International | Sep 07 2018
AXA Investment Managers' Mark Tinker explains why trade war tensions alone do not explain current issues facing emerging markets, with a word or two about Australia.
By Mark Tinker, Head of Framlington Equities Asia, AXA Investment Managers
While all the talk is of trade tensions, what we are seeing in the markets at the moment are the natural consequences of tightening US monetary conditions, both onshore and particularly offshore.
- Anyone who has borrowed USD has been scrambling to pay them back, causing distressed selling of assets and forced purchase of USD. The traders are as negative on high yield carry currencies in Emerging Markets as they were positive six months ago, but North Asian currencies look more stable.
- The US mid-terms are not the only political risk out there, markets need to be wary that politicians everywhere may be tempted to embrace populist measures that may threaten existing market structures.
We have been talking for several months now about how the whole story on Trump and trade wars has become the comfortable narrative behind the sell-off in Emerging Markets (EM), when in fact the realities are more complex and nuanced. After a week or two travelling around the region we remain convinced that this is as much if not more about liquidity than economics.
In the last note I discussed how the actions of different operators in markets could be inferred from the consensus narratives; the shorter term noise traders tend to focus on currencies and commodities as evidence of their narrative being correct. Thus a bull or bear story on China tends to be traded through commodities such as copper, or currencies like the Australian dollar. Chart 1 Shows how a trader’s view on China, usually derived from relatively high frequency data such as the Caixin PMI (shown here in purple) can flip around and be reflected in the tradeable prices such as AUD and Copper, as well as the Shanghai Composite.
Chart 1: Using China PMI to trade Equities, Currencies and Commodities
Source Bloomberg, AXA Investment Managers, September 2018
The Caixin Purchasing Managers’ Survey (PMI) tends to be preferred as it covers more private, export oriented companies and, as can be seen, traders do appear to use the survey as a basis for their views on China. The fact that any PMI index is a diffusion index and actually deals with the second derivative rather than the first (i.e. not growth, but acceleration or deceleration of growth) tends to be widely misunderstood however, and thus we constantly hear comments that “a level below 50 means that the economy is shrinking”, even though this is totally incorrect (!). If an economy was growing at 6.9% and the PMI is below 50, it means that it could soon be growing at 6.7% (as actually happened in China in 2016). However, just as the non-farm payrolls tells us almost nothing about what the Fed will do next, the truth on the PMI does not matter. If traders believe that markets follow it, they will act accordingly. So, a weaker China PMI means sell copper and sell the AUD (and of course vice versa) and having done so the story or narrative behind the move gets louder to allow the noise traders to exit their positions. Until a positive PMI flips it all around.
There are of course other drivers to currencies, (such as politics), and to commodities, (such as supply issues), but generally the narrative is framed in terms of cyclical economic demand. So a view on a weak China means to bet on a weak copper price and the view on a weaker China is then justified with reference to the weak copper price (!). Obvious risks of circularity abound. Here in the chart we can see how the Shanghai Composite is also dragged into the equation, showing a recent very high correlation with the Australian dollar. This is where it can get interesting. If, for example, the AUD is weak for a different reason, say that the attraction of “carry” over the USD has lessened, then there is a danger of a false reading onto the Chinese economy. The same is true of “Dr. Copper” which is held up by bond economists as being much smarter at spotting demand than the equity market (though to be fair, most bond economists think almost anything is smarter than the equity market). If there are supply or inventory issues for example then the price will not be telling us anything meaningful about Chinese or indeed global demand.
When we consider the possibility of ‘other reasons’ for market movements rather than simply weak Chinese growth, the most obvious candidate is USD liquidity. This is something we have been discussing for over a year now, with reference to US Libor, which has essentially doubled in price over the last 12 months. Given that this is the ‘raw material’ for the majority of the world’s financial products this is obviously very important. In particular it helps explain the collapse in popularity of ‘Carry Trades’ in financial markets, principally currencies. Certainly if we look at chart 2, something appears to have begun back in February, which is picked up as a sign of distress from looking at the market indicator known as the TED spread – the spread between 3 month Libor and 3 month Treasury Bills, as shown in this lower of the two charts.
Chart 2: US $ liquidity stress in February led to closure of many carry trades in Q2
Source Bloomberg, AXA Investment Managers, September 2018
The top chart shows the steady rise in Libor over the last 12 months while the lower chart shows the spike in the spread earlier this year indicating liquidity stress. Note that the spikes in 2016 were not stress in the same way, but rather to do with (necessary) changes to regulation of money market funds, something we discussed at the time, but were nevertheless a key driver to the longer term rise in Libor.
One obvious event that took place in the first quarter was the Trump tax cuts, and the repatriation of trade from large US multinationals. Given that most of this cash was offshore, sitting in repo markets or in money market funds, this move back onshore was less of a driver for the USD (it just swapped offshore dollar for onshore dollar) and more of a driver for tighter liquidity in offshore markets.
We also think that something else happened back in February to cause a scramble for USD liquidity, the collapse of the short volatility trade. This was something we discussed in considerable detail at the time, but to recap, the traders were all heavily exposed on a bullish China bet in the second half of last year and into late January 2018, doubtless encouraged by the Caixin PMI index shown in Chart 1. At the same time many were also short volatility (essentially selling puts) as a way of funding their positions. This situation was made unstable by the existence of a large and popular ETF with the ticker XIV, which was an inverse of the VIX implied volatility index. As traders sold volatility and the VIX fell, so the XIV rose, gaining almost 400% over the eighteen months leading up to February this year and dragging a lot of momentum traders into the ETF. Of course when they bought XIV, the market makers to the ETF essentially went out and sold volatility, creating a virtuous circle that ultimately turned vicious. If the VIX was the fear index, the XIV was the greed index. This not only caused the traders to flee the markets in February, but they took their liquidity with them.
Together these liquidity events helped to drive US Libor higher throughout the first quarter, from 1.7% to 2.3%. and I think it is no coincidence that two of the bigger offshore dollar carry trade currencies in Asia (Indian Rupee and Indonesian Rupiah) peaked at around this time.
Which brings us to look at Chart 3, showing USD Libor, the Hong Kong Dollar, the offshore RMB and China currency reserves.
Chart 3: Tighter $ liquidity drives Chinese currencies lower
Source Bloomberg, AXA-Investment Managers September 2018
We can see that the Hong Kong Dollar, which is pegged to the USD, has simply tracked US Libor over the last 12 months, weakening as US rates rise, but my suggestion is that the CNY, or offshore RMB, has also responded. When rates spiked in February to around 2.3% this triggered Chinese companies with offshore borrowings in USD (mainly property companies) to pay back their debts and switch back to RMB. We know this anecdotally, but we can also detect it from movements in the official reserves (shown here inverted). Of course, as already discussed, a stronger USD then acted as a catalyst to the taking of profits by asset allocators in the EM versus Developed Market (DM) trade. This hit China and Chinese equities the hardest as they are 44% of the benchmark and when everyone wants out at the same time the hit to prices can be meaningful, but it ironically benefitted a number of countries where benchmarked investors were underweight as a general reduction in risk – i.e. move to hug the benchmark – appears to have occurred.
It hasn’t gone unnoticed for example that while the rest of MSCI Asia is off notably from its highs, the Indian markets continue to make new highs, which seems strange given that India has all the characteristics of a ‘bad’ emerging market economy in terms of current account deficits, foreign debt, political uncertainty and so on. Throw in the fact that the US has imposed tariffs on Indian goods (notably steel) and that they are an importer of oil (including from Iran) and it looks even stranger. The obvious explanations centre around the fact that earnings are good, India is less affected by trade wars than the rest of EM, and that it is immune from the Asian tech sell-off. However, I do not find these very convincing. Instead, I see a number of issues around market mechanics that make me wary of jumping in.
At the micro level, earnings have actually been pretty good, which frankly makes a change, as their capacity to disappoint while promising great things ‘soon’ is well known to EM investors. Even then, there seems little prospect for much upside from here in terms of ratings as Indian equities are at 10 year highs in terms of valuations. Second, I suspect there has also been some rotation by benchmarked investors. As previously discussed, once the traders had left the Emerging Markets back in February the asset allocators waited until the end of Q2 before rotating out of EM into DM, tracking a stronger US dollar. This prompted a number of benchmarked investors in EM strategies to close out their long China/short India positions, picking India up from its May lows and delivering a healthy relative performance catch up.
In effect, by having relatively little in terms of technology, India has ‘benefited’ from the rotation out of Asian Tech names such as Tencent and AliBaba. A somewhat pyrrhic victory, if you ask me – “we didn’t go down this year because we haven’t got any growth stocks to take profits in”. The narrative to support this benchmark flattening has largely focused around the fact that India is relatively unaffected by Trade Wars which is of course the go-to explanation for everything at the moment, but if we are to believe the bottom up data from across the region, nor are many other stocks, sectors and markets. In fact, one of the biggest potential losers under a trade war scenario is the US – which is also at new highs!
Moreover, we should note that some of this apparent ‘strength’ is largely mechanical, reflecting the recent weakness of the Rupee, which as well as a carry trade rolling over has reflected the economic weaknesses just mentioned. Thus, the Sensex, Nifty or MSCI India are not hitting new highs in USD terms. A second point that is not often mentioned is that almost a third of the rise in the market year to date has come from a single stock, Reliance, making its largest shareholder, Mukesh Ambani the richest man in Asia. Reliance accounts for around 10% (by market cap) of the various Indian indices and should obviously ring some alarm bells about market breadth, certainly with the experience of Tencent and AliBaba last year, where stellar share price moves made Jack Ma and Pony Ma (Ma Huateng) the first and second richest men in Asia, while Tencent became between 15% and 20% of many local indices. In some sense I am also reminded of the Macau stocks back in 2014 which were also a very crowded trade for both locals and international investors and peaked around the time of the headline that the majority owner Lui Che-Woo, Chairman of Galaxy Entertainment, then at almost HKD80 was declared the second richest man in Asia, behind Li Ka Shing. A year later, the stock was at HKD20 and he (obviously) wasn’t. He is okay though, with a stock rally since then he is getting by at 17th place with $15.7bn. The title passed to Jack Ma and now it is Mukesh Ambani.
A final thought on India. With the announcement last week that Warren Buffet is buying into payments company PayTM, India is quite clearly going to be the battle ground between the US and Chinese Tech giants. Facebook, Amazon and Google are going head to head with Tencent and AliBaba with the more traditional retailers like Walmart coming in behind them. Such capital inflows are undoubtedly going to improve things for Indian consumers – building a logistics infrastructure for a start – but may well also explain some of the resilience of Indian markets.
Earlier we looked at the Australian Dollar and suggested there may be some other reason for its sell off (in which case the Shanghai Composite might perhaps not be sensible to track it) and the obvious one would be politics. With the seventh Prime Minister in ten years, perhaps not surprisingly the local Madame Tussauds are refusing to update their waxworks and if anything it highlights the reality that while in many countries there may only officially be two or three major political parties, there are serious factions within these parties, making the situation far more like a coalition government than it might seem from a distance. In a world where government policy is increasingly becoming as significant as monetary policy this could be very important, for in order to carry an official party, populist policies may be brought out to unite the factions which could have significant impact on markets. If we take Australia as an example – and I stress I have no insight at all here – we might find ourselves with some serious potential black swan events. To explain, let’s think up a populist campaign or two.
Were I, say, the Labor leader and looking to unite the party, I might suggest the following. Declare that the release of superannuation funds on retirement has made a happy hunting ground for the ‘unscrupulous financial services industry’ in a world where it’s increasingly difficult to match assets and liabilities on retirement. Then announce a new type of index linked annuity bond, government backed and only available to retail investors, offering a very respectable 3% real yields – or a return based on a rolling lagged nominal GDP. This would obviously be massively popular with pensioners and play into the anti-Bank sentiment surrounding the Royal Commission. Obviously there would be criticism of the higher interest cost, but this could be deflected by saying that it deals with a problem that existing governments are trying to keep off balance sheet, i.e. that people unable to find decent annuity income may end up dependent on the state anyway.
You could also announce that you could pay for it by removing the imputation tax credit enjoyed by Australian equities. (I stress I am not saying this is a good idea, just that it may be presented as one). The UK did something similar, albeit in two stages, getting rid of dividend tax credits just as Australia adopted them. The offset was to lower corporate tax rates, but that benefited the companies more than the savers and while the relative strength of the two pension systems over 20 years later should give pause for thought, it probably won’t.
Indeed, in March the leader of the Opposition, Bill Shorten, already announced he would do this if elected. There are some interesting and quite sensible suggestions out there, but not, I would suggest, in the share prices of a number of the dividend rich Australian stocks. Back in the UK, it was argued that the structure encouraged too much equity funding at the expense of corporate debt (although I personally wouldn’t see that as a bad thing) but also played on the notion that UK companies were not investing enough. This didn’t change when dividend credits were withdrawn, but it did damage the funding position of many individuals and corporates and diverted cash into pension funds investing in low yielding bonds instead of pursuing corporate growth in assets or dividends.
Another policy to both raise revenue and apparently reduce distortion would be to phase out interest relief on mortgages. While obviously not popular, this also happened in the UK, with a steady phasing out while encouraging people to save in other instruments than houses. Given the low implied yields on Australian residential property at the moment, there would not be much room for manoeuvre. Those are just a few ideas that would be plausible, populist, and yet deliver significant upheaval to many in financial services, from Banks and brokers to real estate. I am not saying they will happen, but the possibility of radical reform is certainly a long way from current prices.
To conclude, while Asia has been battered by summer storms, both literal and metaphorical, Europe and particularly the US have had a much more pleasant few months. Some are noting on the 10th anniversary of the Lehman collapse that this for the US is now the longest bull market in history, and what a grumpy time this has been! Commentators have been calling for an imminent collapse almost constantly for the last decade, with the possible exception of January and early February this year – which should have been a warning!
To my mind, the sell-off in Emerging Markets over the summer has largely been a function of tighter offshore USD liquidity, asset allocation rotation, and benchmark investor de-risking. The traditional problems of emerging markets – too much USD debt, current account deficits, fragile institutions have resurfaced, but for non-traditional Emerging Markets this is not the case, presenting value opportunities. Currently the traders are once again going after EM currencies, this time on the short side, making the carry trades look (still) very vulnerable, but with offshore USD liquidity stabilising, North Asia looks better positioned for a more positive fourth quarter.
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