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Market Outlook

Socio-Macroeconomic Overview

Today’s paradigm of free trade can be traced back to the early post-war period. Following harmful trade protectionism which saw global trade fall by ~65% during the Great Depression, the General Agreement on Tariffs and Trade, in operation since 1948 and superseded by the World Trade Organisation (WTO) in 1995, created the environment in which tariffs tumbled from an average of ~40% in 1947 to ~4% in 2016. The scaffolding of treaties, institutions and laws now supports an interconnected global economy – an underlying principle of economic development facilitating greater utility and welfare. Trade though, has its downsides. For one, the most innovative and competitive nations are less likely to benefit from technology transfers, whilst at a greater risk of outright intellectual property theft. Secondly, the impact of free trade is asymmetric, with the winners (consumers who benefit from lower prices) dispersed, and losers (those affected by competition from foreign producers and jobs that move offshore) concentrated, creating pressure for political protection. In the US, against a backdrop of a current account deficit, record high income inequality and declining real incomes for those at the bottom of the income distribution, one might be forgiven for an emerging preference towards mercantilism, however misguided.

 

Income inequality rose at its fastest pace during the 1990’s, when trade represented ~20% of US Gross Domestic Product (GDP). During this period, real incomes of the top quintile of earners grew just under three times as fast as those in the bottom quintile, and the current account deteriorated by ~2.6% of GDP.

By way of contrast, the last decade witnessed an improvement in the current account, whilst income inequality increased at a slower pace despite trade rising to ~30% of GDP. The difference between the two decades is that during the latter, all Americans fared poorer, with those at the bottom of the income distribution worse off in an absolute sense – a likely source of social discontent.

Whilst the analysis is simplistic, the casual observation is that trade (and by extension immigration) represents a convenient whipping boy for the antediluvian economics of the Trump administration, with the impact of skill-biased technological change, arguably the biggest challenge for the US labour market, yet to be addressed.

Trump hopes to “bring back American jobs” through a series of strategic trade policy decisions – withdrawal from the Trans-Pacific Partnership (TPP), renegotiation of the North American Free Trade Agreement (NAFTA) and the implementation of tariffs on foreign (particularly Chinese) goods. Framed in the context of increasing domestic jobs and repatriating profits from foreign firms to domestic competitors, these policies make sense – in theory.

Assuming no reciprocation, tariffs raise the price of foreign goods and services, shifting demand for imports to domestic producers, whilst exports remain untouched. This in turn increases domestic output, all else equal. The problem with this theory is the payoff accrues to one nation at the detriment of another – put another way, every nation is incentivised to retaliate.

Historical evidence suggests protectionist policies have a negative impact on the volume of world trade11. Whilst the protectionist mindset for all is more rational than a protectionist mindset for some, the outcome is sub-optimal in aggregate, with the role of the WTO to police the incentive for nations to deviate towards protectionism.

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 in investment. To date, the US has announced ~$250b of tariffs on Chinese exports to the US, roughly half of 2017 exports. China has responded measuredly, announcing ~$110b of tariffs on American exports to China, or ~85% of 2017 exports. Given China’s relatively greater reliance on US trade and limited manoeuvrability as tariffs escalate, the likely outcome is a more strategic response, i.e. increasing domestic subsidies whilst seeking stronger bonds with other nations.

China’s greatest strength in winning allies might be that its domestic demand remains relatively robust, allowing it to import more from other markets. Emerging markets, for example, have increased their goods exports to China from ~2% to ~15% since 2002, whilst exports to the US have declined from ~25% to ~15% over the same period. Despite the People’s Bank of China (PBOC) lowering the reserve rate requirement for banks three times this year, unleashing tax reform and infrastructure stimulus, domestic policy remains tight as China remains committed to working off the excesses of the prior loose environment through a combination of macro-prudential property related policy and restrictive banking regulation12. This may reverse should the trade war continue to escalate, to the benefit of domestic facing Chinese and European equities.

Opportunistically, China may pursue trade deals Trump walks away from. Following the ratification of the new TPP, Japan has been gazing eastward towards the Regional Comprehensive Economic Partnership  (RCEP), whose members account for roughly half of the world’s population and more than a third of its GDP and global trade, almost twice that of the TPP. Despite the negative backlash to their outward investment profile, China will be well served to maintain high levels of foreign direct investment. In 2016, Chinese investment in the European Union (EU) jumped to nearly €36b from €2b in 2009, with Europe increasing its share of Chinese FDI from a fifth to a quarter. Somewhat cynically, one could assert that much of this state-backed investment speaks of China’s longer-term strategy to keep Europe from helping the US contain its rise.

As trade tensions continue to build, the probability of a miscalculation or provocation rises. On September 30, a Chinese navy destroyer caused a near collision with the Decatur, a US guided-missile destroyer conducting a Freedom of Navigation Operation in the South China Sea, evidence of increasingly confrontational Chinese policy. Sustained confrontation could result in a further weakening of the Yuan to offset tariffs or damage to US commercial interests in China, not dissimilar to the plight of Korean corporates operating in China following Korea’s deployment of the US designed Terminal High Altitude Area Defence (THAAD) system. Although, as the US Department of Commerce’s now lifted ban on US companies selling goods to ZTE demonstrated, it too can inflict damage on national champions. Nevertheless, US companies that are vulnerable to Chinese confrontation include those with China dependent supply chains or sell products in China with readily available substitutes – for example, Caterpillar, Apple and General Motors. Post November’s mid-term elections, sanity may prevail with Chinese authorities keen to de-escalate.

In the US, against a backdrop of relatively subdued inflation, growth is soaring, with Trump’s domestic policy analogous to burning all the furniture in the room. Whilst some indicators, such as the corporate profit cycle, industrial production, unemployment and consumer confidence suggest the economic cycle is maturing, residential/corporate investment and wage inflation is still at early or mid-cycle levels. The risk to the cycle is monetary policy, with an increasingly limited fiscal backstop.

Following the GFC, as policy rates neared zero, the Federal Reserve (Fed) actively targeted a flatter yield curve, rebalancing portfolios towards risk and duration, with the wealth effects of asset price inflation a key transmission mechanism to the real economy. The expansion of the Fed’s balance sheet flooded the US banking system with reserves such that to maintain control over the target rate of interest, the Fed began paying interest on excess reserves. Today, the US banking system is incentivised to hold excess capital, risk free, at 2.2% p.a.

The Fed’s path to normalisation is as much about allowing the market forces to dictate the shape of the yield curve as it is about managing the target rate in-line with inflation. Allowing the balance sheet to shrink – QT – is the strategy to achieve this, though the risk is that at some point we transition from a banking system with excess reserves, to one where reserves become scarce.
The Fed’s intention is to allow its balance sheet to run-off at a rate of $50b a month into the foreseeable future. As the balance sheet contracts and reserves are destroyed, the banking system will be required to compete for liquidity, signalling a return of Open Market Operations to manage the target rate. The point at which this occurs, and the Fed reaction function is a matter of substantial debate.

The requirement for reserves in the US banking system is now structurally higher – a consequence of post crisis regulatory changes to the banking system requiring banks to maintain an adequate stock of unencumbered high quality liquid assets – meaning the Fed may not be able to safely reduce their balance sheet by much without provoking strains within the system, and with it, heightened volatility across all asset classes. Should this materialise sooner than expected, and the Fed struggles to navigate the liquidity driven turbulence that may arise as consequence, the ability of the Fed (and other central banks) to pursue QT to its end may be in doubt, and with it a return to the flatter yield curve targeting regime of the past decade. Within equities, this will likely favour the status quo i.e. a stylistic preference for “structural growth” or
“quality” at any price – Figure 6.

Source: Antipodes Partners

However, a successful (even if turbulent) implementation of QT, in conjunction with reduced bond buying by other central banks, is likely to steepen the US yield curve as the influence of central banks wane, the rate hike cycle matures and the Fed risks clamping down on growth. Whilst the market has typically imputed weaker growth as meaning further balance sheet expansion and yield curve compression, a sustained and gradual Fed run-off is likely to alter this dynamic, with the natural lever of the Fed to reduce policy rates before scaling back on QT at the risk of damaging its credibility. Simplistically, with US nominal growth running at ~6% and ten year nominal yields at ~3% (Figure 14), long rates can be rationalised higher. The historical relationship in Figure 6 suggests that in this environment, a stylist preference for low multiple stocks could evolve.

Until the process of QT becomes more entrenched (Figure 7), the more immediate 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 may be exacerbated by the inflationary nature of Trump’s tax cuts and trade policy (though somewhat offset by a stronger dollar), accelerating the need to tighten. Given a capital market structure that has changed profoundly post GFC, with central banks and passive liquidity acting as shock absorbers to risk assets more broadly13, the progression of QT is likely to trigger increasing volatility across all asset classes. Longer term, we’d expect a successful implementation of QT to reverse the distortions of the low rate and flatter yield curve environment that has characterised the prior decade.

Increasingly, Emerging Market stress over the quarter has been symptomatic of the Fed’s path to normalisation, with the high yielding capital importers enduring the impact of the stronger dollar and exposing the underlying frailties of weaker EMs such as Argentina and Turkey. In Hong Kong, courtesy of the USD peg, loose US monetary policy has driven a rapid accumulation of corporate sector credit to 250% of GDP and with it, rampant property price inflation, with residential and grade A office space prices up ~6x from their 2003 lows. Should the currency peg hold, HKD denominated assets are increasingly vulnerable to tightening USD liquidity.

 

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, at the risk of labouring the point of market fragility, we apply the Herfindahl index – commonly used in ecology to examine population diversity and competition law to measure how monopolistic an industry is – to quantify how concentrated the leadership of the market has become. In a rising market, the leadership has become increasingly thin, and at the time of writing, we argue somewhat responsible for the recent volatility.

Conclusion

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.

Antipodes Partners’ investment goal is to build portfolios with a capital preservation focus from non-correlated 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 of US monetary tightening, the Fed reaction function and the global growth outlook, 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 as indicative of broad pragmatic value opportunities, both long and short.


11 Eichengreen & Irwin, 2009: The Slide to Protectionism in the Great Depression: Who Succumbed and Why?
12 See our June 2018 outlook at antipodespartners.com/wp-content/uploads/combined-Jun-2018-Quarterly.pdf
13 See our blog post “Volatility: Dead or in Hibernation” at antipodespartners.com/Volatility-dead-or-in-hibernation