Reflation Trade Becomes Consensus…

In a vintage year for contrarian asset allocation, the trajectory for markets has been to overreact to China deflation/devaluation risks, the shock of the misguided negative rates experiment (which served to confirm deflation fears and therefore backfired as a signalling tool) and what we termed the  ‘sideshow’ of Brexit. Overly pessimistic expectations were reset from Q2 as macro data such as PMIs and net earnings revisions across the MSCI AC index rebounded (led by EM), reflected in the turn in bond yields from July as ‘macro hypochondria’ peaked.

Positioning for the commodity cycle and EM bottoming in Q1 looked to us like a compelling bet, as did overweighting value as a style factor. Globally, value has outperformed by about 20 ppts since July, the second-best run versus ‘quality’ as a portfolio factor in almost 40 years. Our rotation from bond yield flattening to steepening sector exposure mid-year (including long Eurostoxx banks) also generated huge alpha in the tactical portfolio. If there was one issue this year which reflected a spectacular failure of nuanced analysis and caused global shock waves, it was the Q1 panic over Chinese FX reserves and the risk of a ‘shock devaluation’ which coincided with equally hysterical forecasts of oil going to $20 to generate a deflation panic rippling across markets.

Our view was that at least half the apparent capital flight was in fact rapid FX debt deleveraging and that rather than a deflationary shock, China was poised to inject an inflationary impetus to the global economy as the investment cycle turned. Ironically, the rebound in China’s fixed investment (particularly residential construction) has been weaker than we expected but the surge in industrial commodity prices even stronger, now that reflation is suddenly fashionable as an investment thesis. We stuck with a $50-60/bl end 2016 oil price target as market rebalancing began, making global E&P stocks and US HY energy debt a contrarian overweight. Meanwhile, the RMB correcting from very overvalued real effective levels was something to be welcomed, so long as orderly.

The US election has provided an alibi for sell side strategists to wipe the slate clean on an astonishing series of analytical errors and belatedly jump on the reflation trade. If the overwhelming investor consensus a year ago was for further EM/commodity downside and long quality/growth, this year it is long USD and reflation winners and positioning has shifted accordingly but simplistic extrapolation remains the default forecasting tool of most analysts. Indeed, almost comical herding behaviour continues to define markets from oil to the JPY (for instance, the yen has seen consensus targets versus the USD gyrate from 125 in mid-2015 to 90 by mid-2016 and now back to 125 again). Investors have been stampeding in and out of markets with record speed as the narrative and momentum shifts. With the rise in AUM of systematic trend following funds and the retail ETF hordes that ride their coattails, markets have never been more of an ‘echo chamber’ of confirmation bias  – remaining strictly agnostic is key to getting ahead of crucial inflection points.

The consensus was hugely misguided a year ago, and the impact of the Trump regime whether in terms of tax policy or geopolitics looks less benign than it now naively expects. Ultimately, if Trump is to attract cheers rather than jeers at the rallies he intends to continue holding for his rustbelt true believers, low-skilled labour has got to get a bigger share of the economic pie i.e. companies will have to divert cash flow from shareholder distributions to capex and wages and shift their capital structure from debt to equity.

Tax cuts will accordingly come with strings attached designed to incentivise investment and manufacturing re-shoring. The USD and Treasury yields are not a one-way bet given subtle negative feedback loops and both look extended, global miners ex gold now look relatively expensive and quality growth/defensives decent value again. While 2017 is unlikely to be quite the contrarian bonanza this year was, it would be wise to read those investment bank annual outlook notes with a healthy degree of scepticism. Or perhaps safer still to ignore them completely…






China Housing Booms on Land Shortage…

‘The property sector contributes about 15% of GDP directly, but up to twice that on a broad multiplier basis on HKMA estimates, while real estate accounts for about 70% of household assets. On a cyclical basis, the housing market has been improving since mid-Q1, despite the misguided Spanish/Irish property crash parallels drawn by some observers (ignoring the huge equity cushion, the lack of securitization or a secondary market to propagate panic selling etc.). Ongoing easing measures and liquidity displacement from equity markets will boost property in the leading Chinese cities further this summer. Ultimately, the government desperately needs the fixed investment cycle in real estate to stabilize…’ Macro Weekly, May 22nd 2015

‘Mainland developer destocking continues to tighten the market as sector lending picks up. Indeed, the chart showing cumulative real estate floor space started versus sold is a critical one right now – it shows the huge inventory build-up in recent years has peaked, ex the Tier-3 cities – it’s hard to see destocking going much further. Your view on global cyclicals/materials as well as Chinese momentum hinges on whether you believe that property investment is set to stage a rebound.’  Macro Weekly, Jan 11th 2016

It was clear by mid-2015 that a cyclical rebound in China’s property market was looming, driven by healthy fundamental demand as inventory levels peaked, yet this critical macro inflection point was bizarrely overlooked by most commentators. We’ve gone from a China ‘running out of FX reserves’ consensus narrative in January to a ‘running out of apartments’ one now i.e. the feared deflationary impulse has become an inflationary one for the global economy, even before housing investment catches up with the inventory cycle.

Indeed the surprise has been the relatively weak new build response, but the suggested Q1 overweight bet in domestic deep cyclicals exposed to the construction cycle as well as global materials/mining has outperformed substantially this year. The largest Chinese cities have joined many in the West from San Francisco to Dublin and London where soaring prices have failed to generate significant developer new supply, partly because of zoned land and funding shortages.

This latest property boom is therefore very different to the 2009-2013 one, when developers and local SOEs rather than households were the driving force and leveraging aggressively. Given the fevered price surge, which is reaching even third tier cities, it’s remarkable that new starts fell over 19% y/y in September. Rapidly shrinking inventories offer fundamental support, although the recent spectacular pace of official price growth (exceeding 30-40% y/y across several of the 15 largest cities) is clearly unsustainable.

The backdrop remains broadly positive – rapid urbanization (from an official but likely understated 56% in 2015) is spurring first-time housing demand; demand for housing upgrades will increase alongside rising incomes as about 40% of urban households are living in low-quality housing built before 2000 while there are more than 230m people aged 20-29 who will be first time buyers over the next decade. The affordability ratio nationwide was at the lowest end of the historical range at just over 7x income as of the end of 2015, making property relatively attractive as interest rates fell and A-shares imploded. The ratio of house prices to household disposable income in Tier-1 cities was just under 15x at the end of 2015 and has now risen to about 20x, approaching HK levels and well above London/NY.

However, these conventional metrics are distorted by the huge amount of space hoarded as ‘concrete deposit boxes’ by the top 1% of households (who own about 25% of vacant space) and substantial undeclared ‘grey income’ for the elite. An alternative ‘reality check’ is to look at housing wealth versus national income; aggregate Spanish residential property peaked at about 460% of GDP in 2007; Australia (and NZ), considered the frothiest global real estate markets alongside Canada (and a surge in Chinese buying has been a major factor in all three) are now worth over 350% of GDP.

The US peaked at just under 200% and is now 140%. China’s property market is worth 350-400% of GDP at current price levels. Land remains the key form of collateral within corporate balance sheets and the wider financial system, as with Japan in the 1980s and national average prices are up 5x since 2004 on the independent Wharton/NSU/ Tsinghua index, and 11x in Beijing. It’s important to note that Spain, the US and Ireland all saw a dramatic supply response to rising prices which alongside the collapse in credit availability helped crash the market 40-50% peak to trough post 2008. China doesn’t face the same series of shocks but real estate is now clearly overheated and calming the market is becoming a policy priority for Beijing.

The bottleneck is what has been historically been a rapid new build response in China capping price surges is land. In the first nine months of 2016, residential land supply in 100 medium and large cities dropped by 10% y/y, even as apartment sales soared. In Shanghai and Beijing, land supply through September dropped by 33% and 80% respectively y/y. The recent trend of developers bidding aggressively for premium land is directly due to low levels of zoned land for sale (itself partly a function of the ongoing anti-corruption drive, which has created local government paralysis in what has been a very lucrative activity for city level bureaucrats).

Significantly, the Shanghai government has just tightened regulation on the financing of land purchases – developers are not allowed to buy land using financing from banks, trusts etc. but from internal funds. Developers violating the new regulations would lose the deposit they make before auctions and will be banned from purchasing land in Shanghai for three years but this looks more a supply than demand side issue.  The only sustainable solution is significantly more land and new floor space supply over the next year, further boosting producer prices and cyclical growth momentum, even as housing prices peak.

Cyclical Bet Remains Attractive…

‘I would overweight MSCI China in a GEM portfolio, and particularly H-shares. Deep cyclicals in China remain favoured on growing evidence of a fixed investment recovery. That backdrop would force side-lined investors, as yet unconvinced by the sustainability of the Q1 rally, to reallocate. From a technically driven repositioning rally, the next leg globally would see a shift to a positive net earnings revision trend and multiple expansion.’ Weekly Insight, 12th April

That unfashionable cyclical bet has paid off but while the RMB proxy short via H-shares (particularly banks) has been much reduced over the summer, global funds are still underweight offshore China by almost 300bps, near a decade high. A key theme is that you have to ‘reality check’ economic data points more than ever in the current environment of rapid structural change and low amplitude trend growth that leaves Japan and Europe repeatedly on the cusp of apparent recession.

That’s even truer in a global economy where incremental growth is digitizing and the global economy is becoming ‘lighter’; it is significant that services added more to global trade growth than manufacturing last year for the first time ever. The standard macro data points used by consensus analysis are increasingly misleading and as Silicon Valley giants start employing large teams of PhD economists, it seems clear that the web giants now have a uniquely powerful perspective on economic data flow from ‘live’ consumer prices to merchandise inventory levels. Investors will likely be buying proprietary data packages from Amazon, Google etc. within a few years that are far more powerful than anything Wall Street can offer (the ‘billion prices’ project at MIT is an early view of the potential of big data and real-time online transaction networks).

There are now hundreds of data releases every week that didn’t even exist a decade ago, with dozens of bank economists commenting on almost every one, but little of that activity is of any practical help in generating actionable insight.  Back in Q1, scanning the outlook statements from key global cyclicals would have reassured any investor paralyzed by ‘sell everything’ headlines from excitable IB strategists. The granular corporate evidence has been more reliable than economist extrapolations all year and remains broadly encouraging.

As for China, Komatsu has seen a 10% rise in excavator utilization hours, the seventh consecutive month of growth. I spoke to a client recently who had attended a major tech conference in Taiwan and thought confidence among companies he met was at levels he had rarely seen over the past decade. To do this job, you need to have an analytical telescope and microscope and most importantly know when to switch between them.

Growth, inflation and earnings expectations are all turning modestly but decisively higher. That  more than central bank actions will generate volatility near-term as complacent bond investors front running central bank buying reposition for a less pessimistic economic outlook. It’s also clear that even central bankers are accepting that monetary policy is at the limits of both creativity and effectiveness, and as Harvard’s Larry Summers has recently argued, fiscal policy focused on infrastructure spending now looks a more rational policy response. By boosting the velocity of money in the real economy, that would be inherently more inflationary medium term than endless monetary stimulus that ex asset inflation effects simply gets trapped in bank excess reserves.

While recent US data has been mixed in housing etc., historically low level of combined debt service and energy outlays at just 14% of disposable income are offsetting soft wage growth, while balance sheets and net worth continue to improve. We have seen some slowing in growth in corporate bank borrowing as more companies tap booming credit markets, but the slowing in corporate bank loans has been offset by an acceleration in real estate and consumer lending.

An interesting lead-indicator granular data point is the Chemical Activity Barometer, published monthly by the American Chemistry Council, up 3.9% y/y recently and suggesting that US industrial production will accelerate into early 2017 now that the energy/inventory adjustment drags are abating. The biggest surprise to a consensus still suffering ‘macro hypochondria’ would be a synchronised cyclical growth rebound over the next 3-6mths and our overweight cyclical risk asset strategy since Q1 remains in place.

EM Led ‘Pain Trade’ Rally Gains Momentum…

In the last post in June, I concluded that ‘the ‘pain trade’ for  global investors terrified of and positioned for a seemingly endless list of macro tail risks remains further risk asset performance in H2’ and so it has proven since. I’ve maintained a non-consensus overweight on EM equities and local currency debt all year, the latter helped by record DM portfolio inflows into the asset class as the pool of negative yielding bonds in Europe/Japan has surged to $12trn. GEM trades on just over 12 x forward multiple with 6.5% consensus earnings growth versus over 16x and just 0.6% for DM (adjusting for growing US GAAP reporting distortions makes the comparison even more flattering to EM).

Net earnings revisions momentum continued to improve for both Asian and wider EM in July, and should turn positive by Q4. There has certainly been EM multiple expansion this year but from historically low relative valuations, particularly versus the US and in line with historical experience at turning points in the earnings cycle. The outperformance of EM equities (particularly versus Europe/Japan) has been an embarrassing surprise this year to many asset allocators. In recent weeks as overextended commodity markets consolidate, stale bears have highlighted the divergence between resilient equities and the reversal in the CRB index with which they tightly correlate historically.

However, while the EM FX rally this year was led by the terms of trade recovery as commodities rallied, we’re also seeing ROE bottoming, particularly in Asia as the focus shifts from revenue growth to cost control. EM corporates are recovering from a toxic mix of overinvestment, excessive leverage and poor cost discipline in 2009-2014. The result was excess inventory, overcapacity, and ultimately output price deflation and crashing margins – in that context, it’s significant that Chinese PPI is now responding to the housing and commodity price recoveries, down just 1.7% y/y in July and set to move positive into early 2017.

Profit margins have also been under pressure since 2010 as wage growth outpaced productivity – however, wage growth is now moderating toward mid-single digits in China, or less than half peak levels. As for overinvestment, for the MSCI AXJ, capex growth is likely to be y/y negative by about 10% this year and 5% next as companies focus on cost control and margin expansion. That is broadly a positive trend, particularly in China but not in India, which has seen a sustained collapse of private sector capex since 2009 as it boomed elsewhere in the region.

There are also overlooked positive structural factors for EM as new technology bridges the chronic infrastructure deficits which have been a drag on growth. As I’ve long highlighted, ubiquitous cheap smartphones are allowing a ‘leapfrog’ effect for emerging economies – there is no longer any rationale to build out a fixed line phone or bank branch network. Instant messaging services like WhatsApp are being used by small businesses from Brazil to Bangladesh to market themselves and attract customers while mobile payments are allowing the unbanked to trade.

Alternative card payment services like Stripe are allowing small businesses anywhere to trade globally (and ‘on demand’ service exports from graphic design to software coding will become more important than container traffic over the next decade for many of these economies, from the Philippines to Argentina). Certainly, upgrading basic physical infrastructure remains  crucial but  the ‘economic optimization’ role of technology advances is even more valuable in countries with scarce infrastructure and high frictional logistics/transaction costs than in developed economies.

Indeed, the digitization of incremental growth will help offset the institutional weakness of many emerging economies and do more to drive inclusive growth for the economically marginalized (Alibaba in China being a prime example) that any number of well-meaning World Bank programs. That’s especially important now that the classic East Asian development model of a sustained trade surplus and captive household savings funding fixed investment is becoming redundant, given China’s unassailable manufacturing scale economies.

UK Vote a Sideshow For Markets…

‘Even if the UK votes to leave and begins the prolonged legal and political process of exiting, the comparisons with Lehman as a broader economic shock look very overblown as is any imminent prospect of wider EU/EMU contagion led breakup. This would be a messy, acrimonious divorce which would adversely impact UK growth/funding costs over the next couple of years, but no major economic shock for Europe, with an exit vote likely forcing EU reforms and a narrower but much deeper level of integration, notably via the banking system (deposit guarantees etc.). A kneejerk FTSE 100 selloff in that scenario would be a buying opportunity given the earnings boost from sterling for resources, pharma etc.’ Macro Weekly, 17th June

And so it has proven; we have closed the longstanding GBP short on twin deficit funding risks (initiated in mid-2014), the long JPYUSD position from last summer and the long VIX position from April into the post Brexit turmoil, as this always looked less like a Lehman than non-event for global markets. It was striking that our  non-consensus overweight on emerging markets/commodities remained resilient through the initial selloff and global investors remain very underweight both the FTSE 100 and EM, despite clear signs that net earnings revisions are improving rapidly (and about to turn positive in the UK).

The UK stumbled into what I termed in recent months an ‘accidental Brexit’ thanks to weak turnout among young voters and astonishing political incompetence in both calling the referendum in the first place and them mismanaging the campaign. This is now widely seen as a howl of provincial protest expressing popular anger at the London elite, reflecting the global inequality narrative, but anti-immigration sentiment was a key factor.

Most ‘leave’ voters were under the delusion that inward migration from the EU would suddenly stop, when free movement will be central to newly negotiated trade deals. The political atmosphere will become even more strained when the reality dawns that the referendum ‘taking back our country’ soundbites are simply unenforceable in practical border control terms. Importantly, the UK is an outlier in terms of Euroscepticism; no other EU electorate is likely to vote to leave the EU (or be offered the chance). Indeed, the Spanish election at the weekend saw the ‘rejectionist’ Podemas movement lose share to the centrist pro EU parties of left and right. The EU is now likely headed belatedly for a ‘two tier’ structure of a far more Federalist core of 5-7 nations that drive decision making led by Germany and an ‘EU lite’ membership for the rest.

European banks have been hard hit by the referendum shock driving a further rise in the proportion of negatively yielding Eurozone bonds . The key to a sustained sector rally remains Italy – the badly designed new stricter EU ‘bail in’ rules created a crisis of confidence in Italian banks and allowing a more decisive recapitalisation is now critical to creating a moat around the Eurozone economy.

A much more flexible German attitude looks likely to be forthcoming shortly, as Italy has to be a member of a new core Europe political arrangement. Substantive recapitalisation of Italian banks (€40bn plus) would trigger a risk rally far beyond Eurozone banks – the ‘pain trade’ for  global investors terrified of and positioned for a seemingly endless list of macro tail risks remains further risk asset performance in H2.

Central Bankers Learn to Fly Helicopters…

The original QE framework was essentially a simple asset swap by central banks taking private bond market assets onto their balance sheets against a matching liability, thus creating a displacement effect as those private sector holders use the cash to buy riskier yielding assets, suppressing funding costs across the economy. That has since been extended to other assets, including corporate bonds in Europe and equity ETFs in Japan. QE was a very justifiable response to  initially contracting and then very weakly recovering private sector credit creation after the 2008 systemic shock. What matters for the real economy is the aggregate balance sheet growth of the financial system i.e. central plus commercial banks.

That’s a key point the many observers predicting an inflation breakout in the years following QE adoption missed. The fact that commercial banks hoarded excess reserves post 2008 (partly to meet tougher capital adequacy rules) meant that the velocity of money actually fell, and far from the hyperinflation risk many forecast in 2009/10 we’ve seen persistent deflationary pressure. The BOJ’s balance sheet is now about 80% of Japan’s GDP, compared to ‘only’ 20-25% for the ECB, BOE and Fed. The ECB is now buying corporate bonds in the primary market and willing to hold up to 70% of any single issue, a scenario that would have been greeted with incredulity back when EMU seemed poised to implode in mid-2012.

So far, no central bank has taken the step of simply cancelling the debt it has absorbed, although you could argue that in market collateral and economic cash flow terms that is exactly what has transpired. For instance, the Fed has paid back to the US Treasury about $500bn in profits since 2009, which equates to the interest the Treasury has paid the Fed on its bond holding. It’s not deficit monetization in any formal or explicit sense, but looks a lot like it in practice and it’s increasingly likely that we will see a move to formal deficit funding.

The defining macro issues of the past decade have been slowing trend (and indeed potential) GDP growth as populations rapidly age against a backdrop of rising debt ratios and historically weak productivity growth, all of which of course first became evident in Japan 20 years ago. Despite falling unemployment, wage pressures remain muted globally – jobless claims in the US keep falling to record lows while non-farm payrolls have been trending higher at over 200k/mth, but much of the job growth is low productivity/wage sectors that so far have proved immune to automation trends (e.g. leisure and hospitality has generated almost half of all US new jobs since last September).

For all the armies of PhD economists they employ to calibrate their vast general equilibrium macro models, essentially the framework for what central banks are trying to achieve in restoring is astonishingly simplistic. They have a trend GDP growth path and as the real economy deviates below that trend, an ‘output gap’ opens up which they attempt to plug with loose monetary policy to stimulate faster demand growth and hence inflation as spare capacity reduces. On this basis, the orthodox view is that the lower real rates they go, the more inflationary the economic impact by boosting lending growth etc.

Ultra-low rates have in fact been deflationary in several respects; for instance, they drove an investment boom across commodities in 2010-14 (including US shale oil) and the additional supply helped exacerbate the subsequent price crash. They also depressed the value of annuity style income for retired savers whether relying on bank deposits or bond market holdings, forcing their required savings rate higher (a particular drag on aggregate demand in Japan/Europe).

As for investment, despite soaring house prices from HK to Sweden, the UK, US and even Ireland, we have seen a very muted investment response because of supply side constraints. These range from stricter planning laws limiting development land to tighter credit availability and simply far fewer developers left in the market – we will see something similar in US shale over the next few years i.e. a permanent loss of capacity. Meanwhile, the ‘servers over structures’ digitization of incremental growth has reduced the need for fixed investment outside resources/housing, particularly as technology investment goods have continued to deflate rapidly.

We are now likely in the process of shifting to a nominal GDP targeting framework, likely to be implemented in Japan and China first. That implies that central banks directly fund fiscal stimulus to achieve an overall nominal growth target, which brings us into the realm of ‘helicopter money’. It’s now widely accepted that the world needs fiscal policy to work in tandem with monetary and bizarrely Germany and Japan are being paid by investors to build ‘bridges to nowhere’ although upgrading transport infrastructure is likely to generate a better return in the US even at current yield differentials. Politically, it’s hard to get German or US Republican politicians (who remain obsessed with paying down debt) to accept that wider deficits are part of the solution.

Prof. Milton Friedman coined the term “helicopter drop” in a 1969 essay to describe how central banks could print money and distribute it to citizens to offset deflationary pressure. QE reduces bond yields, lowers borrowing costs, and encourages spending through an enhanced wealth effect (although estimates of the impact of the wealth effect from financial assets and housing have been declining). Ultimately, though, the influence on consumption and output is looser than would be the case with a direct infusion of reserves to households, particularly low income ones with a high propensity to spend the windfall.

Central banks were founded to issue currency, prevent bank panics, and be the lenders of last resort. Over time, their mandate has expanded to include correcting episodes of deficient demand, which tests the border between fiscal and monetary policy. They don’t typically have the legal authority to send out windfall transfers directly to citizens, which is what many understand ‘helicopter money’ to mean.

For example, all members of the Eurozone would have to agree for the ECB to implement this strategy. Congress would have to authorize the Fed to undertake such a plan. In addition, the reserves (i.e. liabilities of the central bank) created by helicopter money do not have a corresponding asset, unlike QE programs to date. The only way around this issue is for helicopter money to work as a fiscal expansion funded directly by the central bank. The helicopters will be hovering over finance ministries to deliver their windfall, not households.

Indeed, in former Fed Chairman Ben Bernanke’s famous 2002 helicopter speech, he noted that the coordination of fiscal and monetary policy amounted to a helicopter drop of money: ‘A money-financed tax cut is essentially equivalent to Milton Friedman’s famous “helicopter drop” of money.’ In his latest blog post for the Brookings Institution, he expanded on that key point:In more prosaic and realistic terms, a “helicopter drop” of money is an expansionary fiscal policy—an increase in public spending or a tax cut—financed by a permanent increase in the money stock.’

He concludes that: ‘Under certain extreme circumstances—sharply deficient aggregate demand, exhausted monetary policy, and an unwillingness of the legislature to use debt-financed fiscal policies—such programs may be the best available alternative.’ Given all the factors he lists are very much apparent in economies like Japan, and the failure of negative rates, which amount to a de facto tax on private bank credit creation, this is where we seem inexorably to be heading. Near term the broad commodity rally and modest China re-acceleration should support stabilizing global inflation trends over the balance of this year, but in the next global cyclical downturn and for Japan quite possibly well before, fiscal and monetary policies look set to converge. 

‘Lazy Consensus’ Positioning and Sentiment Now Shifting…

‘Performance in 2016 will hinge on whether USD/commodity/EM trends persist (consensus) or to varying degrees reverse (my view). On a CAPE basis, global value is at its cheapest versus growth since 2000 and cyclicals are at their lowest relative valuation since the crisis and we should see a mean reversion rally. Local currency EM debt, Euro, JPY, EM equities, US HY credit, copper, oil, AUD, and CAD all look attractive…’  Dec 15th 2015 Asset Allocation Note

Those macro views are suddenly becoming fashionable, but certainly weren’t at the turn of the year versus what we termed a ‘lazy consensus’. The overwhelming view from Wall Street analysts was that the dollar rally would be sustained through 2016, energy/materials equities and credit remained an obvious short and emerging markets would flirt with disaster.

The RMB devaluation ‘running out of FX reserves’ hysteria in January marked a climax for that popular bearish narrative. Hedge fund sentiment and positioning has shifted radically since then, from oil futures to resource stocks – the yen has now replaced the dollar as the biggest bullish currency bet, a prospect that would have been greeted with disbelief a year ago.

Investment bank FX strategists have had a disastrous few months, having missed the potential for euro and yen strength, as well as the dramatic EM currency rally. If you believed consensus wisdom, the euro should now be sub parity versus the USD and the yen well over 130 by now. They missed the importance of the dramatic current account improvements across many EM economies last year, as well as that in Japan.

Alongside already very cheap currencies on a trend real effective basis as calculated by the BIS, that made a high probability macro backdrop to the ‘surprise’ rally we’ve seen, with the recent ECB/BOJ action merely a catalyst. Fundamentally, global cyclical momentum is now turning higher, from factory new orders to Chinese cement and steel rebar prices anticipating a rebound in fixed investment activity.

Oil demand growth continues to be upgraded, notably from India (seeing demand growth of about 600k bpd this year) while US gasoline demand this year will almost certainly reach a record high on rising average mileage/SUV fleet share. So far supply destruction from the crash in global energy capex has been modest but remains critical to rebalancing the market. Our Brent crude target back in December for end 2016 was $50-60/bl and remains so.

Equity net earnings revision ratios  remain negative across nearly all markets, but the second derivative is turning as the pace of analyst downgrades slows, particularly in Asia. We retain the overweight stance on deep cyclicals, materials and energy as well as EM with a focus on North Asia. Japanese exporters, many of which have seen 20-30% declines YTD on record foreign investor net outflows.

That panic selling has taken global funds slightly underweight versus benchmark. High global beta stocks exposed to EM demand now look a very attractive anomaly as the  consumer and investment demand cycle turns higher from China to Indonesia,  offsetting yen strength as an earnings drag.   It’s paid to be contrarian this year, and that’s unlikely to change just yet…

Hyperactive Central Bankers Fuel Volatility…

“The constraint of the ‘zero lower bound’ on a nominal interest rate, which was believed to be impossible to conquer, has been almost overcome by the wisdom and practice of central banks. It is no exaggeration that [ours] is the most powerful monetary policy framework in the history of modern central banking,” BOJ Governor Kuroda, displaying ominous levels of hubris

‘The existential threat to market confidence and trigger for a true panic remains a collapse in investor faith in central bankers, who remain perched on their pedestals for now. To maintain precious credibility, it would be wise if they stood back from healthy bursts of volatility like we are seeing, rather than rushing to soothe nerves…‘ Macro Weekly, 20th October 2014

That ‘existential threat’ point I made back in 2014 remains key – unfortunately, instead of standing back, central bankers keep tinkering and risk squandering their most precious policy tool – credibility. What if rather than the ‘wisdom’ of central banks as Kuroda would have it, the negative rate experiment undermines bank profitability and thus credit creation? What if it leaves life insurers facing a solvency crisis and forces households to save more, thus deepening the ‘liquidity trap’ extreme monetary policy is meant to overcome? While weak nominal growth and thus growing deflation risk is the underlying issue, uncertainty regarding highly experimental central bank policies, their predictability and effectiveness is the big concern right now, and has partly driven the rout in global financials.

The Swedish central bank last week cut its repo rate to minus 50bps, in a country growing at 3.5% this year and with one of the most overheated housing markets anywhere (up 18% last year). They did this purely to meet a typical simplistic and (given the structural technological/demographic headwinds) misguided inflation target. Some will call this an effort at competitive devaluation, but it’s striking that both the Swedish Krona and JPY rallied after an initial selloff on negative rate announcements. While the Fed was suggesting four rate hikes this year (which markets never really took seriously), many if not most US investors are now talking of no further rise this year and even a rate cut.

Many observers are beginning to ask: do central bankers really know what they’re doing? This is all highly experimental monetary policy with minimal academic literature to support it and the unintended consequences on tighter liquidity by squeezing the private banking system (and in a fractional reserve system, banks ‘create’ money via the credit multiplier) and fuelling asset bubbles will likely be significant. Eventually the consumer price inflation targeting ‘fetish’ will be abandoned by policymakers.

The core issue for central banks as I cover repeatedly is how to bring excess savings and structurally weak investment demand into balance via an ‘equilibrium’ price for capital which has driven ever more intense levels of ‘financial repression’ to prod savers to spend, despite the secular demographic backdrop and digitizing growth/consumer spending patterns. Negative rates in the US are now being discussed by mainstream commentators, despite nothing in the macro data to suggest that would be justified on either core inflation or growth grounds.

Negative rates are probably net tightening financial conditions and the ‘signalling’ impact of these extraordinary moves on investment return expectations both in financial markets and the real economy could well end up boosting precautionary savings and depressing investment further. It also has so far contributed to widening credit and equity risk premia, but the biggest risk is that bank’s lending confidence starts to reflect their plunging security prices, squeezed yield curve ‘carry’ and shrinking net margins so the selloff risks becoming to some degree self-fulfilling. Clearly, regulatory bank stress tests now need to include the ability to cope with deeply negative rate environment in the next global downturn.

Markets have seemed in recent weeks on the edge of a nervous breakdown, with investors  overwhelmed this year by a rapid sequence of tail risk panics, from (we think misplaced) fears of a dramatic RMB devaluation to oil falling into an abyss (in our view far more likely to be bottoming) and now a banking meltdown, all of which pushed the MSCI ACWI to a 20% decline from its highs last week. Despite the old adage that ‘news follows prices’, much of the recent selloff looks largely psychological/technical.

However, central bankers need to stand back and remember the PBoC governor’s wise words that they are ‘neither a god nor a magician, there is no way we can wipe out all uncertainties’ i.e. act with extreme caution in extending the negative rate experiment until unintended consequences become clear. It would certainly be helpful if the ECB reassured markets on Eurozone bank funding, by offering backstop repo lines if necessary and broadening its range of credit instrument purchases.

Investors need to get over the psychological scars of 2008 and accept that very few have the insight to spot a true ‘Big Short’ moment. Indeed, the uninspiring recent record of leading hedge funds, from the US biotech debacle to the short Euro frenzy back in December underlines that groupthink has never been more potent a force in markets. As about half the headline ‘capital flight’ is in fact very healthy external debt deleveraging, that makes the current popular ‘China is running out of FX reserves’ narrative another crowded bet likely to implode, with a little help from Chinese central bankers schooled in Leninist brute force.


2016 Investment Consensus Looks Lazy…

The investment bank consensus for 2016 is a pretty unanimous (lazy?) extrapolation of recent macro trends. US biotech, the RMB, India, risk parity and the euro are just a few examples this year of North Korean levels of investment industry groupthink going badly wrong and leaving many hedge funds reeling. Asset allocation performance in 2016 will hinge on whether USD/commodity/EM trends persist or to varying degrees reverse, as we think likely. As has been much commented upon, US equity performance has been extremely narrow, focused on 9-10 growth stocks. Indeed, growth as a performance factor has outperformed value (Price/Book) by a large margin in the US and Asia ex Japan, more modestly in Europe while in Japan, our favourite major equity market throughout 2015, value has held up.

There are structural drivers (e.g. our longstanding dematerializing economy structural theme, reflected in the global manufacturing versus services PMI divergence) but relative valuations have now we believe overshot on a cyclical basis. Supporting that thesis, on a CAPE basis, global value is at its cheapest versus growth since 2000; cyclicals are at their lowest relative valuation since the crisis

We maintained a 1.10 fair value USD/euro target throughout 2015 and see no reason to change it now  – the Fed-ECB policy divergence is peaking into Q1, oil at this level net reflationary for Eurozone real economy vs. US and euro supportive while the aggregate current account surplus will test new record highs, offsetting the impact of yield seeking capital outflows. We also saw the JPY as fundamentally undervalued a year ago on a real effective/PPP basis and likely to resist an ongoing USD rally  – while that is now a more consensus view, risks remain tilted toward underlying yen strength and we prefer domestic equity exposure e.g. via real estate, banks and inbound tourism plays. In contrast, a year ago we thought a 5% RMB devaluation seemed likely  – a modest depreciation path remains the base case and for a country focused on attracting $2-3trn of foreign capital by end decade to successfully deleverage its corporate sector (via benchmark inclusion and deeper capital markets), a dramatic FX move looks counterproductive. Meanwhile, the growth data in much loved India looks to us more dubious than in China and underlying corporate debt/ROE and bank non-performing loan trends deteriorating versus consensus expectations…

As for EM FX, the rapid closing of current account deficits as consumption and thus merchandise imports are suppressed reduces funding risks and should lead to a revival in carry trade inflows – local currency debt is a good way to play that surprise and an improvement in overall EM sentiment. Despite fears of an EM debt implosion, ex-commodities EM corporate IG leverage is flat as deleveraging in Asia offsets the pick-up in leverage elsewhere and USD debt, which was our preferred ‘safe haven’ exposure has performed well this year.

While about 7% of the US HY market now in deep distress, trading above 20%, the HY/leveraged loan maturity profile is supportive through 2017. Once crude stabilizes by end H1 and likely trades above $60/bl by year end on a growing perception that the $250bn slump in sector capex will create a supply deficit beyond 2017, energy junk as well as MLPs should rebound. Now that funding options to bridge collapsing cash flows have belatedly closed, US shale output will likely fall faster in 2016 than the consensus expects and prove less elastic to rising prices than assumed – US construction offers a sobering template for an industry that discarded skilled workers who never returned, constraining output capacity.

The US credit underperformance this year reflects the heavier weighting in commodities versus the S&P500 (26% in US HY,, only 18% in S&P) rather than being a recession risk signal. It’s very plausible that US credit will outperform equities in a mean reversion dollar/oil environment. With limited scope for multiple expansion in global equities (ex EM if ROE stabilizes in Asia, likely a good bet), equity index returns should be in line with earnings growth of 8-10% in Europe and Japan and 7-8% in GEM with the US lagging at 2-4%. A sustained USD/oil reversal to say 105-110 on the broad USD index/$50-60 on WTI would boost US earnings momentum by 3-5 percentage points and justify closing the maintained underweight bet.  Oil and the dollar will be key to all else and by mid-year should be surprising a crowded consensus…

‘Peak Pessimism’ on China and EM Suggests Q4 Rebound…

The narrative of slowing global growth, rising deflation pressures and monetary impotence to do much about it remains dominant in markets – that’s reflected in very bearish positioning among global asset allocators on most survey evidence and certainly conversations we’ve had. Back in our last blog post on the risks to emerging markets at end July, we concluded that: ‘While the modest recovery in Europe and Japan looks sustainable, a full blown EM crisis would be a global deflationary shock, particularly if associated with an RMB devaluation. The PBoC is now fighting deleveraging risks/propping up asset collateral values on so many fronts, from the ever growing local government debt swap to the attempt to stabilise collapsing A-shares, that something will have to give…’

Our view since last year was that the RMB’s real effective appreciation against EM peers was unsustainable and likely to reverse with a target of 6.8 versus the USD by end 2016. The ‘shock’ RMB depreciation move in August deepened anxiety about the scale of China’s slowdown and the credibility of policy makers to deal with it. The poorly managed and communicated FX shift, like the preceding stock market intervention, indicates that Beijing’s clever and largely US educated technocrats face a steep learning curve in managing capital market expectations.

The subsequent collapse in commodity and resource stock prices looks more reflective of a 20% RMB fall versus the dollar rather than a 2% one. After the worst quarter in several years across global markets from high yield US debt to Japanese equities, will a degree of stability in China boost risk appetite in Q4? Recent measures to restrict capital outflows have seen the CNH/CNY rates converge and volatility subside, while the margin debt deleveraging process for A-shares now looks complete. The slowdown in China led by investment/heavy industrial activity has long looked inevitable and is ultimately healthy; the services sector is likely being systematically underestimated (possibly by upward of $1trn) given the Soviet style ‘count the bricks’ GDP methodology – whatever you believe ‘true’ GDP growth to have been this summer, with a fast improving property market and recent stimulus measures, momentum should be soon improving from that cyclical nadir.

From a  tactical perspective at least, we’re likely approaching ‘peak pessimism’ for both EM and commodities – negative sentiment and flows for both have been driven by deepening China fears. Even slightly better China data through year-end after the concerted fiscal and monetary stimulus of recent months would lead to stabilizing commodity prices and hence EM currencies; that would trigger a resumption of carry trade inflows as well as equity fund net flows turning positive. Turkey and Brazil remain high risk given political uncertainty, high bank sector loan to deposit ratios and weak net international investment positions (-50% of GDP in Turkey’s case). Real rates in Brazil are already touching 5% and further rate hikes to support the real would push the economy into an even deeper recession next year and drive a surge in corporate defaults.

However, EM Asia looks attractive after the summer selloff; the MSCI AXJ is now on just 11x forward earnings, and while net earnings revisions remain net negative, the pace of downgrades is abating – HK listed H-shares, Taiwan and Korea look likely to outperform if broader sentiment rebounds and unusually high levels of institutional cash are deployed. So does Japan, which despite the softening economy raising deflation risks remains attractive on the multi-year bottom up corporate governance/payout ratio theme. The odds on further BOJ intervention are rising, likely focused on equity ETF and REIT buying given liquidity issues in the JGB market. Overall, improved cyclical macro news flow from China remains key to a rally across global markets into year end and should be imminent, even if the huge structural challenge of deleveraging and rationalizing the SOE sector remains…