Market Thinking - a view from the equity market - commentary from Mark Tinker, AXA IM - Bunds, Bots and Batteries
Bunds, Bots and Batteries
- Short term the third quarter is about low volumes and pressure on bond investors from a turn in monetary policy representing the start of a longer term shift. This may shake out some weak hands with a modest threat of contagion if there turns out to be too much leverage in the system.
- Carry traders look vulnerable and are nervous that the G20 and other initiatives suggest looser fiscal policy which may in turn accelerate a bond to equity shift. Meanwhile the reduction in relative political risk premium continues to support the euro.
- The concept of the ‘Fourth Industrial Revolution’ is energising us and our clients, but this is another round of serious disruption and we need to focus as much on avoiding losers as finding winners.
As we move into the third quarter and the seasonal drop in volumes and activity, the noise traders are scrambling around for news to react to. In the outside world, the focus has been on the G20, while when considering the internal politics of markets themselves, the dominant feature has been the bond market and in particular what the ‘end of quantitative easing’ (QE) means for fixed income. Everywhere I look, I read references to “the Fed moving the punchbowl” suggesting that the ‘Connecticut Consensus’ is developing a new meme, which is an attempt to flip back to the reflation trade. I wouldn’t trust it, apart from taxes and regulation, every growth driver we can see is lowering prices not boosting them.
Normally when looking at bond markets, the focus tends to be on the US Treasury yield and this in turn tends to drive an obsession with the every utterance from the Federal Reserve (Fed). This last few weeks however have probably more to do with the European Central Bank (ECB) and the impact it appears to be having on German bond yields. Consider the first Chart, which shows German 10 year bund yields breaking out of the 0 to 0.5% range they have been in over the last 12 months.
Chart 1. Bund yields breaking out
Source: Bloomberg, AXA IM, July 2017
This, in my view reflects the growing expectations that the ECB will step away from its unconventional monetary policy of buying fixed income securities. It also reflects an ongoing reduction in the political risk premium surrounding all euro assets, something also reflected in the recent strength of the euro currency itself, currently looking very strong from a technical point of view, especially against sterling, which had been seen as a potential ‘safe haven’ in the event of political turmoil in the European Union (EU). The broader issue however is what this shift in expectations on policy will do to investor behaviour and to assess this we need to remember that for a lot of investors in fixed income securities, they are not holding the bond to redemption and thus the return is a function of a low yield plus a small and hopefully positive capital movement. As such, even what might be considered a relatively modest movement in prices by other markets– for example the 30 basis points (bps) move in 10 year bund yields last week – can wipe out any return from the bond yield itself. As my colleague Chris Iggo points out in his latest piece, a 10 year bond with a yield of 1% and a duration of 8 years being held for 1 year would see its 1% yield wiped out by a move of a mere 12.5bpsin the capital value. This is hugely significant for bond investors and even more so for traders who are funding leveraged ‘carry’ positions from increasingly expensive overnight money. They have been using leverage to ramp up the carry which of course means that they can be wiped out even more quickly. Or they can leave the field of play, but in doing so the liquidity disappears along with the bid for the bond. That’s always the problem with a momentum trade, you never know when it is going to end, but you do know you don’t want to be there when it does.
So far during this bout of bond weakness, equities and high yield credits have done well, certainly relative to bonds, but as always, this is as much about the speed of any selloff as much as its magnitude. If a move is large enough and fast enough to trigger distressed selling, then as we saw ten years ago with credit default swap (CDS) markets, there is, almost literally, no buyer as the same systems that told everyone they had to buy, switch to telling everyone they have to sell.
As ever, it is worth repeating that the moves in bond markets are not based on an economic forecast of growth or inflation. To the extent they are a mechanical calculation based off the Fed Funds Rate (FFR) which in turn is supposed to reflect the economics. I repeat the point that the Fed has not followed the Taylor Rule (which attempts to codify exactly this relationship between economics and Fed Funds rates) for over a decade. This does not mean markets will not try and infer a forecast however – thus we are told a selloff in bonds, and a rise in bond yields should push us to buy cyclical stocks and commodities. I disagree, first the selloff reflects internal dynamics of an over-bought and leveraged asset class and second, commodities and related corporates have their own pricing dynamics that are better examined from the bottom up. Oil and iron ore for example are telling us demand is exceeded by supply while copper is telling us the opposite. Interesting to note that Goldman whose once mighty commodities unit regularly used to earn more than $3bn a year in revenues has apparently had its worst start to a financial year in a decade and Bloomberg estimate that commodities trading revenue across the whole financial industry dropped as low as $800m in Q1. Just for context, that is less than General Motors spend on advertising these days. Goldman are suggesting that oil could go below.
The other thing catching the attention of traders at the moment is thee exchange rate, which as shown in Chart 2 has an amusing symmetry that it is trading at 1.13 against both the dollar and sterling, albeit from opposite directions . Technically it is difficult to see any signals from either exchange rate, dollar or sterling, beyond a challenge to 1.15 on the dollar cross. We know that net speculative positions in the dollar index are at their lowest level since last summer and are all but flat and the euro has clearly been a beneficiary. With pressure to sell from elsewhere in European fixed income this may well trigger some profit taking or unwinding in other asset classes.
Chart 2. Euro at 1.13 – against sterling or the dollar - from different directions
Source: Bloomberg, AXA IM, July 2017
To the outside world then and the G20 has, understandably, a political dimension and the reporting reflects this. Ahead of the G20 the US China rhetoric appeared to harden, particularly with reference to expectations over North Korea, but then soften again. We will have to get used to this and would caution against getting too bearish on the talk of trade tariffs. It also needs a little perspective; China exports 620,000 tonnes of steel to the US every year, but this is extremely modest compared to US production of 80 million tonnes and statistically insignificant to China itself which produces 800million tonnes a year. Most Chinese exports go elsewhere in Asia and the US could only impact global steel prices if everyone in Asia also agreed to put on large tariffs – which simply isn’t going to happen.
From an investment point of view, whether or not the meeting between presidents Trump and Putin lasted longer than expected or that president Trump refused to back down on his desire to exit the Paris Climate accord is less relevant in my view than the fact that Trump offered liquid natural gas (LNG) from the US to Poland. There is a clear pattern here, LNG is America’s big new export product with the potential to help the US trade deficit while giving the US a new form of soft power, particularly against Russia. The US just signed a deal with China for LNG for example and now that the US has switched from an importer of gas to an exporter, the geopolitics with other exporters such as Iran and Qatar will also clearly have changed in the last five years. Some have pointed to the shift in Gulf policy on Qatar coinciding with the recent ‘soft coup’ in Saudi Arabia that installed Prince Salman as Crown Prince. He has been the main architect of the war in Yemen and the oil price strategy and many are now wondering if, with even more control over the Kingdom he might now reverse his oil policy and try and limit production to push up prices. Even if he does try this, I think it is difficult to see how he can prevent non OPEC, particularly the US, from simply pumping more, or even as previously mentioned, release some of the US strategic oil reserves that as an oil exporter it arguably no longer needs to hold.
As I explained in a recent note (essay to be honest) on the fact that the institutions of globalisation are being ‘Uber-ed’ all the actions of the Trump Administration are consistent with a recognition that with Asia and particularly China as the dominant provider of global savings, the ability of the US to set the ‘rules’ is changing. With One Belt One Road, the Asia Infrastructure Investment Bank (AIIB) is arguably more relevant than the World Bank, the G20 has already taken over from Western dominated G7, foreign direct investment (FDI) into emerging Asia is coming from China, not the International Monetary Fund (IMF), the actions of the People’s Bank of China (PBoC) are now more important for Asian investors than those of the Fed and so on. Meanwhile, although president Trump has rowed back on his questioning the need for NATO, his speech in Poland emphasised that he sees the real threat as from religion and ideology rather than other nation states. In other words, he recognises that the institutions of the Washington Consensus come from a world of Cathode Ray tubes.
More broadly on China, it looks like Xi has negotiated this G20 with a relatively low level of attention, which is clearly the preferred path ahead of the key political meetings in October and November. No one talked about trade, no one talked about the South China Sea, or indeed about North Korea. As noted earlier, the spike in rhetoric from the US appeared to calm down again and Xi and Trump appeared cordial once more. Indeed, calm and stability is clearly the preferred route for the next six months and that spills over into domestic policy as well. While the Connecticut Consensus continues to demand rapid reform of State Owned Enterprises (SOE) and to panic about debt levels, the Chinese government in turn continues to ignore them and move at its own pace. Last year the focus was on tightening excess capacity in commodities, this year it is on regulatory tightening in the shadow banking area. The boost to profitability in the old economy as a result of last year’s focus on capacity has boosted profitability such that deleveraging of some of the more stretched balance sheets can take place. Just as QE in the West allowed stretched balance sheets in the financial sector to be rebuilt, so quantitative restrictions in the old economy have allowed some rebuilding and deleveraging of corporate sector balance sheets in China. This is one of the reasons why we mentioned last week that the big banks in China are in better shape than many realise or accept. The shadow banking system meanwhile is opaque by definition and the process to regulate it is a careful one involving multiple agencies. The People’s Bank of China (PBoC) for example started to incorporate wealth management products into its Macro Prudential Assessment (MPA) framework earlier this year, while the China Banking Regulatory Commission (CBRC) issued a range of circulars and documents tightening supervisions on banks, credit, liquidity, risk management and shadow banking activities in Q2. The Ministry of Finance issued circulars to tighten local government financing in Q2 while the PBoC steadily tightened rates on all the liquidity instruments to help reduce leverage in the interbank market. Just like everywhere else, the authorities are trying to curb the excesses within financial markets themselves while avoiding damaging the real economy. However, unlike the west, the leverage within the real economy is almost all in the corporate (SOE) sector rather than the household sector, which is a key reason why the Chinese consumer remains so robust. They are being driven by higher wages and some increase in consumer leverage whereas in the west there is no wage growth (see last week’s payroll data) and a general deleveraging of household balance sheets.
One of the reasons Chinese wages are rising is policy guidance and the other is that the labour force is shrinking. This of course is one reason why China is the world’s biggest buyer of industrial robots, replacing labour with capital. This really took off in 2014 as part of the ‘Made in China 2025’ initiative and we estimate that while from 2005 to 2013 growth ran at around 5% per annum on average, between 2014 and 2019 growth in industrial robots will run at three times that level, or 15% per annum.
Chart 3. Worldwide annual supply of industrial robots (thousands)
Source: IFR World Robotics 2015, AXA IM, July 2017
As we mentioned last week, robotics and automation is a key future theme for us and goes beyond the more obvious industrial robots in auto factories. What is increasingly being referred to as the Fourth Industrial Revolution, that of robotics and automation – with some extending it to include artificial intelligence (AI) – is boosting growth by making all factors of production more efficient – labour, land (including resources) and capital. Robotics and automation are making our factories smarter and our people smarter, while AI is going to make our computers even smarter and by extension our financial system smarter and our capital allocation more efficient too.
From an equity investor point of view, and remembering Warren Buffet’s famous dictum about the invention of the motor car that the one thing you knew for certain was to go short horses, this industrial revolution is as much about avoiding the losers as it is about finding the winners. Here the reliable Porter’s Five Forces framework comes in handy with its focus on competitive threats and pricing power: 1) pricing power against suppliers, 2) pricing power against customers, 3)threat from new entrants, 4)threat from new products and 5)internal competition. Much of this drives the ‘automate or die’ call that means robotics and automation are an integral part of capital expenditure in a business to business (B2B) sense. This tends to make them a relatively long cycle, although they are always vulnerable to a sudden downturn in the business of their main customers (think concerns on autos last year for instance). The history of innovation is such that the real winners are almost always the consumers as the new technology brings in competition and lower prices. This is one reason why we would perhaps be wary of consumer products (B2C) based on automation, the speed with which new products can come into the consumer market and compete on price. This latter point is undoubtedly behind some of the weakness in Tesla share price recently as traders interpreted the statement by Volvo (now part of Chinese auto giant Geely) that all its cars would be electric by 2019. To be fair it said electric or electric hybrid, which is a much bigger statement of threat (a new product) for traditional auto internal combustion engines than it is (a new entrant) for Tesla. Arguably the more important announcement for Tesla this week (even more so than the launch of the Tesla 3) was the go ahead on the plan to build the world’s biggest lithium ion battery with South Australia which we discussed a few months ago. With not a little irony, Australia, currently the world’s second largest exporter of LNG, does not have enough domestic gas left to avoid brown outs and even black outs from its expensive renewable energy system. The storage battery will go some way to help that. Tesla is a battery company that makes cars, the rest are car companies that now need batteries.
To conclude. Thin summer markets always have the tendency to spring, usually unpleasant, surprises and so far in my view the likely focus looks to be the bond markets. While nothing terribly bad has happened so far, the narrative has definitely shifted in favour of tighter monetary policy and the end to QE and its variants. Many carry trades, especially leveraged ones, are now under-water and may trigger distressed selling which in turn could trigger forced tactical asset (re)allocation and I remain nervous over the leveraged portfolio insurance plays, especially the reverse leveraged ETFs on the VIX index. When markets start selling retail strategies based on professional hedging tools it rarely ends well. On a more positive note, China looks stable ahead of the Party Congress in Q4 and is steadily working through its growing pains, while the agonies of the globalists are not being matched as yet with any of the dire consequences they believe will accompany their own diminution. They are being ‘uber-ed’, challenged by a different platform for investment and capital allocation, but so, as our work on robotics, automation and AI tells us, are we all.
Head of AXA IM Framlington Equities Asia
Notes to Editors
All data sourced by AXA IM as at Tuesday 11th July 2017.
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