lots of leverage. Despite claims, they are not risk free simply because they have low volatility. There is little need to take liquidity risk or leverage risk.
6. Investing  thematically is on the rise – geographic and sector funds are less relevant than they were and focus on fundamentals, especially cash flow.
7. Keep an eye on low volatility, it’s less a sign of complacency and more a sign of too many people chasing income and selling volatility.
8. Quantitative easing (QE) is receding as an influence, be wary of products that have may have thrived on easy and cheap money this last decade. At best they have peaked, at worst they could reverse sharply.
9. You can ignore China but it won’t ignore you. Watch the People’s Bank of China (PBOC) as much as the Federal Reserve (Fed) – if not more so.
10. Crypto currencies are a symptom of wide ranging changes coming via the blockchain, but to my mind they should not be seen as an investment.

The chart below makes a further point on long term investing and the usefulness of long term moving averages as asset allocation signals. It shows MSCI China, which as we know was one of the best performing markets in 2017, but over the last five years. Because of the big squeeze up and subsequent sell-off in 2015 and into 2016, MSCI China began last year pretty much at the same level as it was in 2013. From an asset allocation viewpoint, while the long run moving average (green line) would not have got you out at the top (the shorter term moving averages give better signals obviously, but this is not hindsight portfolio management), they would have delivered a 15% return from June 2014 (crossing up) to June 2015 (crossing down), before putting you back in in June 2016 15% lower down still.

Chart 1: Market timing – don’t believe you can pick the turning points, focus on capturing the trend

Source: Bloomberg, AXA IM. January 2018

Currently the index is as stretched above its long term moving average as it was back in 2015. Is that a sell signal? Will we get out at the top? Depends, but to believe one can get in at the bottom and out at the top could be a fool’s game. If one can capture the majority of the trend I’d say they’d be in great shape.

The flip side to the China chart is probably the one of US Treasury yields. Notice how in Chart 2 yields on the 10 year Treasury had a short term peak in June 2015 on that China sell signal and bottomed in 2016, just as that buy signal on China appeared. Notice also that the 10 year yield broke above its long term moving average in October 2016, back below for three months between August and October 2017 and is now firmly above the long term moving average. The short end is obviously much clearer in its up trend in yields and of course Libor continues to squeeze sharply higher threatening the funding costs of leveraged products.

Chart 2: US interest rates now all appear to be in structural uptrends

Source: Bloomberg, AXA IM. January 2018

High yield corporate bonds look to be struggling too, having broken their long term moving average to the downside on the index, while emerging market (EM) debt has broken to the upside. Intuitively this is not surprising given the spread of EM sovereign yields over western corporates for essentially the same or better credit ratings.

In terms of currencies, the euro, which is back to 2014 levels has been in an uptrend against the dollar since last April/May, as has sterling. As to where it should go, I was reminded of the Economists Big Mac index when I was in New York over New Year and we were required to make a pit stop to feed a hungry teenager. It felt ‘too expensive’, so I looked up their index. According to the economist’s calculations the price of a Big Mac in the US is USD5.30 compared to GBP3.19, which implies an actual ‘correct’ exchange rate of 0.6, or 1.67. For the euro area they suggest a correct rate of 1.35. Just to confuse things however, the price of a Big Mac in Arkansas according to a McDonald’s price tracker is only USD3.95, which is less than the UK cost at current exchange rates. New York is in fact one of the most expensive states for a Big Mac, which does raise some questions about the price indices being used more generally. If something as generic as the Big Mac can vary between states by up to 30%, how can we measure inflation or purchasing power parity (PPP)? Perhaps more important, do PPP calculations take into account the different state taxes or the ‘voluntary’ but ‘trying to getting away with less than 20%’, service charges? Intuitively the cost of living in New York feels too high compared to London at current exchange rates.

Not that the tourist dollar will necessarily drive the exchange rate, but I suspect that the emerging downtrend over the last six months in the dollars is starting to drive capital flows out of the dollar zone. Some of that will come into emerging markets on the theory that as a strong dollar is bad for EM, then a weak dollar must be good. Even though I no longer believe this relationship to hold – principally because EM growth is not fuelled by dollar debt like it was in the past – I think this will undoubtedly be having an effect and certainly driving some portfolio flows into strengthening EM currencies. When an EM BBB sovereign debt such as Indonesia is yielding 6% plus and the currency has just strengthened against the dollar through its long term moving average, then the fact that this is 12 x the yield on bunds or 4 x the yield on investment grade European corporates could start to attract attention, and flows.

Commodities, led by oil, broke up through their long term moving averages last October, which not only reflects cyclical growth and a supply demand imbalance in terms of fundamentals but is also a reflection of the market rotation towards cyclical value. Interestingly the Baltic Dry Index, which is a reflection of the supply/demand imbalance in dry bulk shipping and often a good lead indicator of global trade activity is dropping back down to its long term moving average.

Chart 3: Baltic Dry not telling quite such a bullish story as commodities generally

Source: Bloomberg, AXA IM. January 2018

To be fair, the Baltic Dry is not a traded index in the way that commodities are and as such tells us less about financial market behaviour and more about real world demand and supply and as such has been a useful lead indicator of turning points in commodities. In early 2014 for example it warned of a top and in both mid 2016 and mid 2017 it gave positive signals ahead of rallies in commodities. Obviously much of this is to do with iron ore and we would just note that Chinese iron ore inventories are currently at extremely high levels. Partly this is a function of the upcoming Chinese New Year, but it is also likely to act as a brake on export activity in the coming months.

So far, bitcoin is off some 40% from its peak and while many can say that they are still up multiple times the party atmosphere and gold rush like enthusiasm has clearly dimmed in ‘dry January’. Crypto currencies seemed to be all that anybody was talking about over the holidays. “You work in finance? What about me buying some bitcoin? I almost put (unlikely amount) in back in the summer, but didn’t. Should I buy now?” That anecdote in itself to my mind should act as a warning and my standard response was something along the lines of the fact that its real importance was in the emergence of initial coin offerings and the blockchain in general. On occasion I may have mentioned things I wrote before Christmas such as the fact that 40% of bitcoin is owned by less than 1000 people and that the marginal buyers before Christmas appeared to be leveraged day traders in Japan who usually punt foreign exchange, but largely people didn’t want to listen, they were just looking for confirmation of their existing views, which basically seemed to be ‘get rich quick and get out right at the top’.

Meanwhile some of the more questionable activities that have grown up around the whole crypto currency arena are unwinding very fast. I notice that bitconnect, an exchange that offered huge returns if you lent them your bitcoin appears to have closed down, wiping out most of their customers. I still believe that some core crypto currencies will survive and that the real importance is the emergence of the distributed ledger that is the block chain, but this feels like it is going to be painful.

Meanwhile, the truly disruptive currency, the renminbi (RMB), is getting stronger against the dollar, almost certainly helped this week by an announcement from Germany that RMB will be going into German foreign currency reserves. The currency is now back to the levels last seen in the wake of the June 2015 sell off in Chinese equities, and yes, from a long term investor perspective the currency broke down through the long term moving average (in this case this means strengthened) back last May. This should mean that China should benefit from the capital flow effect described earlier with respect to emerging market debt – the positive trend in the currency is seen to reduce the risk of a currency loss and thus increase the expected dollar returns from buying higher yielding Chinese assets. This in turn can drive the currency as well as the assets higher, triggering further flows. It doesn’t last forever, but it is certainly powerful in the short term.

So to risks and as we saw with crypto currencies, one of the biggest problems a market has is when it is gripped by greed rather than fear. It is often said that the low level of volatility in equity markets reflects complacency or even a perception that there is no risk out there, a lack of fear. However, I think actually a good part of this comes from greed. Chart 4 shows one of the great momentum trades of the last two years, XIV, the ETF that is the inverse of the VIX – a seven bagger over the last two years. Not bitcoin, but not bad!

Chart 4: Selling vol as a powerful momentum trade

Source: Bloomberg, AXA IM. January 2018

As previously noted, this phenomenon does concern me as by buying the ETF, the investor prompts the market maker to effectively sell volatility. There is obviously nothing wrong with a considered judgement about the attraction of selling volatility, but my fear is that this is less about taking a view on a the price of volatility and more on chasing a momentum trade. Obviously should they wish to unwind that positon then the VIX itself could spike sharply having knock on effects into portfolios. Encouragingly from a risk perspective volumes seem to have slowed, but the outstanding amount remains meaningful. We continue to watch this closely.

The other risks to my mind are unexpected inflation and too much leverage in a world exiting QE. While it would be an exaggeration to blame the woes that fell UK housebuilder and contractor Carillion on QE, there is no doubt that a focus on its debt problems would have saved equity investors a lot of money. Particularly interesting was the exposure of the UK company to German private lending known as Schuldschein. These private debt markets have increasingly been funding non German companies, encouraged no doubt by the willingness of yield chasing institutional investors to embrace ‘private debt’ as a so called alternative strategy. As outlined in my above New Year resolutions, I see no need for long term investors to take credit risk unless they are properly compensated and do appropriate due diligence, and certainly would be wary of private placement markets that need no credit rating or public disclosures. Equally I tend to be wary of any company using said markets. Carillion had other debts of course and undoubtedly the use of reverse factoring – in effect getting banks to settle your sub-contractor debts on your behalf – may have led the casual observer (or naive systematic quant model) to under-estimate the true debt exposure. But there is another factor worth exploring, even if it didn’t actually apply in Carillions’s case. Inflation. I stress that I do not know if this applies in Carillion’s case specifically, but the construction industry can in my view misprice contracts in an attempt to land business and in many cases they are fixed price. This can go badly wrong if you lose control of your costs, be it poor management or unexpected cost rises, often due to raw materials. More broadly we are therefore looking at pricing power in a cyclical upturn. If your supplier can raise their prices but you can’t your margins will suffer. For most businesses their biggest ‘supplier’ is their workforce, so the wage rises that macro investors are always looking for as a ‘good thing’ because of consumption, can be a bad thing for a lot of companies. Being cyclical works both ways. Even worse when those wage rises are mandated because they don’t reflect an environment of strong aggregate demand that allows price rises. Once again this implies careful stock selection.

By Mark Tinker, AXA IM

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