International | Apr 17 2018
By Mark Tinker, Head of AXA IM Framlington Equities Asia
Trade War talk obscures a fundamental shift to a multi-polar world.
Trade relationships are having to be reset
- Trade tension is being blamed for what is essentially a ‘normal’ market correction. It is not irrelevant, but it is the new economy that is more important. As last year, Xi has made important concessions on access, without appearing to do so.
- China’s capital markets continue to open up with a huge increase in daily stock connect quotas, a stock connect with London, the ability of foreigners to own asset management businesses and the restart of the QDII quota system all announced in the last few days.
- Geo-Political Tension over Syria is also a repeat of a year ago, we have to hope it fades in a similar fashion. Meanwhile Libor is literally double the levels of last April promoting further deleveraging.
Almost exactly this time last year we were facing military tension in the Gulf and threats of a trade war in Asia, so we have something of a sense of deja vue at the moment. In this instance I believe that we are seeing a fundamental re-set of the post WWll trading era, to recognise the role of China. A new “New World Order’ if you like.
The market behaviour in Q2 continues to be one of de-risking and it is clear that the noise traders who came so enthusiastically into equity markets around the turn of the calendar year have gone again before the start of the new financial year, taking their leverage with them. This may be evident from the way that Emerging Markets, though most sensitive to the supposed cause of the correction, the threat of Trade Wars, have actually outperformed the US equity market over this period. It is also evident from the way that stocks owned in leveraged ETFs have been affected. For example, when we look at the [US] energy sector ETF, XLE, we see a rush of enthusiasm between mid-December and mid-January and a jump of almost 15% in the price before it all disappeared practically overnight in the early February volatility spike. Naturally ERX US, the three times leveraged ETF that tracks the energy sector index was a multiple of that – approximately plus and then minus 40%. In a similar fashion, FAS, the three times leveraged financials ETF rallied over 20% and then lost it all. Encouragingly, the last week or so has seen much greater stability across the board and most if not all sectors and markets remain sound from a technical perspective.
The other factor behind the deleveraging in the financial markets is a simple one. Price. As we have noted many times, the cost of money as a raw material for financial products as proxied by Libor has doubled over the last 12 months. With the US yield curve all but flat out to 5 years – at 27bp the spread between libor and 5 year bonds is not far from the lows seen in the 2012 – the opportunity for simple carry and spread trades has shrunk, especially compared to the 2013-15 period where it was around 130-150bp. Similarly the spread out to 2 years is now negative. Some people are making a lot of the notion that a flat yield curve is a lead indicator of a recession, but I would argue that those models can’t really properly take account of the unusual era of QE we have been living through. Having said that, countries with consumer borrowing rates tied to libor will have seen (and continue to see) pressure on the disposable income/cash flow of households and companies with floating rate debt. Strong balance sheets and sensible balance sheet management are already coming into focus.
The market needs a good narrative and concern over trade wars provides something suitable, but it is not as if trade tensions between the US and China are anything new, indeed it was one of the dominant talking points of q1 last year, until calmed down by the discussions between Presidents Xi and Trump almost exactly a year ago, after which China made a number of concessions on access for US financial services and agreed to import more of the US’s latest key product, LNG. The short history so far suggests that President Trump is using trade and the threat of sanctions, in effect America’s economic power, in order to obtain what he regards as a better deal for America in its relations with the rest of the world. As a deal maker his opening statements will always take an aggressive position, hence the expression from a year ago that we should take him seriously, but not literally and it seems that the markets, if not necessarily many in the media, are doing just that. The recent announcements on steel and Aluminium for example make a lot more sense when viewed as part of a coercion strategy to get Mexico and Canada, who were far more affected than China, to push through a re-negotiation of NAFTA as well as South Korea to agree a new bi-lateral agreement. Interestingly the US has acknowledged that it may well re-join the TPP if conditions are right and made its statement on Steel and Aluminium literally a few hours after the TPP – 11 (i.e. not including the US) made a number of breakthroughs on service industry related issues at its recent summit in Peru.
Indeed as I write this I hear that President Trump is calling for his economic advisers to revisit TPP. This is about acknowledging it is no longer a unipolar world and trying to line up as many countries behind ‘your team’. It’s a grand reset. The benefits of specialisation and trade are one of the things that almost all economists agree upon, although not necessarily all politicians do and of course the upcoming US mid-term elections certainly have a role to play in all this. However, in my view much of this is about geo-politics rather than domestic politics. For example, trade pressure from the US in turn reportedly produced trade pressure from China that appears to have brought North Korea to the meeting table, while trade pressure on Europe and others is being shaped to try and ensure that it is America, rather than China that ‘sets the rules’, not so much for the old economy of steel and aluminium, but for the new economy of fintech, cloud computing, AI, biotech and autonomous driving. China has set out its aims to excel in these areas in its ‘Made in China 2025’ strategy but as President Trump’s new Trade advisor Peter Navarro pointed out in an Op-ed in the media this week, if China “captures these industries, the US simply will not have an economic future”. This is the heart of the issue, that the US wants the fourth industrial revolution and the ‘internet of things’ to be American, not Chinese. In practical terms, what the US also really wants is greater access to the Chinese Consumer and the giant US multi-nationals who used to fight off the protectionist tendencies of US politicians are no longer doing so, recognising that they need an aggressive US trade stance to wring concessions from the Chinese.
While the noise traders try and play currencies, commodities and ‘thematic stocks’ like steel and shipping, as equity investors we find that If we listen carefully we can already hear the rhetoric has shifted to tech and services. Importantly the Chinese authorities are more than aware of this and we have already seen from recent statements that the process of opening up access to certain Chinese markets will continue. Xi’s comments this week, in my view are a classic example of this; a concession without appearing to concede. There are promises of more to be done on financial services, autos and IP protection. The latter is interesting because a big part of recent US complaints about China is the theft of Intellectual property, but this is to confuse invention with innovation. The idea of patents is to allow those that invent something to benefit from doing so – and thus encourage invention. They should not however be used to prevent innovation, the second stage of the process whereupon a different set of actors – in this case entrepreneurs rather than inventors – take the original idea and modify it to suit consumer needs. None of these are really concessions, they were already happening, the high profile rhetoric has simply ensured that it continues to do so. Moreover, the concessions such as they are, are all for the benefit of the Chinese consumer rather than the producer.
China clearly no longer feels the need to protect certain industries from competition, the classic case for emerging industries in emerging markets, but while providing access they are not necessarily going to provide instant profits for western companies. It is likely that it will be no easier for a US financial corporation to ‘break into’ China than it is for a European to break into the US. Non trade barriers outside of the WTO rules abound, as they have done for years so we should be careful about getting too carried away. As I pointed out to some US government economists in Beijing recently, the reason why third party countries will more willingly accept Union Pay than MasterCard or Visa is the same reason they currently accept American Express; it’s the preferred choice of the consumer with the most money. As to who will benefit most from the burgeoning Chinese consumer, well we would suggest that will be the investor who picks the best companies, regardless of where they are quoted.
For investors a move to a multi polar world is actually a good thing not least from a diversification point of view. We are seeing increasing interest from clients globally in how, rather than why, they should invest in Chinese companies and about how the capital markets are opening up and there was yet more positive news on that front this week from multiple directions. Diversification works both ways of course and we saw an announcement by SAFE, who manage the Chinese foreign exchange reserves, about the restart of the QDII quota system after it had been suspended for the last three years. Essentially this is quota in US$, in this case $90bn or so, that can be invested overseas. Meanwhile the PBOC announced a Shanghai–London stock connect link would be operational by the end of the year. In terms of inflows, this came on the same day that the PBOC announced that foreign investors would be allowed to take majority stakes in fund management, securities and life insurance companies, while the Hong Kong Exchange announced a significant expansion in the size of the daily limit for the Hong Kong Shanghai and Shenzhen stock connects. Approved by the mainland and Hong Kong regulators, the Northbound daily quota will increase from RMB13bn to Rmb52bn and Southbound from Rmb 10.5bn to Rmb42bn.
One other interesting development over the last few weeks has been the launch of an oil futures contract in China traded in RMB. This has been discussed before and particularly the notion that as the world’s largest importer of oil, China may ask its two biggest suppliers – Russia and Angola – to accept payments in RMB. The fact that neither might have sufficient interest in RMB purchases could be dealt with by passing the RMB contracts through to gold, which ultimately threatens the status of the petro dollar. Be careful what you wish for as they say and those insisting on an immediate full convertibility of the RMB may find themselves worrying about the USD losing its reserve currency status and all the privilege that goes with that.
Conclusion. Recent market moves are not really about Trade tariffs, but that is not to say they are not important. In fact they are highlighting very important economic and political ‘re-setting.’ With political power consolidated, Xi is moving back to economic and financial reform. The trade pressure from America is notionally aimed at China but is really about adjusting the post War US centric trading system to account for the emergence of China while seeking to pull the ‘rest of the world’ in behind America. The policy of made in China 2025 is the key focus of US concern, China has moved too rapidly up the value added chain for comfort as far as many western corporations are concerned and policy is being aimed at both gaining access to Chinese consumers and trying to shut increasingly sophisticated Chinese producers out of lucrative third party markets. In response China is making concessions on market access, but in my view only where they suit China. Where there are strong domestic players established – autos and finance for example, they are increasingly allowing foreign access, recognising that competition is good for the end consumer. Just in the last week announcements about changes to the size of the Hong Kong stock connects, opening up outbound quota again, building a stock connect with London, allowing foreign ownership of asset management firm illustrates the speed and scope of the changes coming. The winners and (losers) of this newly emerging ‘world order’ will be geographically diverse, both in their headquarters and their listings and in our view investors will be far better served by taking an active bottom up approach in constructing portfolios to capture the winners and just as important avoid the losers.
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