Product Cycles Imply Looming PMI Inflection Point…

‘I even think the President has recognized it’s not cost effective to push the tariffs anymore, and if he wants to continue pressure on China, which I think he probably does, I think this would be a good path to pursue. I do think we reached the end of the road with regard to cost-benefit analysis on the tariff side. In fact, I think a lot of the tariffs that have been recently suggested on the last tranches aren’t going to take effect…this is a matter, in my mind, of consumer protection…” Economist Larry Lindsay, former Fed governor and director of the National Economic Council under President GW Bush, speaking recently

In the course of recent client meetings in London and Asia, I’ve reiterated the message contained in the notes since late August  – tariffs had outlived their usefulness for the US as a trade policy tool given the negative feedback via consumer and business.  Even if this ‘phase one’ trade agreement hadn’t been announced, it seemed doubtful the December hike would have been implemented and further US containment measures will likely shift toward technology and capital flow restrictions, with a narrower market impact. China and the US acted in their narrow self-interest and therefore this ‘non-deal’ which has attracted much dismissive comment stands a good chance of surviving to a Trump-Xi photo opportunity in Chile.

As usual, sentiment will follow price action into year end, and extremely defensive positioning is fitfully unwinding and that will accelerate if we see a second derivative improvement in the macro data through year-end. The market has been  braced for more bad news and hugging long duration bonds and their equity expression via quality/low-vol equities as an expensive comfort blanket. In fact, we’ve seen a strong rally over the past six weeks in high global beta, deep cyclical markets from the DAX to KOSPI and Topix. For students of behavioural finance, the next few BoAML institutional surveys will be fascinating to read after the ‘hunkered in the bunker’ fearful tone of recent ones. The dollar index reacted predictably to trade relief,  crucial to EM participating in a wider risk appetite reversal and for the White House is as important as selling more pork and soybeans (even if the FX ‘stability’ aspect of the deal is a theatrical stunt).

To sustain the recent rotation toward cyclical value, we need a rebound in two key industrial sectors we’ve been structurally bearish on since 2016/17 – autos and smartphones. In both cases, a technology shift (diesel to hybrid electric in Europe/Euro 6 equivalent in China, 4 to 5G in mobile) and the rapid rise of a second-hand market in China have dented new sales. Those postponed consumption/extended replacement cycle headwinds are now abating – mainstream German car brands have electrified, and buyers of ICE cars worried about residual values can now choose a VW e-Golf over a Tesla.

Indeed, the Ifo survey of German auto sector confidence is showing signs of stabilisation, while annualised output is also likely bottoming at just over 5m units. Last month, EU demand for new passenger cars increased by 14.5% to 1.2m units – the growth is certainly flattered by a low base following the introduction of a new emissions testing regime last year, but its striking that four of the five major EU markets saw double-digit gains. Over the first nine months of 2019, new car registrations were down 1.6% y/y but that should be turning positive into early 2020 – much of the slump in demand has been due to a technical industry transition creating consumer confusion over residual values etc. Tighter emissions standards have also been a drag in China, which adopted the local equivalent of Euro 6 for ICE engines in June this summer – sales have begun to recover since.

As for smartphones, while 5G handsets are still only about 1% of Chinese sales, with 40 cities fully networked by mid-2020 and operators offering 30-40% discounts on 3000-4500 RMB handsets (taking them closer to 4G prices), that proportion should surge toward double digits through H1. Given this upgrade cycle and flattering base effects, the overall market which has been falling 5% or so y/y in recent months should turn strongly positive by mid-2020. Pre-registrations for 5G service are approaching 10m users, even with just a handful of handsets currently available (although dozens more Chinese designs will be launched by mid next year).

Making China the biggest and fastest 5G deployment is a key technology priority for Beijing, not only for the direct benefits in terms of stimulating the service economy with related new products but the scale economies it affords to then dominate the global market for handset and infrastructure hardware. It’s critical to dig beneath the headlines to understand the role of say weaker semi pricing in the slump in Korean exports by value and the resurgence in the Chinese current account surplus YTD, as much as the role of Boeing’s 737 fiasco in US export/durables data. A semi restocking cycle into Q1 now seems plausible and the divergence between chip equipment names like ASML and the commodity chipmakers in Asia, who have lagged US peers YTD, should close.

Against this backdrop of a nascent cyclical recovery in key global sectors which have been a drag on PMI and trade data, you can be constructive on risk exposure at this point while utterly realistic about the low odds of any comprehensive trade settlement over the next year. The weakness seen in global PMI and other industrial data over the past 12-18mths was as much about a transition in key technology product cycles as it was trade uncertainty…that will be true of any ‘surprise’ rebound in H1 20 also.

 

 

 

 

 

Oil and USD Rallies Shake EM…

The oil rally reflects the fundamental tightening we were writing about since late Q2. Crude futures moving into backwardation last summer saw oil tanker storage turn uneconomic and the popular ‘glut’ narrative which saw several high profile bank analysts predict $40-45/bl Brent this year is now shifting…keeping 1.2 mb/d (plus nearly 0.6 m bpd from non-OPEC) offline for another year could push the market into a deficit situation, leading to accelerated inventory drawdowns and prices heading to the $80-90/bl range in H1 19. That’s a scenario worth stress testing in portfolios…’  4th January 2018 blog post

The macro outlook described back in December was for an asset allocation environment of rising rates, oil and the USD – the dollar rally took a long time to arrive, but JPM’s emerging market currency index has tumbled to its lowest level since early 2017. We’re seeing an unusual divergence between the declining broad EM USD carry index versus rising broad commodity indices, with which it usually correlates positively – that will have blown up a few hedge fund macro books.

That anomaly is partly because energy has dominated the commodity rally YTD and diverged from industrial metals impacted by slower Chinese credit/fixed investment (indeed short metals versus energy was one of our December resource trades) and US shale capturing some of the windfall from higher oil prices. We downgraded our view on EM equities to neutral coming into 2018, having been overweight since Q1 16. Arguing for the ‘cheapness’ of EM equities by looking at price to book or PER discounts to DM is simplistic; on an EV/Sales versus operating margin basis, the picture is far more nuanced across the EM universe with Asia looking most compelling, albeit distorted by IT where H2 earnings are now being broadly downgraded. Indeed, Asian tech was one of the most crowded bets cross global portfolios in Q4 an hasn’t delivered, while overall MSCI EM earnings momentum on a three-month rolling aggregated net analyst revision basis is now negative, as indeed is European.

Our view was that a growing divergence between Chinese growth and US inflation (and rates) momentum would become a key portfolio factor as dollar liquidity peaked and ebbed.  On that basis, the consensus long EM and euro trades looked vulnerable to sudden reversal, and indeed popular  carry trades have become lossmakers over the past month as the first signs of an offshore dollar funding squeeze emerge. For the euro, 2-year yield and relative macro data  differentials versus the US suddenly matter again and positioning remains very vulnerable to a further selloff, even if Italy’s new populist coalition avoids further antagonising Germany with ECB write-off talk.

We’ve been long DXY as well as global oil equities in our tactical portfolio, although the crude rally is now extended, with Brent at our year-end target and discounting immediate geopolitical risks. We noted bearish cognitive bias as a factor back in the January post, but the growing number of $100 forecasts from the same IB analysts calling for $40 a year ago reflects the career incentive to herd and momentum chase.

If Q1 was a dollar inflection point and DXY is headed for 100 plus alongside crude in the $70-80 range and 10-year yields sustaining a move above 3%, EM will be a net loser as QE morphs into QT through H2 at a time when import bills surge for twin deficit countries like India and Indonesia after recent FX weakness. The pressure to curtail current account deficits/domestic demand will intensify as funding tightens while more aggressive FX intervention running down official reserves  and pressure to hike rates (as in Indonesia this week)  will become widespread policy responses over the next few months – it’s hard to see even Turkey resisting for long more.

The rise in offshore leverage across EM since 2009 has been broad, although focused in some markets in the banking system (e.g. Turkey where the loan to deposit ratio has reached 120%) and in others the non-financial corporate. There is certainly no immediate prospect of a rerun of the 1982 Mexican or 1997 Asian crisis but the IB “buy the dip, this time is different” mantra looks as misplaced as their blind panic on the asset class in early 2016 deflation scare. When it comes to analyst groupthink, this time is never different…

 

 

Asian Crisis Still Resonates…

There haven’t been any official events to mark the 20th anniversary of the Asian crisis, which erupted when Thailand freely floated the THB on July 2nd 1997 (having struggled to fund an 8% current account deficit, twice the average across EM Asia at the time). Within a year that had caused a domino effect ‘margin call’ across emerging markets, culminating in the collapse of Russian markets and the devaluation of the ruble in August 1998. Russia only accounted for just over 4% of world GDP in 1997, but was a major borrower of short-term capital and the contagion effects were rapid.

What was until then a regional crisis spread across GEM and then global markets, causing spreads and volatility to surge with a cross correlated violence that blew up value-at-risk models. That contributed to the collapse of $126bn AUM hedge fund LTCM by year-end, which led to a Fed engineered bailout. That would have been a potential shock on a par with Lehman’s implosion, but the fallout was pre-empted unlike in 2008 – LTCM had successfully hedged most of the risk from the Asian currency crisis and delivered a 17% after fees return in 1997 (after over 40% in each of the previous two years by applying huge leverage on its ‘relative value’ strategy).

Global capital flows since then have been shaped by these events, as Asian (and wider EM) governments committed to never allow themselves to become vulnerable to speculative attack again, driving mercantilist policies and a huge build-up in official reserves as a bulwark. Asia’s currency reserves stand at almost $6.3trn over half the global total, versus less than $1trn in 1996 as a portfolio flow ‘margin call’ loomed.

Those reserves were largely recycled into Treasuries, funding persistent US current account deficits and the steady deterioration of the country’s net international position or ‘net worth’. Aggregate Asian CA surpluses are back at pre-crisis levels of over $600bn (and with China’s surplus looking understated because of very questionable growth of the estimated tourism deficit as covered in a recent Fed analysis, probably well over $700bn).

I’ve just been to Budapest, where the raddled face of hedge fund legend George Soros stares down from government sponsored billboards, labelling him  as a scheming currency manipulator (he has accused his native country under its right-wing, anti-immigrant leadership of becoming a ‘mafia state’). It seems unlikely that for all his pseudo intellectual ‘reflexivity’ theories Soros could have anticipated the longer-term fallout from his currency attacks across Asia in those tumultuous months. One of those is that he helped end the era of swashbuckling macro hedge funds bending intimidated governments to their will – no hedge fund balance sheet can fight an aggressively deployed central bank one.

As we highlighted back in 2014/15 as the consensus abandoned EM assets, the move to floating exchange rate systems and high reserves versus FX debt made another crisis, which was widely feared at the time, highly unlikely – tumbling currencies acted as an EM macro pressure relief valve and forcibly closed current account deficits from Indonesia to Brazil, underpinning the ‘surprise’ rally in EM assets over the past 18mths. However, the sustainability of the capital recycling model built up since the late 1990s looks very doubtful – the US economy simply can’t absorb huge surpluses from both Asian and Europe any longer as the ‘consumer of last resort’.

The Asian crisis led indirectly to the 2008 global one, as the ‘savings glut’ being forced upon (a very receptive and overly deregulated) US suppressed funding costs, as explained by Ben Bernanke back in 2015. In the interim, the Fed by rapidly cutting rates in an overreaction to the LTCM debacle fuelled the Dotcom bubble – unintended consequences have been the defining feature of central bank policymaking over the past two decades. Meantime, is there another LTCM combination of hubris and leverage lurking within the global financial system after another extended period of low volatility? We’ll find out as the first central banks take tentative steps toward policy and balance sheet normalization in the next 12-18mths, but it’s probably not in Asia…

Contrarian Bets Pay Off in Q1…

‘Wall Street has projected its wildest fantasies onto the largely blank canvas Trump provided, but this is politics reinvented as performance art. As the lack of policy coherence or even consistency becomes painfully clear, investors risk a degree of buyer’s remorse. Many of the key policy suggestions look contradictory, such as the border adjusted corporate tax system and its impact on boosting the already ‘too strong’ USD or the proposed tax cuts… political gridlock is now a risk if he also splits the Republican Party with what is fast looking more like a Silvio Berlusconi than Reagan style administration.’ Weekly Insight, 23rd Jan 2017

A key theme since December was that the consensus assumption of a rampant USD,  10-yr Treasury yields testing 3% and accelerating US growth looked as misguided as the deflation panic a year ago. The implosion of what we termed a month ago as the ‘incoherent mess’ healthcare proposal occurred during our recent Asian roadshow, further shaking complacency. The overweight bet in EM equities paid off, with a 13% return the best quarter in five years while a resumption of carry trade inflows boosted EM FX to its second-best quarter led by the 11% Mexican Peso rally (18% from its January low), distilling the broader Trump reassessment across markets.

Global growth has outperformed value as expected and our preference for North Asian cyclical exposure (notably tech) has been justified – Korean exports surged almost 14% last month led by semis while Samsung is one of several regional tech names hitting new highs. Chinese and European demand rather than US has been the key upside driver for Asian trade this year. India’s rally has been surprisingly strong and driven further multiple expansion on a surge in domestic mutual fund inflows YTD, but the credit and earnings growth backdrop remains very weak. Reflecting the rapid shift in sentiment, on IIF data net capital flows to EM were positive last month, with China seeing the first  inflow since 2014.

With the yield curve flattening again, US banks have now joined the reversal of crowded post-election consensus trades. The hope that feuding Republicans factions can now regroup and move swiftly on tax and regulatory reform looks optimistic – the CBO projected $839bn in savings on Medicaid spending over a decade as 14m beneficiaries were removed, a key offset for deep corporate tax cuts. The border adjustment tax was meant to be a revenue windfall to cut the headline rate, but is already mired in Congressional wrangling and the conservative Freedom Caucus looks set for a war of attrition ahead of next year’s mid-term elections.

The Washington swamp has drained Trump, whose ignorance of even basic policy details and lack of a core political base in Congress were always obvious weaknesses which will have to be addressed but this is not a man with any experience in building coalitions. Before tax reform can even be discussed seriously, the highly controversial budget has to be passed, with many Senators angry as brutal cuts to key departments and basic scientific research budgets. Our view remains that tax cuts will be both more modest and later than most expect.

With the dollar index testing four month lows, we have taken profits on the tactical short on USDJPY and the FTSE 350 mining sector, which has corrected with the sharp iron ore reversal. In contrast to further upside (particularly for surprises in Europe, recent US data looks soft. That ranges from the slump in gasoline and supermarket food sales (both branded and generic) to a broad downturn in bank credit growth.

With investment banks belatedly noticing the divergence between ‘soft’ survey and hard reported data, consensus inflation and growth expectations look vulnerable for H2. We’ve been highlighting rising stress in the auto loan market since Q4 and the auto market bears close watching in Q2 for deterioration in sales volumes, loan delinquencies and residual values.  New vehicle incentives are reaching new highs at about $3500 per unit while second hand values are now falling at an almost 8% y/y pace, as subprime repossessions spike after a 5% decline in 2016.

These signs of underlying US consumer weakness will be key to Q2 asset allocation, as will be the risk of China tightening policy more broadly to slow a still booming housing market. For the US consumer, while belated IRS tax refunds will help, the shock of absorbing 20% plus hikes in healthcare insurance costs will squeeze discretionary spending across low income households in H2. Growth is more likely to slow to about 1.5% rather than accelerate and we remain underweight US ex tech versus EM and Europe.

There are signs that the recessionary style freefall in gasoline demand is now abating, which drove US inventories to a record in February and has been a bigger factor in the crude selloff than shale output rebounding. If we see an OPEC output cap extension, as seems likely give the Saudi desperation to get the Aramco deal away next year, a bullish stance on energy should pay off and we’re now adding long global oil E&P exposure to the tactical portfolio. Downside on that trade would require  US gasoline sales to sustain the remarkably weak trend seen in Q1, in which case the wider economy is heading for a much deeper slowdown and the 10-year is more likely to test 2 than 3% by mid-year…

Painful Emerging Market Mean Reversion Continues…

Collapsing terms of trade from the commodity slump, a liquidity squeeze from the USD rally and a rapidly weakening credit cycle amid stagnant productivity growth isn’t the macro backdrop for EM outperformance. Emerging market equities as measured in the MSCI index have underperformed developed markets by another 6 percentage points so far in 2015 while the price/book ratio on the MSCI EM has fallen to about 1.4x versus 2.2x for the MSCI World,  a discount of over 30%. Emerging market equities reached a price/book premium to the MSCI World of 18% in 2010, amid consensus ‘10% China growth forever’ euphoria as the country fuelled the post-crisis commodity rebound with an historic credit/construction boom, now unwinding.

A point we’ve long made is that the biggest losers from China’s trend growth slowdown/falling resource intensity of growth would be outside the country, among the countries pulled along on its credit/investment stimulus coattails pre 2012. While GDP, retail sales, investment and credit growth are all clearly slowing across GEM, an added problem is deteriorating data quality at a critical time for policy credibility. For instance, India bulls often say that for all its faults, at least unlike China the country has data you can trust and independent institutions like the RBI. That’s become a highly questionable assertion.

While the country’s GDP calculation certainly needed modernizing, political pressure drove changes to the methodology which have made the new data hugely flattering and at odds with other metrics from listed corporate revenues to credit growth. It’s a far guess that manufacturing added value is about double what it should be and non-financial saving about 2.5x higher, if the calculations were based on internationally accepted conventions and the recommendations of the CSO’s own subcommittee. On the official data, EM growth is now only three percentage points higher than developed world, but given that China’s growth is likely overstated by 1.5-2% and India’s by 1-1.5%, the differential is even narrower.

Our view since 2013 has been to structurally underweight commodity FX terms of trade losers from Indonesia to Malaysia and Brazil (and note that amid the wider EM FX carnage, the Indonesian Rupiah is now at a post Asian crisis low, as while Indonesian consumer credit growth has fallen sub 10% y/y). China’s shift to a services led growth model since 2013 (albeit flattered by the booming stockbroking sector in recent quarters) was predictable but still stunning in its speed; manufacturing and real estate investment growth running at over 30% and 27% y/y at end 2011 is down to sub 10% and sub 5% respectively as at June.

Import volumes into EM countries ex China are now negative, investment growth is heading that way and with persistent currency weakness pressuring inflation higher as the Fed prepares to finally raise rates, many EM economies will have to raise rates to curtail capital outflows. The net equity earnings revisions ratio (and return on equity) is still deteriorating just about everywhere, but especially for commodity exporters like Malaysia and Indonesia and the Eurozone and Japan still look relatively better value.

If emerging economies continue to deteriorate in H2 as seems likely, the impact will be felt globally as their huge FX reserve accumulation since the late 1990s continues to reverse (undermining the oft quoted ‘liquidity glut’ theory for low US rates) while multinationals with large EM consumer exposure will see earnings and revenue forecasts pressured far beyond the luxury market e.g. motorbike sales are slumping in Indonesia. 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…

US Demographic ‘Mean Reversion’ Supports Growth Outlook…

If we stand back from the endless noise in markets, the demographic shift to lower fertility/longer lifespans underway globally is having a macro impact on several levels. For instance, the shrinking working-age population dragged down Japan’s potential GDP growth by an average of over 0.6 percentage points a year since 2000 and that drag will reach a full percentage point through end decade (the impact on the Eurozone, where the working age population is now also declining, is likely to be at least half a point off already anaemic trend growth). Another impact is on capital flows – demographic decline as a deflationary force boosts the inherent attraction of fixed income, while risk aversion as retirement looms drives inflows into bonds over equities.

Fewer workers means the economy needs a smaller capital stock while an ageing population has less need for more housing or consumer durables and more for services, such as health care or tourism. Furthermore, the price of technology investment (a growing share of corporate capex as the economy digitizes) has seen dramatic and sustained deflation from storage to bandwidth – companies struggle to productively invest the record free cash flows they are generating given a declining need for fixed structures versus new data servers to generate incremental revenue. Secular demographic and technology shifts in combination are pushing investment down and saving up. The central bank policy response fixated on inflation targeting is perversely exacerbating the impact of ageing i.e. one of slowing trend growth, excess saving and historically low interest rates, by forcing over 50s to save more to achieve their target incomes.

Screenshot (29)

Source: BLS, Census Bureau, Entext Economics

The US population is aging much more slowly than that in Europe and Japan – indeed the median age of an American will fall below that of a Chinese citizen with a decade, thanks to a surge in ‘Millenials’ as the population in the peak consuming age group is increasing again after a decade long slump. There were 3.8m fewer Americans aged 30 to 44 in 2012 than there were in 2002, but by 2023 there will be almost 6m more in this age cohort, suggesting that underlying demand patterns for housing and consumer durables such as autos will have a structural tailwind (you can’t easily Uber the kids to a ball game, after all). On Census Bureau data, the 25-44 age cohort in the US spend the most per capita on food, housing services and furniture which is in line with the classic ‘life cycle’ theory of consumption taught in Economics 101.

Meantime, the sluggish post crisis economy has created pent-up demographic demand for housing – there are over 2.5m young Americans living with their parents who would on pre-crisis trends by now have moved out. The average annual household formation rate since 2008 is the lowest since records started being kept in the late 1940s. About 45% of 18- to 30-year-olds are currently living with older family members, at least five percentage points higher than long-term trend (although now showing signs of peaking). Even gasoline sales have been impacted  – the number of prime-driving age Americans plunged by 2.8m from 2005-13 as baby boomers aged i.e. it peaked with average miles driven per capita. Aside from low gas prices boosting mileage and an aging vehicle fleet underpinning a replacement cycle, the looming demographic ‘mean reversion’ implies a buoyant auto market in the 16-18m annual sales range for several years. As much as the shale energy revolution, the US will soon enjoy a demographic windfall that supports relative economic outperformance through end decade…