Macro Overview – March 2018

Sparked by rising interest rates in the US and increasing tension between the US and China over trade tariffs, global markets experienced a return of volatility in the first quarter of 2018. Andrew Clifford takes a deep look at these issues and shares our outlook over the medium-term.

Over the course of the first quarter of 2018, a number of issues have arisen that gave investors reason to return to a more cautious stance despite the global economy continuing to grow robustly. Among these concerns are:

- rising interest rates in the US,

- the impact of China’s financial system reform on that country’s economy and on asset markets both inside and outside of China, and

- the potential for a trade war between the US and China.

Over the last year, we have highlighted that rising US interest rates are the most likely source of a setback for the economic outlook and for markets. In developed economies, historically the pattern has been that initial increases in rates have little impact on growth, but as rates continue to rise, they will eventually act as a handbrake on the economy. As for whether the next rate hike will be the straw that breaks the camel’s back, it is difficult to foretell even at the best of times. After a period of quantitative easing and near zero interest rates, the task is perhaps even more challenging. That debt levels remain elevated across most of the major economies adds further complexity to the problem!

For the moment though, it is clear that the US economy continues to travel well. Employment is strong, with initial unemployment claims (an indicator of new job losses) at the lowest level in 45 years. Wage growth remains healthy (average hourly earnings growing at 2.5% annually), and workers continue to be attracted back into the workforce with the participation rate^[1] gradually rising. While the concern is that higher wages will ultimately be passed along through higher prices, for now, inflation in the US remains subdued at 1.9%.^[2] The current scenario of steady gains in employment with wages rising and little evidence of inflationary pressures to date appears to be a very positive one.

We would think investors faced with this scenario would remain relatively optimistic about their prospects, and through January they appeared to be so. Of course, the environment can change quickly, and the big change was President Trump’s tax cuts which were passed by Congress in December. The stock market’s first reaction was clearly welcoming of the change as US companies would see a significant lift in their after tax profits. However, there are other impacts to be considered. Firstly, as tax cuts flow through to US corporates and households in the months ahead, one would expect them to boost the economy to some degree as a result of either increased consumption or more investment. The risk is that these cuts will add fuel to an economy that is already growing strongly, thus causing greater inflationary pressure and possibly an acceleration of interest rate hikes.

The secondary issue is that the consequential increase in the country’s fiscal deficit – which is expected to rise from 3.7% of GDP currently to around 6% of GDP in 2020 as a result of the tax cuts – will see a significant increase in the amount of government bonds that need to be issued, with the potential to move long-term interest rates higher. In some respects, this increase in the supply of government bonds looks even more dramatic when one considers that there was a net negative supply not very long ago – the bond purchases made by the Federal Reserve in 2012-13 under their quantitative easing policy were greater than the new bonds issued. Viewed in this light, the net supply of new bonds will effectively have moved from less than zero to over 6% of GDP in the space of six years. And all this is without taking into account how President Trump’s other policy initiatives (such as infrastructure spending) might further stretch the deficit and add to the bond-issuing task!

It is easy to start envisaging both long- and short-term interest rates moving much higher than previously expected, in the process upsetting economic growth prospects and indeed equity and debt markets. We will address the issues for markets later in this report, but first it is worth noting that in the period prior to the tax cuts being passed, the 10 Year US Treasury Note was trading at a yield of around 2.35%, and subsequently ran up through the first months of the year to just below 3%, before settling back at 2.8%. It is easy to see why some commentators are excited about bond yields going much higher even though the US government’s bond-issuing task hasn’t even started.

The problem with this analysis is that while we have an approximate idea of the future government deficit, there are many variables that no one can fully predict. As an example, to what extent will consumers spend their tax cut or save it, and will companies invest more or simply pass it through to shareholders in the form of dividends and buybacks? The degree to which this happens will not only have an impact on the strength of the economy and on inflation, but also on the amount of savings in the economy available to purchase the bonds. In addition, the move in the US 10 Year Treasury yield to 2.8% may already be sufficiently attractive for investors to fund the deficit, especially for the European and the Japanese whose equivalent rates in their home markets vary between zero and around 1.5%. Ultimately, the economic and financial systems we are dealing with are dynamic and the simplistic predictions are often wrong.

The other important development is the ongoing reform of the Chinese financial system, a topic that has received relatively little coverage in the Western media. The key change that has been causing concern is a directive that requires the assets and liabilities of the shadow banking system be brought back onto the balance sheet of the sponsoring financial entity. The issue is that banks and other financial institutions are required to have a minimum level of shareholders’ funds (or equity capital) for a given level of lending, and bringing these shadow banking assets back onto the balance sheet will lead to many banks breaching these capital adequacy requirements. The solution is relatively straightforward: limit new lending and seek repayments of loans where possible.

There is, however, the additional complication that the loans funnelled to the shadow banking system and kept off balance sheet were loans that the banks would have otherwise been restricted from making. Also, the regulator has tightened up on the use of Chinese banks’ balance sheets to fund the purchase of offshore assets. The result is a forced deleveraging by companies, particularly those that have taken on significant debt to acquire assets both at home and overseas. An example well publicised here in Australia is the divestment by Wanda, a Chinese shopping mall developer, of a major residential project at Sydney’s iconic Circular Quay. Other names impacted include HNA Group (airline operator turned real estate and hospitality conglomerate) which now has a stake in Virgin Australia, and Anbang Insurance, whose vast portfolio of assets includes the Waldorf Astoria in New York.

In conjunction with these changes, China is looking to further develop its domestic bond market in order that companies and local governments can borrow money in a more transparent fashion. The issue is that this mechanism will take time to replace the shadow banking system as it is today, and as a result the availability of loans will be much reduced. Indeed if we look at the broadest measure of credit growth in China, it has now slowed to 12.9% year-on-year, a relatively subdued level by Chinese standards. The question then is what impact this tightness in credit availability will have on the Chinese economy and asset prices both inside and outside of China.

On the economic front, our expectation is that there will be relatively little impact. The dynamic, growing part of China’s economy is predominantly the private sector which has traditionally had relatively poor access to credit. Another area of growth has been government sponsored infrastructure spending, an area to which we expect credit will remain readily available. While we may well see ongoing forced divestitures of assets by some groups, they remain as much an opportunity for those that are in a position to buy as they are a problem for the sellers. Simply, we don’t see this as a problem for the economy, and as investors, you want to be an owner of the companies buying, not those selling. Finally, we would note that as a result of these concerns the Shanghai A-share market has retreated over 10% from recent highs and remains at levels reached in late 2016 when the economy was still in relatively early stages of recovery.

President Trump’s decision to apply tariffs on US$50 billion of Chinese imports and China’s response to do likewise for a comparable amount of US imports have sparked concerns of trade wars and potentially a broader decline in free trade. It should be noted that these announcements are of intentions, and there will be months of deliberation domestically in the US and opportunities for negotiation between the two countries. Most commentators assume that negotiations will yield some compromise on starting positions as well as some concessions granted by China to US demands for removing existing trade and investment barriers. We consider such a compromise the most likely outcome. But even if these tariffs end up coming into force, their broad economic impact on both sides will probably not be particularly significant.

The greater risk here is the political environment, present in much of the Western world, which makes the idea of such policies politically appealing. At the core of the issue, we believe, is that low income households have shared relatively little of the prosperity of the last 30 years and, as such, see no great downside from the end of ideals such as free trade. As governments continue to fail to address the issue of income disparities, it is likely that populist policies will remain part of the landscape across the developed world. The other issue that is unlikely to fade away is the instability of the Trump administration. A particularly concerning move by President Trump was to allow reciprocal visits between senior US and Taiwanese officials. While China’s initial response to the announcement of import tariffs was measured and constructive, the response from President Xi on the Taiwan announcement was much stronger.

Market Outlook

While interest rates rarely make for a particularly enthralling discussion, at times they are critical for outcomes in markets. The reason is that the rate of return from owning cash or government bonds is the anchor off which all other assets are priced. The higher the yield on a government bond, the greater the return investors will demand from any given stock (all else being equal^[3], which in turn means a lower share price. A significant increase in interest rates therefore can be a catalyst for equity markets to move lower.

We think this is particularly true today, as many of the popular or fashionable investments of the moment will likely be very sensitive to interest rate moves. As we have stated over the last year, if there is an accident in financial markets waiting to happen, we suspect it is most likely to happen in the debt markets. Many investors in an attempt to avoid risk in recent years have crowded into bond funds, and the room for disappointment there is significant.^[4] Other popular investment strategies such as risk parity funds,^[5] we suspect, will also be susceptible to higher interest rates. Some observers attributed the initial sell-off in February to activity by risk parity funds.

Undoubtedly, low interest rates have played a significant role in bringing about the very high valuations currently attributed to fast growing companies. While the share prices of Facebook, Amazon, Netflix and Google (now Alphabet) – the so called ‘FANG’ stocks – are mentioned in almost every financial news report, the reality is that these companies represent just one part of the extreme market valuations reached in recent months.^[6] We have seen similarly high valuations across a range of companies in biotech, medical devices, artificial intelligence, autonomous vehicles, and even some in the consumer sector. Companies on such inflated valuations are very susceptible to a setback, should rates move higher.

Our problem, as stated earlier, is that the art of predicting where interest rates will go and when the moves will happen is a highly imprecise one. The broad statement we can make is that we are in an environment where interest rates are rising and that this will act as a dampener on markets. Ultimately our outlook for the next three to five years is guided by the returns implied in the valuations of the stocks we hold in our portfolios and the ease with which we find new ideas to buy. On this front, we are optimistic on future investment returns over the medium-term.

In the next 12 months or so, besides the question of interest rates, the trade policies of President Trump are likely to be a major focus for markets. We think trying to predict outcomes on this front is even more problematic than forecasting interest rates. Our approach to managing the associated risk is to simply ensure that we have cash reserves in our portfolios to take advantage of any trade war-inspired sell-off.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.