Against a backdrop of tightening monetary liquidity, an exceptionally strong global earnings cycle, moderating Eurozone and Chinese growth and growing trade tensions, the June quarter witnessed a notable reversal in global cyclical risk appetite. The adverse movement in non-energy commodities, bonds, credit and in equities, the underperformance of global cyclicals, EM and low multiple or “value” stocks and an extreme narrowing in winners1, is suggestive of a tougher environment ahead.
In prior quarterlies we’ve highlighted the success of Quantitative Easing (QE) in rebalancing portfolios towards risk and duration, with the wealth effects from asset price inflation a key transmission mechanism to the real economy. Meanwhile, since the Global Financial Crisis the structure of capital markets has changed profoundly, with central banks and passive liquidity acting as shock absorbers to risk assets more broadly. With Quantitative Tightening (QT) now in play, markets are increasingly fragile, with liquidity scarce when required the most. Since 2007 asset markets have experienced at least eight flash crashes. Whilst post QE the median level of volatility is lower, markets are alternating between longer periods of calm and increasingly severe drawdowns. In January this year this scarcity was reflected in a severe underperformance of stocks exhibiting high historic “momentum” i.e., winners and the outperformance of low multiple or “value” stocks and in May the exact opposite occurred.
The rise of nationalist rhetoric has implications for domestic and foreign policy. The decision by US President Trump to impose tariffs on US$50 billion of Chinese imports, escalated by an additional US$200 billion following China’s calculated retaliation, jolted investors to the potential of a full scale trade war. After several rounds of negotiation and a vow to work together to reduce the US-China trade deficit, the escalation caught the market off-guard. A reversal in globalisation would steer the global economy into uncharted territory, with the real risk of trade uncertainty sapping confidence and leading to a deferral of investment. Post this November’s US mid-term elections, sanity may prevail with Chinese authorities keen to deescalate. In the meantime, many US corporations with large Chinese interests must be rightly nervous. Chinese authorities will be inclined to quietly punish the US by damaging its commercial interests in China, as witnessed by the plight of Korean corporations operating in China, such as Hyundai Motors, following Korea’s deployment of the US designed Terminal High Altitude Area Defence (THAAD) system against China’s wishes. US companies that are vulnerable to this type of boycott are those that sell products in China with readily available substitutes; Caterpillar, Apple and GM come to mind.
Figure 1: Most Extreme Credit Gaps (2018)
Weighing on global equities sensitive to Chinese growth is increasingly restrictive banking regulation which, coupled with a wave of bond defaults, has stoked fears of weaker Chinese growth. Empirical studies2 of financial crises have shown that rapid debt accumulation, whether it be by governments, financial institutions, corporations or individuals, contribute more to systemic risk than the absolute stock of debt. In the case of China, whilst the sheer level of debt (~260% of GDP) is reason enough to pause, it’s worth highlighting the pace at which it was acquired, and thus the potential for misallocation. Figure 1 shows the most extreme “credit gaps” today, i.e. the difference between credit to GDP and long-term trend. Hong Kong and China stand out in a global context, driven largely by their corporate sectors, followed closely by the US government and property driven debt cycles in Canada, Singapore and Scandinavia.
In response to this debt overhang, over the course of the last 3 years China has implemented strict measures to control excesses in the shadow banking system – a system that has allowed smaller banks to bypass regulatory scrutiny and continue extending credit to State Owned Enterprises (SOE) operating in overcapacity industries. By late 2015, these industries were pressuring the profitability of the entire industrial sector, and with ~US$1 trillion of the ~$US10 trillion SOE debt stock having interest coverage below 1, posed a serious threat to the economy. Since then, Chinese authorities have implemented a series of measures to reign in the excesses of the shadow banking system, including forcing banks to re-classify shadow loans as traditional corporate loans (thereby bringing the loans back under regulatory scrutiny), take on more nonperforming loans as over-capacity industries shut down and reduce their reliance on wholesale funding to alleviate liquidity pressures. Despite the sustained rebound in the industrial sector’s profitability and the PBOC’s lowering of the Reserve Rate Requirement (RRR) for banks three times this year, monetary conditions are likely to remain tight as the long-term nature of Chinese policy remains committed to working off these excesses. Ironically, this may reverse should the trade war escalate and exports slow.
In stark contrast with China’s move to deal with past excesses and the EU’s commitment to fiscal rectitude, even in the face of pressure from France and Italy for greater flexibility, the US has adopted a policy of aggressive fiscal stimulus. We have moved from a paradigm of synchronised global growth to one of US fiscal exceptionalism. As shown in Figure 2, the US has only ever previously adopted this level of fiscal stimulus in times of economic crisis or war. Not surprisingly, since 2016, 3M USD LIBOR has risen consistently with a rising Fed Funds Target, with this year’s tightening made acute by a ~7% YoY increase in US Treasury Public debt outstanding.
Figure 2: US Fiscal Deficit as % of GDP (1929-2028)
With the US running both a current account and fiscal deficit, i.e. twin deficits, in some ways US macroeconomic policy settings are akin to that of a peripheral emerging market, hence, the paradox of these policies leading to a unilaterally stronger USD and coinciding with selective emerging market stress. Past Fed policy has been quite sensitive to global signs of stress, though given the current focus on US inflation, it may tighten beyond the point that is helpful for many over-levered participants.
The ~$11 trillion3 “offshore” US dollar funding market represents one obvious point of vulnerability. Offshore USD funding is largely facilitated by surplus deposits within the Japanese and European banking system which are deployed by non-US banks wherever they can pick up interest rate carry (typically after hedging-out their currency risk). As the relative shape of the US yield curve flattens, the provision of USD funding by offshore participants becomes less attractive as their own domestic yield curves provide more carry without the cost or complexity of hedging offshore currency exposure. Put another way, higher shortterm dollar rates make it more expensive for foreign investors to hedge their dollar exposures, whilst lower long-term rates reduce the relative return. Since the beginning of 2018, currency hedged 10Y sovereign yield differentials have ceased to offer carry for the European investor, whilst still offering a small, but declining carry for the Japanese. In the current cycle, much of this “discretionary” offshore USD funding has been lent to emerging market borrowers and, over the quarter, we have seen selective countries and companies hit hard as this funding starts to be rationed. Conversely, these funding pressures are relieved by a relative steepening of US yield curve and/or a weaker USD.
Figure 3: Hedged 10Y Sovereign Yield Spread (2001-2018)
Taking stock of the past 12 months, the biggest deviation from our base case was the lack of follow through in European growth and rates. At the end of 2017, European business surveys hit multi-decade highs with 4Q industrial production expanding 7% YoY followed by a severe reversal in Q1 2018, with a cliff like 3% YoY contraction and a tepid Q2. Though still in expansionary territory, a softening in Chinese PMI’s has no doubt contributed to this, with the Chinese growth engine inextricably linked to the rest of the world, particularly export sensitive economies such as Germany.
Figure 4: German Exports/Orders vs China PMI (2005-2018)
More broadly, the weakness in European industrial production is also related to a 2H 2017 inventory build combined with Euro strength and higher oil prices weighing on demand. After years of running super lean due to weak demand, EU businesses reversed attitude and stocked up too aggressively in 2H 2017. Against this weaker backdrop, the formation of an Italian populist government was all the market needed to once again dump continental European domestic exposures. At the current rate of devolution, the entire European market may be soon tagged “peripheral”. Politically, illegal immigration is a tough issue for Europe to deal with as most solutions require some reversal of EU enshrined rights to freedom of movement. However, if France and Germany wish to forge ahead with EU reform such as a functional banking union and finance ministry, Italy and Spain’s support will require greater appreciation of their need for stimulus. All else equal, this scenario is a fundamentally bullish one for European domestically exposed equities.
Looking forward, the broad implication of the Fed enduring with its commitment to tightening is a flatter, potentially negative US yield curve, and without a rebound in European growth and/or a reversal of Chinese regulatory tightening, the risk of a Fed policy mistake is very real. This risk is exacerbated by the inflationary nature of Trump’s tax cuts and trade policy, accelerating the need to tighten and the potential confidence sapping impact of trade uncertainty. Whilst we highlight these concerns, we also believe that in the near-term, economic indicators will rebound as the first half European slowdown reverses and the global economy sustains its momentum into year-end. This also should serve as a reminder that global liquidity from other central bankers may also reduce given this growth dynamic.
Figure 5: Regional Purchasing Manager Indices (2005-2018)
In a world of growing capital scarcity, we would normally expect the current account surplus currencies (e.g. Euro, NOK, SEK, Yen, KRW) to outperform the deficit nations (USD, AUD and the weaker Emerging Markets). However, with the gap between US policy rates and developed markets poised to expand, the USD may strengthen despite the relative flatness of the US yield curve drawing capital away from the US. Hence, we remain relatively neutral on the USD versus the other major alternatives of the Euro and Yen.
Finally, the key question for 2018 and beyond remains to what extent can the benign environment persist? Putting aside trade wars and policy missteps, whilst the US growth environment is unlikely to accelerate much from here, the combination of fiscal stimulus and the easiest US financial conditions since the Global Financial Crisis should sustain growth at current levels for longer. However, we believe the unusually favourable goldilocks combination of accelerating growth and tepid inflation experienced in 2017 will not repeat. Instead, normalisation of interest rate policy will likely upset the rhythm with more volatile and less forgiving markets. We simplistically see two opposing scenarios, with the most recent weight of evidence supporting the second outcome:
- Cyclical growth surprises to the upside driving greater urgency from central banks to normalise policy. To minimise disruption to short-term funding markets, tapering would likely focus on the long-end of the yield curve leading to a potentially self-reinforcing pro-growth steepening, resulting in a significant increase in bond volatility and headwinds for the crowded/expensive bond proxy and quality/growth equity exposures.
- Cyclical growth disappoints due a US or Chinese policy error. In this scenario, credit volatility would spike triggering a major sell-off in credit sensitive equities. Conversely, the inevitable central bank reaction function would further amplify imbalances and support a continued melt-up in the quality/growth factor, led by the Internet and Software giants. Antipodes Partners’ investment goal is to build portfolios with a capital preservation focus from noncorrelated clusters of opportunity. In our long investments we seek both attractively priced businesses (margin of safety) and investment resilience (characterised by multiple ways of winning), with the opposite logic applying to our shorts, i.e. no margin of safety and multiple ways of losing. Whilst the investment case will always be predicated on idiosyncratic stock factors such as competitive dynamics, product cycles, management and regulatory outcomes, we seek to amplify the investment case by taking advantage of style biases and macroeconomic risks/opportunities.
Given the divergent risks that the above two scenarios represent, investors should focus more than ever on uncovering sources of idiosyncratic alpha rather than relying on momentum or passive beta. In this sense, we’re encouraged by the high level of valuation dispersion within and across markets (region/sector/factor) as indicative of broad pragmatic value opportunities, both long and short.
1 Netflix and Amazon together account for ~50% of S&P500 Index YTD return
2 “This Time is Different: Eight Centuries of Financial Folly”, Carmen M. Reinhart, Kenneth S. Rogoff, 2009
3 Bank of International Settlements (BIS), 2017