China: Crash Landing Fears; Another Perfect Storm? – Rothschild Wealth Management
China’s unhappy new year
“When sorrows come, they come not single spies, but in battalions…” – Hamlet
Another perfect storm?
Michael Mauboussin: Challenges and Opportunities in Active Management And Using BAIT #MICUS
Michael Mauboussin's notes from his presentation at the 2020 Morningstar Investment Conference, held on September 16th and 17th. Q2 2020 hedge fund letters, conferences and more Michael Mauboussin: Challenges and Opportunities in Active Management Michael Mauboussin is Head of Consilient Research at Counterpoint Global in New York. Previously, he was Director of Research BlueMountain Capital, Read More
We noted in December that the current business cycle is now a relatively mature one, and that there would be another US recession, and another financial crisis too, at some stage. Little did we think that the markets were seemingly about to pronounce in January that both were at hand.
Concerns focus on a weaker US economy; China’s slowdown and its wider impact; and the oil sector.
So far, despite volatile markets (figure 1), worries do not seem to have spread to the Western banking system (figure 2), though banks’ share prices have fallen more sharply than most. Bank balance sheets are stronger now than in 2008, and markets’ concerns are less systemic in nature. We believe it is still too soon to abandon the “muddle-through” assumption that has worked so well since 2009.
US recession worries
Current turmoil may prove to be another illustration of American economist Paul Samuelson’s quip that “the stock market has predicted nine of the last five recessions”.
Unfortunately, he might have added that “five of the last five recessions have not been predicted by most economists”, which is also true (hence our wariness of point forecasts).
The US economy did slow markedly in late 2015, as we noted in December. An annualised pace of growth of 0.7% sounds more robust than it is: a revision of a mere 0.2% to the level of GDP would turn it into a small decline. And with severe weather yet again disrupting New Year economic activity, a decline in US GDP in the current quarter is feasible. A back-to-back decline in quarterly GDP numbers is a popular definition of recession.
But much of the weakness looks erratic or temporary. A largely “technical” recession might be a misleading investment signal: the decline might be minor and brief.
There are some underlying reasons for the US slowdown. The strong dollar has eroded US competitiveness, acting as a brake on manufacturing in particular. The slump in the energy sector too is having an impact. However, these don’t look potent enough to deliver a meaningful recession of the sort that might warrant repositioning long-term portfolios.
We still see few of the sorts of excesses in final spending or borrowing that might typically warrant retrenchment. US consumers and businesses have not been behaving in an obviously reckless fashion of late. The latest survey data is consistent with US manufacturing struggling (figure 3), but the overall economy continuing to grow.
China: Crash landing fears
Whether China’s growth is overstated by the official data or not, the pace of slowdown does not seem to have suddenly intensified (figure 3 again). The economy is not collapsing. Also we know that global markets are relatively insulated from China, and that much reportage is hyperbolic – particularly that relating to its indebtedness and exchange rates.
China’s onshore stock markets, for example, have not been easy for overseas investors to access. The market is not widely held even within China – there are reportedly 50 million active investors in a population of 1.4 billion.
China’s total (gross) debt has surged relative to its GDP, but we know from the Western experience that such ratios are not always relevant (whatever the millenarianists say – see second essay). Internationally, China is still a net creditor, even after its massive foreign exchange reserves have fallen by a fifth. Government and consumer debt ratios appear unremarkable.
China is the biggest single contributor to global GDP growth, but is under-represented in global capital markets, and growth in global GDP does not always matter most to investors. The direct contribution of China to developed world GDP growth is small, and its net contribution is usually negative: the West buys more from China than it sells to it. This ignores the operations of Western companies in China. But a country with a trade surplus and a largely inaccessible capital market may not be as big an influence as its raw size might suggest.
China’s exchange rate policy also seems widely misunderstood. The small depreciation of the yuan against the dollar (5% since August) is not a serious attempt to price China back into faster growth, but part of the ongoing process of liberalisation. Against a wider range of currencies, the yuan has been more resilient, and remains relatively expensive.
If China were to use its exchange rate as a counter-cyclical weapon, and declare the currency “war” that many claim is already under way, its real trade-weighted exchange rate would likely need to fall by perhaps a fifth or so to make a material difference to growth. Such a move is unlikely, not least because of China’s residual capital controls.
Oil and troubled waters
As oil prices have continued to slump in the face of ample supply, the pain felt by producers and employees in the sector has intensified.
Losers cut back before winners spend, and some oil-producing countries with big holes in their national budgets may have been selling assets from their “rainy day” sovereign wealth funds (which helps explain the widespread nature of the stock market sell-off). The result has been a striking correlation between falling oil prices and the big stock market indices.
We think this correlation will prove temporary. Lower oil prices are not a bad thing for global business, but a good one. Not because many large companies are big buyers of oil: they aren’t. But their customers are – and they spend higher proportions of their incomes than the losers, and are benefiting from a $2 trillion-plus transfer of spending power equivalent to more than 2% of global GDP.
Each big surge in oil prices in the last half century has reflected a shortage of supply, and been associated with economic difficulties (figure 4). Big falls were usually associated with plentiful supply, and were followed by economic gains – of varied duration, but distinct nonetheless.
We see this as an important contrast between the current situation and 2008 in particular, when there were no breaks in the financial clouds and the storm was a perfect one.
Central banks to the rescue?
We do worry at the seeming acceptance by central banks that they need routinely to respond to financial volatility; and at the tendency of some commentators to suggest that such action itself is capable of underwriting the outlook.
Both the European Central Bank and the Bank of Japan signaled support in late January, and the Bank of England and even the Federal Reserve (Fed) might follow suit if markets continue to riot (both have dampened expectations of higher rates in response to market noise).
Such actions are not surprising, and are part of a toolkit of potential short-term “circuit breakers” that can help limit financial contagion. But they are not infallible, and their overuse might encourage the wrong sort of risk-taking – in the wrong sort of assets, and for the wrong sorts of reasons.
This does not mean that we see asset markets currently as being wholly distorted. But we view stocks, for example, as attractive long-term investments because we think companies will likely remain profitable, and stock prices are not excessive – not because central banks have somehow abolished risk.
Risk is unavoidable, and the idea that the authorities could or should smooth it away completely is mistaken. It is arguably a little disappointing to see independent central banks so in thrall to interventionist fashion. Would a little deflation, for example, really be such a bad thing? Real interest rates are not about to soar to 1930s-type levels simply on the back of (say) a short-lived 1-2% fall in consumer prices (which in any case is not yet likely). The Fed’s rate hike in December is blamed by some for the New Year sell-off. We doubt that. And if the US and global economy prove unable to cope with a 25 basis point increase in US short-term interest rates, then our world view is wrong.
We can’t predict when sentiment and/or oil-related liquidations will stabilise. But when they do, modest growth alongside negligible inflation (and little interest rate risk) may come to be seen as not that bad an investment climate.
Outside the energy and mining sectors, company earnings look reasonably stable. Stock market valuations looked inexpensive at the end of 2015, and look more so now (figure 5).
We still advise that the best places in which to seek assets whose returns can preserve and grow real wealth on a longer-term view are those which offer exposure to growth at reasonable valuations. These are still predominantly found in global stock markets, with the developed bloc, particularly the US and continental Europe, currently looking most convincing. Speculative grade corporate bonds are looking cheaper again, but are still not compellingly attractive.
Safe-haven, diversifying assets such as government bonds look expensive, but not sensationally so in the current low inflation climate. We doubt they offer positive real returns – that is, net of the modest inflation that seems likely – but talk of a bond “bubble” remains unduly alarmist, we think.
Finally, our ranking of currencies remains largely intact (but with low conviction, as ever). The Brexit-related volatility that we noted as a possibility in December has hit the pound early in 2016, as have the dovish comments at the Bank of England, but on a one-year view we’d still order the majors as: dollar, sterling, yen, euro, Swiss franc and yuan.
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