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Market Thinking - a view from the equity market - commentary from Mark Tinker, AXA IM

08/02/2017

Tuesday February 7th 2017

 

  • The possibility of regulatory reform on Wall Street was much more important than the non-farm payrolls last week. This is helping financials as the rest of the Trump trades run out of steam.
  • Investors remain uncertain on any new fiscal policy direction from the US, but should not ignore the tightening monetary conditions underway regardless of the Fed. Equally while focussing on possible trade restrictions we should not lose sight of the powerful growth drivers within Asia itself.
  • European politics is moving onto the radar screen again, but here in Hong Kong we also have elections in March. Hong Kong’s future is now locked in with cyclical and structural growth in China and one key aspect is that since 2010, the official Chinese fund management industry has grown from US$500 billion in assets to US$7.5 trillion, if we add in shadow banking it could be twice that.

 

Last week was Chinese New Year in Hong Kong (the year of the Rooster) and I was marketing down in Australia. While Chinese markets were closed and an estimated 344 million tourists travelled within China (+13.8% on last year) and a ‘mere’ 6.15 million travelled internationally (+7%), much of the conversation in Australia was on what China thought about Donald Trump. My best guess (and let’s face it we are all guessing at the moment) is that they regard his statements as the starting point of a negotiation and recognise that it is too early to respond. As mentioned before, the best advice I saw about Donald Trump before the election was that it was sensible to take him seriously but not literally and I suspect that the Chinese government are in this camp. Now that he is President Trump, markets are taking him seriously, but also still literally. To this end, the market’s initial response, which has been to take the statements on free trade and tariffs literally, has probably thrown up some value opportunities in emerging markets.

While I was in Australia, President Trump was busy signing executive orders and removing any doubt that he would follow through on his pre-election promises. While on the one hand, the decision to put a temporary ban on immigration from seven high risk countries was not unexpected – he had talked frequently on the campaign trail about the need to improve the vetting procedures and the need to suspend processing immigrants until the system could be upgraded – the reaction to it was not expected by the markets. By hitting the hot button of immigration, President Trump triggered the full ‘identity politics’ agenda, perhaps deliberately or perhaps not, but the spectacle of violent protesters (throwing Molotov cocktails at Berkley University for example) raises concerns of a return to Nixon, rather than a return to Reagan. This is a reason for a rise in risk premia and is in my view behind at least some of the wobble in the markets over the last week or two.

The other, more mundane, reason is that the momentum for the Trump trades has been fading since the start of the year. Post the election, the traders rushed to position for reflation and with the year end in sight, many large investors moved to reduce benchmark risk in their portfolios. This meant that they ‘bought risk assets’. While it can seem counter-intuitive, this happens all the time. When things appear to be changing the sensible position for a benchmarked investor is to ‘get flat’ and this usually means closing underweight positions that would otherwise be regarded as ‘risky’.  In November it was cyclicals and financials. A point I made on many occasions last week was that this should not be interpreted as a prediction of reflation, more a closing out of a deflation trade. However, once the longer term investors had validated the traders’ first move at year end, the traders pushed it again, this time supported by a large amount of algo trading that believes itself to have identified a momentum trade. In relatively thin January markets this caused a further squeeze higher, but it looks like there was no follow through by investors, so the traders have backed down and the trades have drifted off lower. This is most obvious in the big noise markets of foreign exchange (FX) and commodities, but also in the sector rotations in equity markets. The US Treasury market has also recovered a little and this has helped the inflation rhetoric to calm somewhat. This is not unusual, it is the essence of what I have referred to over the years as ‘market mechanics’ and the lesson remains not to invent an economic fundamental to ‘explain’ it.

While I tend to be much more from the ‘glass half full’ camp – I think it is always possible to find some companies doing well even in the gloomiest of macro environments - the general tone in markets is sufficiently upbeat at the moment to warrant a word or two of caution, not just over the more controversial policies that may come from Washington, but also some of the near universally approved ones such as the repatriation of overseas earnings. Last week, Apple issued US$ 10 billion worth of bonds, apparently to buy back stock, even though at the end of last year it had around US $16 billion in domestic cash and around US $230 billion offshore. Microsoft also sold around US$ 17 billion of debt and AT&T US$10 billion. This is great for the banks involved – and helps explain some of the great Q4 trading data for US banks – but looks like tax arbitrage is already taking place before any moves to repatriate the offshore cash. The suggestion is that bringing back this cash will attract favourable tax treatment if it is spent ‘properly’, i.e. not on share buybacks, which is what happened last time, but it looks like companies are already anticipating that and that rather than being invested, it looks like some of it may instead be used to shrink balance sheets where debt has already been taken on to buy back shares.

My real concern however, is the hole that this cash will leave behind once it does return. As we have noted before, the offshore cash of US tech and pharma companies is apparently already sitting in US dollar assets (so little FX impact), but much of it is in relatively short dated cash and fixed income and is almost certainly a key component of the liquidity pools that are feeding leveraged products via the repo markets. One to watch carefully, after all long-term capital management (LTCM) was not undone by the quality of its trades, but by the sudden loss of the liquidity that funded them.

The steeper yield curve meanwhile is good for banks and other financials, and so of course is deregulation. The suggestion last week that the new US administration would be examining ways to lower the regulatory burden on the financial sector, helped further support the momentum trade in US financials. However, even without the concerns about the hole that could be left in offshore funding markets by repatriation, we shouldn’t lose sight of the already rising cost of US dollar financing. If we look at the chart, we can see that while Federal Reserve (Fed) funds have risen 25bps since year end they are still at 66bps, while the three month Libor rates are now 104bps and 10 year bonds are 2.46%. This largely reflects the tightening conditions thanks to regulation in the US money markets increasing domestic demand for dollar funds, but this is spreading to offshore funding, with implications for structured products and leverage everywhere. The biggest danger often comes from the direction you least expect.

 

Chart 1: US Libor is already ahead of the Fed

Source: Bloomberg AXA IM February 2017

 

Some people believed that President Trump would persist with the Trans-Pacific Partnership (TPP), but that clearly is not going to happen, but importantly it doesn’t mean the rest of Asia cannot continue with it – if they wish to. Nor does it preclude any other intra-Asian co-operation bodies. Asia has a lot of its own growth drivers regardless of what the US does, something I previewed in recent weeklies – One Belt One Road, the shift in the Chinese consumer and so on.

China is key to this and has both cyclical and structural growth drivers that are currently positive for the rest of Asia. Close to home we currently regard Hong Kong as primarily a way to play China rather than Hong Kong itself. The local economy should benefit from a cyclical upturn from China, but has a core structural problem due to its housing policies. On the positive side, it is extremely well placed to benefit from the expansion in financial services in the region as China builds out its financial service infrastructure.

Since the great financial crisis (GFC), house prices in Hong Kong have doubled and are up over 400% since the trough post SARS. This is now a classic ‘insider/outsider’ problem. Those that have owned property since SARS or before are sitting on huge capital gains and with very low (relative) running costs, while those on the outside are struggling with affordability and high rents. According to economic consultancy Asianomics, ownership rates in Hong Kong had fallen to a 27 year low of 65.1%, while the average cost of Hong Kong property is now 18.1x the annual pre-tax household income (housing is considered severely unaffordable on anything over 5x). This is largely a result of government policy – to try to restrict demand rather than boost supply – and has been made worse by a new transaction tax of 15% which makes buying housing ridiculously expensive as well as killing off transactions and liquidity. The high cost of property is less of a problem for banks and property companies (people servicing the insiders) than it is for retail sales and consumer spending. The demand supply imbalance means that rents are also very high which gets passed on in the costs of goods and services. Meanwhile household rents are also a large drain on disposable income (personally I would estimate around double the equivalent residential rent in central London for example) which limits spending power – also constrained by slowing real wage growth.

Reflecting these factors, and also the shift in demand from mainland China, Hong Kong retail sales remain extremely sluggish – indeed they have recorded negative year on year growth since the end of 2014 (the spikes around January reflect the shifting dates of the Chinese New Year from one year to the next).

 

Chart 2: Hong Kong retail sales

Source: Bloomberg, AXA IM, February 2017

 

It is against this background that Hong Kong has its own elections for Chief Executive next month – perhaps while everyone in the west is watching Holland and France. The contest can broadly be seen as a continuation candidate – Carrie Lam, expected to maintain the existing pro-Beijing stance of existing Chief Executive CY Leung – and a (relative) outsider, John Tsang, a more free market candidate who is likely to have more of an economic focus. The vote is not for the general public however, it is 1200 members of the Electoral College and much of the frustration of the protesters here in Hong Kong is a feeling that they will simply do what Beijing tells them to do. However, as the Asianomics team point out, this does not guarantee Ms Lam will win. A moderate such as John Tsang may actually serve to diffuse tensions and be more in Beijing’s long term interests.

Ever since arriving here in 2013, I have believed that Beijing regards Hong Kong as a key point of connectivity between China and the rest of the world and the reality is that Hong Kong’s health is highly dependent on both cyclical and structural growth in China. The most obvious area for us in financial services of course is the structural growth in the Chinese savings infrastructure and here the numbers (and the potential) are simply huge. One of the points I was trying to get across in Australia was the sheer size and opportunity for investment management in China. Our own joint-venture in Shanghai has grown rapidly over the last two years, but some recent numbers from consultancy Z-Ben give some idea as to the size of the overall market.

According to Z-Ben, the Chinese asset management industry grew by 40% last year in terms of assets under management (AUM) to reach Rmb 52 trillion, or US$ 7.5 trillion. Moreover, this figure excludes a lot of trust and bank wealth management products, which could easily take the total to double that figure. To give an idea of the growth, the Rmb 52 trillion, which applies to assets that come under the security regulator, was only Rmb3.4 trillion (US$4 96 billion) in 2010. Perhaps even more important is the shift away from shadow banking products towards the more institutional, regulated products recognisable in the west. For context, according to data from McKinsey, assets managed by professional asset managers globally amounted to around euro 64 trillion in 2015, of which approximately half (EUR31.6 trillion were in North America and a further EUR 19.2 trillion in western Europe. Japan at EUR 2.9 trillion and Australia at EUR 1.7 billion) were the nest biggest geographies, while emerging markets (Central Eastern Europe, Emerging Asia, LatAm and the Middle East) totalled around EUR 8bn. China is catching up rapidly and it has only just started.

Regards,

Mark

Finally, some superstitious people I met on my way to Australia were worried that the finalists in the Australian Open Tennis championship – Venus and  Serena Williams in the Women’s final and Roger Federer and Rafael Nadal in the Men’s were the same two pairings from Wimbledon 2008, after which the S&P 500 fell 45%. It was with some relief therefore that both sets of results were the opposite to back then. Not that I am superstitious. Anyway, 2008 was the Chinese year of the Rat!

 

Mark Tinker

Head of AXA IM Framlington Equities Asia

 

-    ENDS  -

 

Notes to Editors

 

All data sourced by AXA IM as at Tuesday 7th February  2017.

 

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