Surviving Chinese Volatility

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¿Cómo sortear la volatilidad en China?
CC-BY-SA-2.0, FlickrPhoto: Carlos ZGZ. Surviving Chinese Volatility

Christine Lagarde, Managing Director of the International Monetary Fund, was once quoted as saying, “Markets love volatility.” She may be correct in the abstract. But right now, investors in Chinese equities would certainly love a bit less volatility.

2016 is likely to be a year of volatility in China. With the government apparently keen to continue intervening in its A-share market, we can expect continued volatility there. And with the manufacturing and construction part of the economy set to grow more slowly, there will be macroeconomic volatility. As privately owned firms take more market share from state-owned companies that too will contribute to volatility. In addition, as the government presses ahead with structural reform in the state sector, capacity reduction will add to volatility.

We can, however, point to two areas where volatility is less likely: China’s booming consumer and services sector; and U.S. – China relations as China prepares to host its first G-20 summit.

This volatility can, however, create opportunities for investors, especially when dire headlines incorrectly assume that weak performance by outdated market indexes signal an economic hard landing. And keep in mind that volatility due to execution of necessary reforms, such as reducing the role of state-owned enterprises (SOEs), is good for the long run.

China suffers from a serious case of “debt disease,” but the treatment and side effects may not be as severe as some expect, and dramatic credit tightening is very unlikely. Debt is concentrated among state-owned firms, while the private firms that generate most of China’s new jobs and investment have already deleveraged.

As I explained in a May 2015 issue of Sinology (“Diagnosing China’s Debt Disease”), the medicine for this problem will be another round of significant SOE reform—including closing the least efficient, dirtiest and most indebted state firms in sectors such as steel and cement—rather than broad deleveraging, leaving healthier, private firms with room to grow. At the end of last year, the government indicated that it was finally prepared to begin reducing capacity in construction-related heavy industry. In contrast to the experience in the West after the Global Financial Crisis, cleaning up China’s debt problem should actually improve access to capital for the privately owned companies that drive growth in jobs and wealth.

Let’s turn to politics. Will U.S.-China relations become more volatile in 2016?

U.S.-China relations will remain complicated and noisy this year, but the two countries will continue to engage productively on the most important issues.

Territorial disputes in the South and East China Seas will again dominate the headlines, but two points are worth keeping in mind. The U.S. does not claim any of the disputed territory, and China seems resigned to the fact that the U.S. Navy will continue to exercise its right to patrol the region. The risk of accidents remains, but none of the players appear to be looking for an excuse to engage in a military conflict.

Finally, with China preparing for its first time as host of a summit of G-20 leaders in September, it is likely to behave more conservatively during the first three quarters of this year.

Finally, how can investors deal with all of this volatility?

The most important thing to recognize is that the Chinese equity markets do not reflect the health of the Chinese economy, and to expect some market volatility. Second, to recognize that the market indexes underrepresent the strongest parts of the economy: privately owned companies, and the consumer and services sector. This is why we believe in an active approach to investing in China, rather than an index-based strategy.

Andy Rothman is Investment Strategist at Matthews Asia.

 

 

Merging Markets

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Las condiciones monetarias de China se han relajado, no endurecido
CC-BY-SA-2.0, FlickrPhoto: Carlos ZGZ. Merging Markets

Despite a slowdown in trade globalisation, it looks like equity markets are more globalised than ever. When one market falls, the contagion quickly spreads to bring the others down as well. This is a change from the past. In the old way of thinking about the world, the US sneezed and the world caught a cold. The S&P 500 was always viewed as the leading indicator for global equity markets. But the perception since last summer is that it is the Chinese equity market that is doing the sneezing.

Figuring out whether a drop in one equity market causes a drop in another is a tricky task. Just because the fall of one equity market is followed by a fall in another, does not necessarily mean that the first caused the fall in the second. To assume so would make you guilty of the logical fallacy of post hoc ergo propter hoc, or “after therefore because of”. There could always be a third factor that is driving both equity markets down, but it so happens that the effect has fed through to one market earlier than the other. But given we can never test everything, there will always be the possibility of a third factor that we did not include.

That is why proper science (as opposed to the dismal science of economics) is based on the idea that you can never prove anything, only disprove something. And here at least economics, or more precisely, econometrics, can help us out. We can figure out if one equity market is good at predicting changes in another equity market. This is known as predictive causality (using a test named after the late Nobel-prize winning economist Clive Granger). If changes in one market are useless at predicting the change in another market, we have at least disproven the causality. If it is useful, then we have failed to disprove the causality (even if we cannot ever prove it).

Things get a bit more confusing when we realise that the causality can actually run in both directions. So a drop in the Chinese equity market might be predictively causing a drop in the US equity market, yet at the same time there is a feedback loop whereby US equities are predicting subsequent moves in the Chinese equity market. As so often in economics, it is hard to figure out whether the chicken or the egg came first.

Ampliar

Sure enough, over the last decade or so the S&P 500 and the Shanghai Composite have both predictively caused moves in each other (see chart), sometimes at the same time. Some correlation is always likely, so readings above 80% probability or so start to become statistically significant (shaded darker). Between 2003 and 2005 the two moved pretty much independently, and then moves in the S&P 500 started to affect the Shanghai composite. The run-up in US equities was good at predicting a subsequent run-up in Chinese equities (albeit with a much larger proportional increase in China).

But then coming into late 2007 and 2008 it was China’s turn to take the driver’s seat, becoming a good predictor of the US. Once the financial crisis hit the causality went both ways, reflecting the global nature of the crisis.

But for the next few years, up until the end of 2011, the S&P 500 was clearly dominant. It was an effective predictor of Chinese equities (and probably most other markets as well). But this is a good example of where a third factor likely came into play. This was the period when the Fed started its quantitative easing, pushing investors out of government bonds and triggering a search for yield. So investors moved into progressively riskier assets: first US equities and then emerging market equities.

Equity markets started to reassert their independence up until the taper tantrum. Once Fed chair Ben Bernanke announced that QE would not continue forever, the effects of QE on investment appetite went into reverse. Investors started to retreat from emerging market equities first, so the causality flipped the other way. Chinese equities became a better predictor of US equities.

Since last summer the gyrations of the Chinese equity market became a clear predictor of what would happen in the US. This does not necessarily mean it was the only factor, or even the major factor, just simply that it led the moves in the US. Ask most investors and they will tell you that China is the dominant factor.

There may be some good reasons for this. Firstly, the Chinese economy has been growing rapidly (even if it has slowed down) so it is an ever larger share of the world economy. Secondly, equity markets are very often dominated by global firms who earn revenues from many other markets. So US firms with large exports to China should be reacting to downturns in China (that is, assuming Chinese equity markets are representing the real economy, which is another question entirely). Lastly, the weakness in the equity market brought about a depreciation in the CNY against the USD, even as the People’s Bank of China had to expend a lot of reserves to prevent too rapid a depreciation. Not only is currency depreciation likely to be bad for US exports to China, but the selling of reserves constitutes a substantial capital outflow, which is bad for financial markets.

But one consequence of the closer links between the Chinese equity markets and the US equity markets is that the US equity market is, almost by definition, telling us less about the US economy. The equity markets may merging, but that does not mean the economies are.

Joshua McCallum and Gianluca Moretti are part of the Fixed Income team at UBS Asset Management.

Schroders Upgrades Crude to “Positive”

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Mejoran las perspectivas para el petróleo
CC-BY-SA-2.0, FlickrPhoto: Paul Lowry. Schroders Upgrades Crude to “Positive”

The price collapsed because global supply increased sharply in 2014-15 while demand growth sagged – and more recently even stopped altogether. The Dollar’s super strength played a key role also. In the past 3-6 months, supply growth has been sagging as a direct result of the lower price, but now it looks like a strong bet that supply is actually going to fall, and fall sharply. As a result, the market is likely to come into balance very quickly. As this happens, the price will recover smartly.

Mark Lacey and John Coyle have been reporting how very recently a number of companies have announced further huge reductions in capital spending, lower production guidance or even shut-ins. In 2016 to date, a very small sample of companies have announced a combined cut in production guidance for this year of 160kbpd already, representing a 5-6% drop from last year. In the next few weeks, as the rest of the companies report, we can expect similar announcements. From the initial sample, we can conservatively estimate a combined cut in production globally for 2016 of 1.5-2mbd, especially as the oil price is at least 20% lower than it was when the first companies reported. This reduction should be easily adequate to balance the market.

Anecdotal evidence which points towards production declines is everywhere now. This is especially in the US and Canada but notably in other parts of the world too. India, China, Kazakhstan and Nigeria are all reporting declines. North Sea activity is coming to a standstill. Tanker rates from the Gulf have collapsed recently as there has been a sharp drop in crude cargoes for February loading. Oil is being shipped to the US from far and wide because the US domestic oil price is trading expensively to the rest of the world, but the premium is being maintained. The futures market contango did not worsen at all as spot prices recently swooned and in recent days it has been reduced. US E&P bankruptcies are soaring and the financial tap is being turned off. The evidence is plain that US production is falling faster than the official statistics report and the required oil is being “sucked” in from the rest of the world. This trend is going to accelerate as US production drops precipitously in the next few months.

It’s not difficult to understand why companies are now reducing activity. Remind yourself of the chart below kindly compiled by Citibank in late 2014.

Ampliar

Everyone is losing money now. Producers are much better off leaving it in the ground than selling it for $27, especially as they know that storage facilities everywhere are pretty much full. The market has been rightfully worried about “tank tops” but the price collapse has now, very likely, done its job.

What can make the price fall further?

A collapse in demand. To some extent, this is already happening. Both Chinese and US demand has slowed markedly, and it could continue (likely will, in my opinion). But my view now is that the speed of supply response is overtaking the weakening of demand. We shall see. A sudden surge in Libyan production would also hurt the price; let’s afford that a 25% probability, given the security issues. A further surge in the Dollar would be a problem also, for sure; my view is that the Dollar’s run is now likely fully played out, at least for now, given the renewed turmoil in global stock markets and the weaker trend of US economic data, both of which suggest the Fed will no hike again anytime soon.

As a final note on Fundamentals, what if OPEC acts? This is a scenario completely dismissed by the market currently. Pressure on the Saudis is now immense. Of course the likelihood of the Saudis flinching may indeed be slim but just a suggestion of it today would be enough to send the price up $5-10 at least. Risk in this market is heavily skewed for sure.

I will be writing an updated formal oil report in the next two weeks.

Our official Chart indicators for oil remain bearish, we looked at them closely yesterday. I will argue, however, that from a Pattern point of view a very significant low is very likely in place, or will be within a few days. I believe the sell-off from the mid-2014 high is finishing now, based on wave counts. If this is indeed the case, the first upside target for crude is $38 (+36%), and after that $48 and $57. Strong supporting evidence, I believe, comes from the performance of some of the oil stocks yesterday: they dropped sharply in the morning but then closed very strongly, e.g. WPX was down 34% first thing but closed down only 6%, which left a bullish candlestick. The relative strength of oil stocks versus crude is another indication of a potential turning point. (And by the way, the gas stocks went up yesterday eg Southwestern up 13%; the chart patter non this stock, I believe, is super-bullish. We already has this stock rated as bullish chartwise. 50-100% upside looks easily achieveable.).

On Sentiment, again, our official indicators remain bearish but anecdotally we can now all read the tea leaves. Just listen to any TV or radio commentator or Bloomberg video, or read the papers. Everyone and his dog can now tell you why we are in a “lower for longer” scenario, and I believe it is notable that even CEOs of major oil companies are now saying the price won’t recover until second half 2016, a big change from their position 3 or 6 months ago. The IEA monthly report was widely quoted yesterday; “drowning in oil”, being repeated everywhere. In summary, the big picture sentiment story is bullish; when our shorter-term indicators turn it will be super-bullish.

To conclude, while more volatility can of course be expected, I would bet strongly that oil will finish this month well above $30. I recommend at least a fully neutral position on oil with a strong bias towards equities, which should be increased aggressively if the prices continue to recover. Gas stocks ditto.

Geoff Blanning is Head of Commodities at Schroders and Energy Fund Managerat Schroders.

What Does 2015 Tell Us About 2016?

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¿Qué nos cuenta 2015 sobre 2016?
Photo: Gabriel de Andrade Fernandes . What Does 2015 Tell Us About 2016?

In reviewing 2015, I am reminded of the issues that dominated multifamily investment discussion.

Let’s start with the funds. Blackstone Group LP, the world’s biggest alternative-asset manager, has closed on $15.8 billion for its global real estate fund. As of June, 2015, it was overseeing $93 billion in real estate assets. Goldman Sachs is oversubscribed for its $5.3 billion real estate fund.

What does this mean?  These are smart people – and they have chosen real estate as their investment class. We all know that real estate provides a stable diversification to the volatility of the equity markets, and it has outperformed those markets for many, many years. But the enormity of these funds is concrete affirmation of its global favor.

Then consider the Millennials:  25 million classic apartment renters are still living at home.  And it will be a while before they can afford—or want –to purchase a home:  student debt; flexibility to move for job opportunities; later marriages and children, etc.  And recently FHA has ruled that potential home buyers who carry student debt will have to include that debt (even deferred) in their debt-to-income calculations. So it will be even harder to qualify for a mortgage.   They (25 million) will need rental housing.  That’s a lot of apartments.

And the Baby Boomers (born between mid-40s and mid-60s) are also looking to rent.  There will be 76 million baby boomers retiring en masse in coming years.  Some reports anticipate that in the next fifteen years, renters 65 and older will grow in number to 12.2 million. (Gloria Stilwell, Bloomberg News)  Other reports suggest that Boomers may be slower to downsize as the housing bubble peaks, but add that this situation is temporary. Boomers currently occupy 32 million homes, but as circumstances inevitably change, “their actions will reverberate through the housing market.” (Kenneth Harney, Washington Report to Miami Herald.  12/6/15.)  That’s even more demand for rental apartments.

That brings us to the housing bubble. With the rise in housing prices, the “US housing market across the board is moving toward rent territory,” Ken Johnson, Ph.D.  Especially in Dallas, Houston, and Denver, in terms of wealth creation, data suggest renting as opposed to buying.

Finally – senior housing:  It’s not your grandma’s “old folks” home. No more rocking chairs; no more flowered wallpaper, antique credenzas and calico curtains; no reference to “retirees.”  By federal law, 55 is the minimum age for “senior housing,” but who at 55 wants to be considered “senior”? (My wife has refused senior discounts because “It sounds so old.”)

Our Baby Boomer renters want a continuation of their active and social lifestyles –but without the headaches. They want modern, show-house furnishings, designer finishes. They want a carefree, luxury lifestyle. They want rental apartments.

Put these all together, and the future of multifamily investment is very exciting.  We are going to be busy.  The problem is that everybody is jumping on the bandwagon, and there are some crazy deals going down.  Good investments are out there, but they are really hard to find.  That’s why the firm has local presence in each of our markets that scout the area for off-market opportunities.

For 2016, multifamily will continue as the darling of the real estate investment industry.  But we must be careful.  I predict a cap rate compression unlike anything we have seen before. And that will create other issues. (But I’ll discuss those in another message.)

In the meantime, we aggressively look for solid B and C properties in B and B+ neighborhoods, properties with steady cash flow that show opportunity for improvement.  It takes hours and hours of looking and a lot of hard work, but we expect 2016 to be even better than 2015.

Opinion by Chris Finlay, Chairman/CEO, Lloyd Jones Capital

 

Facing Up to the Bear

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Encarando los mercados bajistas
CC-BY-SA-2.0, FlickrPhoto: Ian D. Kaeting. Facing Up to the Bear

Widespread fears over ongoing stock market and currency weakness in China, the falling oil price, geopolitical tensions, overvalued assets and an end to fiscal stimuli have led to stock markets plunging around the world. The bear appears to have his claws out and investors with shorter memories may well be spooked.

Oil prices have once again played a key part in this fresh round of market sell-offs, with Brent crude slumping to a little over $27.5/barrel on 20 January – down 75% from its June 2014 high of $112/barrel and 39% off the $45/barrel price we saw as recently as November 2015. Indeed, there are fears that the rock-bottom oil price may even put some oil companies out of business.

Bear markets are typically defined by a broad range of indices falling by 20% or more from their most recent peaks. At the time of writing, at 5,673 the FTSE 100 index is 20.3% off its April 2015 peak of 7,122, while the Dow and the MSCI AC World indices are not far behind. If a bear market is also defined as one where investors should expect further sell-offs, then we may well be in the bear’s claws.

Ironically, the drivers of this bear market may be found in economic policies aimed at stabilising global economies. Volatility has been artificially low in recent years due largely to quantitative easing (QE), with markets settling into a pattern of reassurance that modest earnings growth would continue all the while asset prices were being boosted by QE.

I’ve previously referred to this as markets ‘resting easy as they drank from the punchbowl of QE’, but recent events indicate that markets have perhaps had their fill and, even if the QE bowl is not yet empty, it might as well be.

This should not have come as a shock to investors

The recovery of financial asset prices from the nadir of the last financial crisis has been dramatic; indeed, it has been one of history’s most fruitful periods for investors. The six years ending March 31 2015, for example, stand at the apex of historical six-year returns for the US stock market.

The Greek debt crisis made markets sit up and take notice – reminding them that bull runs do not last forever – while in December the US Federal Reserve embarked on a tightening of policy which eliminated one of the financial markets’ greatest tailwinds. The era of asset price reflation, fueled by both post-crisis undervaluation and aggressive central bank easing, is over and we cannot rely on our returns being flattered by QE or other valuation recovery dynamics.

At a global level, expected earnings are lower than they have been for five years while prices are much higher even if, while volatility is high and rising, it is not in territory that typically marks capitulation and is some way off the levels of volatility we saw in 2008.

China, of course, remains a key driver of volatility. Its economy is slowing as it desperately tries to rebalance (even if the recent rate of decline is not as bad as many feared – for example, its recent quarterly GDP figure indicated growth of 6.9%, marginally better than many analysts expected). This slowdown has already resulted in currency depreciation and stock market woes, which have spilled over into other Asian markets and across the world.

Yet fears over China are also not new and we have warned for some time that the ongoing slowdown in the country would pose challenges not only for Asian and emerging markets investors but for financial markets globally.

Now is not the time to throw in the towel

Dollar strength, liquidity, credit spreads and Brexit also remain key concerns. Yet this is not the time for investors to throw in the towel, as some pugilistic analysts and doom-mongers have suggested.

Investors should be aware that 2016 will be a low growth, low return world, with corporate margins pressured by weak end demand and overcapacity in a number of industries.

The outlook for emerging markets (EM) remains challenging, particularly for those countries that have built their economies to serve Chinese demand for commodities. The outlook for these countries is downbeat, and weaker currencies may not help to lift demand for EM exports where consumer and corporate demand is subdued. A world where the US tightens policy but other central banks retain an accommodative stance should mean a stronger dollar, all else being equal. That is likely to be a further headwind for EMs, as there is a strong inverse correlation between the dollar and emerging markets.

Active managers using multi-asset allocation strategies are well-placed to ride out short-term shocks in markets. The rising tide of global QE that had lifted all boats will begin to ebb, and in that environment it will make sense to differentiate within and across asset classes. In this world, a focus on valuations and fundamentals – ‘old school’ investing if you like – should be more important than it has been in recent years, when markets were backstopped by abundant and growing liquidity.

Longer-term investors know that what can feel like an emergency in the short-term may not hold as much significance some years down the line, so a focus on old school investing values makes particular sense in such a volatile world.

Tackle the bear

But if we are to tackle the bear, we would ideally like to see some markers of stability. If China and its investors could accept the country’s need to rebalance its economy, we might see a smoother stock market ride. Oil price stability would also help, but the situation in the Middle East is difficult to fathom, defined by Saudi Arabia’s continued willingness to pump oil even at current prices and its squabbles with Iran. With demand falling, partly as a result of US shale oil flooding the market, oversupply remains a key issue and it remains to be seen how the geopolitical factors in play will pan out.

Even if the prospect of further interest rate rises have been pushed a little further towards the horizon, they arguably remain one of the key threats. The macro and company indicators that we are seeing at the moment – subdued growth and inflation, soft final demand and a deteriorating outlook for corporate earnings – are not the kind of the things that one would expect to see when the world’s most important central bank, the US Federal Reserve, is starting an interest-rate tightening cycle.

It is clear that the Fed is very keen to start normalising interest rates, but if one simply looked at the data in isolation, it is hard to come to the conclusion that the Fed needs to raise rates quickly or aggressively. The recent US jobs data releases have been strong, but they need to be set in context – labour participation rates in the US are still at 40-year lows. Markets do expect the Fed to act, and we expect the FOMC to do so in a controlled and sensible manner. If the Fed loses control of its own narrative and policymakers are seen to ‘flip-flop’, markets could react strongly.

What does all this mean from an asset allocation perspective? In terms of valuations, we still regard equities as more attractive than bonds and expect to retain that positioning for now in our asset allocation portfolios, although with less conviction than we have done for some time. However, compared to their longer-term history, equities still offer better value than bonds.

Mark Burgess is CIO EMEA and Global Head of Equities at Columbia Threadneedle Investments.

 

Mario Draghi, The Italian Banking Sector, and Oil; Main concerns for Fixed Income at Pioneer

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During last week, the three things that Pioneer’s European Investment-Grade Fixed Income Team talked about where:

1. ECB – “No Surrender”
Bravissimo Mario! After a lacklustre performance at the December 2015 European Central Bank (ECB) press conference, ECB President Mario Draghi was back to his best at this week’s ECB press conference. In a virtuoso performance Draghi signalled that it will be “necessary to review and possibly reconsider in March” the ECB’s current stance, given that the expected path of inflation in 2016 is “significantly lower than the path in December”. To be fair, that was always expected, given the ongoing precipitous fall in the oil price over that period. But Draghi didn’t stop there, giving us other soundbites such as the “risks of second-round effects should be monitored closely” and the emphasis that there are “no limits” to the measures that the ECB will undertake to ensure that it meets its inflation target of “close to, but below 2%”. That comment about “risks of second-round effects” is as close as we will probably get to the ECB admitting that ongoing low levels of inflation is now impacting the general economy – the famous “unanchoring of inflation expectations” that the ECB fears so much. The second comment suggests that all options will be on the table at the March meeting, despite the minutes of the December 2015 showing a distinct preference for a deposit rate cut. Finally, President Draghi noted that the line of communication adopted today was “agreed unanimously” by the Governing Council, suggesting that their bar to further action is very low. At this stage, we believe that another 10bps cut in the deposit rate to -0.30% is likely, with other options such as an increase in the monthly pace of bond purchases, an extension of bond purchases beyond March 2017, and the loosening of current restrictions on bond purchases all open for discussion.

2. Italian Banking Sector – Reality Bites
Media leaks last Monday (January 18th) suggesting that the ECB’s central oversight arm, the Single Supervisory Mechanism, was scrutinising the non-performing loans (NPL’s) and bad debts Italian banking system truly put the cat amongst the proverbial pigeons. While this news does not come as a surprise, the market became concerned that further provisioning may be required for the weaker Italian financial institutions, which would place additional pressure on solvency levels. At the same time, progress on the Italian bad bank appeared to have stalled, with a solution to comply with European Commissions State Aid rules proving elusive. The market reaction was swift and brutal, with both equity and bond prices plummeting. The subordinated bonds of the weaker Italian banks have been under significant pressure since the start of the year and are trading at around 75c per €1 face value. At Thursday’s press conference, ECB President Draghi confirmed that the ECB is not about to force higher provisions or capital raises on peripheral banks as part of its latest NPL exercise. Rather the focus is on improving processes and strategies around the resolution of NPLs across Europe (with the recent NPL information requests sent to a broad range of banks across the region, not just to Italian institutions). Further reports emerged that the creation of a bad bank may be agreed between the Italian government and European Commission over the coming weeks . Finer details remain light, but these reports were enough to drive a rebound in Italian bank spreads on Friday. While a step in the right direction, the Italian banks do not currently have sufficient capital or provisioning to transfer NPLs at market prices to a potential new asset management vehicle. This solution is unlikely to be the panacea to the sector’s problems, but will be welcomed nevertheless and hopefully help to kick-start sales in the NPL market. We have a cautious outlook on the Italian banking sector, and still prefer to sell into strength.

3. Oil is in a Bull Market 
Not the headline you might expect to see after the last couple of months, but technically it could be correct if the recent bounce in the oil price continues. The standard definition of a bull (bear) market is a 20% rise (fall) in the price of an asset. The oil price has appreciated by almost 18% from its intraday lows of last week to Monday morning. What is also interesting is the effect this has had on markets – it has been the main driver of a classic “risk-on, risk-off” sentiment. So as the oil price has risen in the past couple of days, we’ve seen equities recover, core bond yields rise, peripheral bond spreads tighten, the U.S. Dollar has appreciated against the Euro and the Japanese Yen and credit spreads globally have tightened. In turn, that backs up the view of the European Investment-Grade Fixed Income team that much of the price action in the first three weeks of the year is a response to the movements in the oil price, and not a reflection of changing economic fundamentals.

Don’t Fight Today’s Markets With Tomorrow’s Money

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No luche contra los mercados de hoy con el dinero de mañana
CC-BY-SA-2.0, FlickrPhoto: Pictures of Money. Don't Fight Today's Markets With Tomorrow's Money

Crude oil has now fallen below $28 per barrel. Not so many months ago, no one could have predicted — or even imagined — that this commodity would drop from over $120 per barrel so far and so fast. And with this deep decline in the price of oil, the US dollar is rising and global trade is slowing.

It is still my strong contention that cheap oil means more spending and growth. But that isn’t happening yet.

So where do I stand now? Here are my new points:

  1. The majority of the world’s economies seem to be faring a bit better. A number of the eurozone’s peripheral countries have shown signs of turnaround. And in the United States, we haven’t seen the excesses that are typically associated with the risk of recession.
  2. Looking at history, recessions haven’t occurred because commodities are cheap — usually it’s the other way around. Many of the world’s consumers and producers ultimately stand to benefit from low energy costs.
  3. This is not the same situation we faced in 2008, when we were on the brink of the global financial crisis. The global banking system is exposed to oil and China now, but not nearly in the proportions we saw with exposures to risky US mortgage debt then.
  4. I do think the smoke will eventually clear on the business cycle. However, until we get more data to indicate whether the slowdown in manufacturing, the weakness in exports and the stutter step in earnings will persist, fear could rule the markets for riskier assets.
  5. In this unsettled environment, with so many unknowns, there’s a risk of jumping into the global equity markets too early. An investor with new money may want to consider a more conservative asset mix to ride out this storm.

James Swanson is MFS Chief Investment Strategist.

 

 

Driving Mr. Andy

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Uber, a la conquista de China
CC-BY-SA-2.0, FlickrPhoto: Carlos ZGZ . Driving Mr. Andy

Uber, the U.S. ride-sharing company, has big plans for China, and it says the number of Uber trips there is almost as large as it is in the U.S. While Uber has raised more than US$1 billion for its standalone Chinese unit, its mainland market share is dwarfed by that of a local competitor, DiDi. But on a recent trip to China, I was less interested in the numbers than in discovering why some Chinese prefer to drive for the foreign underdog rather than the dominant, homegrown ride-hailing firm.

Same App, Same Credit Card

I was impressed to discover that I could use the U.S. app to request an Uber ride in Shanghai, and bill it to my American credit card already on file. For my first trip, Mr. Xie pulled up in a new Toyota, bemused to see that his passenger was a foreigner. He’d only been driving for Uber for a few days, but was enthusiastic. “My main business is P2P (peer-to-peer) lending, and all of the work is at night, taking prospective clients to dinner and drinking. So I have lots of free time during the day,” he told me.

Mr. Xie was keen to chat about his private lending business. So keen, in fact, that he missed the exit to get us into the tunnel under the Huangpu River, adding 20 minutes to my journey as we were swallowed up in traffic.

He said he hoped that driving for Uber would be a great way to meet new borrowers, and that attracted him more than the pay. “I started driving for DiDi, but the customers were not really the kind I’d want to lend to. Uber riders are richer, so I’m sticking with Uber,” he added. Mr. Xie noted that lots of foreigners also use Uber, but he didn’t think they would end up borrowing from him.

Rich and Bored

While the original Uber app worked well in Shanghai, all of the communications were in Chinese, which might be an obstacle for all but the most adventurous foreigner. But a few days after returning to the U.S., I received a message from Uber: “We’re thrilled to bring you a language-specific service, ENGLISH, to make it a bit easier for expats and global travelers to get around the city [of Shanghai].” According to the message, you just open the app and enter the referral code “zaishanghai” (meaning “in Shanghai”) and then “unlock the English option.”

My second driver in Shanghai rolled up in a brand new Mercedes sports coupe. Mr. Zhang looked like he was about 23 years old, and I couldn’t help but start the conversation by asking why a young guy with a very expensive car was driving for Uber. “Well, my dad has a successful business, so I haven’t had to get a job . . . and I’m bored. One of my friends told me I could meet interesting people driving for Uber,” he said.

I asked how that was working out. “Well, today is my first day,” he replied. “But it is pretty cool to drive a foreigner.” I’d be surprised if he lasted more than a couple of days.

My Own Boss

Mr. Wang was more experienced, having driven his Buick for Uber for a few months. Prior to that, he drove for a company, but he quit for the freedom to set his own schedule. Initially, Mr. Wang drove for DiDi, although he said, “I make more money with Uber, and the customers are better.” He thought many riders were switching to Uber from DiDi, because it is easier to get a car. “DiDi drivers can see the customer’s destination before they pick him up, so often they will reject a fare they don’t like, while with Uber, we don’t know until the customer gets into our car,” he said.

Not a Cop

When I climbed into Mr. Zhou’s Toyota Camry, he said he was thrilled to discover that his next passenger was a foreigner. “This business isn’t really legal, and other drivers have told me that cops are ordering rides and then fining drivers 10,000 renmimbi (RMB or US$1,570). And when I saw you, I knew you couldn’t be a cop!”

Mr. Zhou told me that his son, who is studying in the U.S., bought the car for him specifically so he could drive for Uber. I asked if he was retired. “Ha, no. But I work for a state-owned company, which is almost like being retired! I’ve got nothing to do all day, so I just leave the office and drive to make extra cash!”

Better than Driving a Truck

Mr. Luo quit his job driving a truck to join the ride-sharing economy. He told me he started with DiDi, but said Uber passengers are “better behaved,” something I heard frequently from drivers who couldn’t really explain the difference. 

He said the money was okay, taking home RMB700 (US$110) for a 12-hour day of driving.

Better than Driving a Taxi

Mr. Yu gave up a long career as a taxi driver to strike out on his own. He also started with DiDi, but switched to Uber because “DiDi charged me too many fees. Either is much better than a taxi. More relaxing as there is no boss, and I can take a break anytime. And Uber passengers are much better than taxi passengers,” he said. He estimated that he took home about RMB7,000 (US$1,099) a month driving for Uber.

The Long Haul

Overall, the Shanghai Uber experience was pretty good. Two drivers never appeared—I watched as one drove by without stopping, possibly assuming that a foreigner couldn’t have been the customer—and in both cases I was automatically charged a cancellation fee of RMB10 (US$1.60). But when I filed a complaint through the app, those fees were immediately refunded.

The fares were ridiculously low, presumably due to large subsidies from Uber as they try to grab market share from DiDi. That will be just one of the many challenges the American firm faces in the future, along with an uncertain regulatory environment, and the issue of retaining drivers after the novelty wears off.

Andy Rothman is Investment Strategist at Matthews Asia.

 

Shelter from the Storm

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¿Cómo hacer frente al reto de la diversificación?
CC-BY-SA-2.0, FlickrPhoto: Vins Stonem. Shelter from the Storm

In a late cycle environment, most commentary tends to focus on the challenge of finding return opportunities with reasonable risk and reward characteristics. However, finding reliable defensive assets is equally challenging. Until now, traditional balanced strategies have performed well, especially those with structurally long duration bond exposure. Despite more complex hedging strategies being expensive and at times unreliable, conventional developed market bonds have continued to be inversely correlated with equities, thus smoothing the bumps in the road and providing a return in excess of cash. But this period may be coming to an end. For long periods in the past, bonds have been positively correlated with equities and the risk is that such a relationship re-asserts itself and that conventional approaches to diversification, no longer flattered by high nominal and real interest rates, cease being effective.

While the consensus view is that interest rate increases in the US are going to be gradual, and that few other countries are in a position to follow the US in normalising interest rates, there is a real sense that the rate cycle is beginning to turn. Should growth turn out to be stronger than what is popularly characterised as ‘secular stagnation,’ it would arguably not take much in the way of growth surprises to impact bond yields. Even at the current moderate rate of growth in the US, the run rate of job creation is consistent with a sharp uptick in wage inflation which we believe could easily eventuate in the not too distant future. Furthermore, even if the consensus view proves correct, at current yield levels the benefit of developed market bond exposure in periods of market stress could prove to be very modest compared to previous periods. This was very much the case in August when equity markets sold off sharply and the offset from long bond positions was not material.

So how should one address the challenge of diversification? It is probably time to adopt a rather more tailored approach since one size no longer fits all. If owning US government bonds doesn’t offer the protection it used to, then shorting duration might offer some defence. Given the widely held view on the likely course of US interest rates, put options on interest rate futures appear to be surprisingly attractively valued. There are also government bond markets, such as those of Korea, Australia and Canada, where the likely path of interest rates means that they provide more protection than US Treasuries, particularly at the shorter end where correlations to US long-term interest rates tend to be much lower. Certain currencies also offer attractive defensive potential.

In our opinion, the yen appears to be well supported by Japan’s creditor nation status and improving cyclical fundamentals which should help it perform like a traditional ‘risk off’ currency in periods of market stress. Back in 2007, it was one of a very few defensive assets that provided strong diversification benefits. By contrast, other defensive assets had been pushed to unattractive valuations by loose credit conditions, which is not dissimilar to the impact of the zero rate policies of today. Interestingly, the dollar’s defensive characteristics may be eroding.

Equity options appear neither cheap nor expensive at present and volatility can be expected to rise on a cyclical basis, however pricing can periodically be more benign. Despite volatility strategies appearing attractive, they have tended to be fraught with disappointment in practice because of high transaction costs and volatility that peaks but then rapidly subsides. Effective use of defensive exposures to diversify portfolios has to reflect changing valuation and cyclical contexts in exactly the same way as one should approach growth assets.

Philip Saunders y Michael Spinks are co-heads of Multi-Asset at Investec.

When You Look at China, Are You Looking at Its Past or Its Future?

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Cinco factores que juegan a favor de los mercados de bonos asiáticos
CC-BY-SA-2.0, FlickrPhoto: Skyseeker. When You Look at China, Are You Looking at Its Past or Its Future?

Many investors are pessimistic about China’s economy, largely because they don’t realize how much China’s economy has changed. 

China’s old economy looks weak. Exports are down by about 3% through November, compared to an increase of 6% a year ago. Industrial production is up 6%, compared to 8% a year ago. Fixed asset investment has increased 10%, down from a 16% growth rate during the same period last year. But are those the parts of the economy you want to focus on, or invest in?

Not an Export-led Economy

Exports, for example, haven’t contributed to GDP growth for the past seven years. I estimate that only about 10% of the goods rolling out of Chinese factories are exported. China largely consumes what it produces.

Manufacturing is sluggish, especially heavy industries such as steel and cement, as China has passed its peak in the growth rate of construction of infrastructure and new homes. But manufacturing has not collapsed, with a private survey revealing that factory wages are up 5% to 6% this year, reflecting a fairly tight labor market, and more than 10 million new homes will be sold in 2015.

More importantly, few investors recognize that this is almost certain to be the third consecutive year in which the manufacturing and construction part of the economy will be smaller than the consumption and services part. China has rebalanced away from a dependence on exports, heavy industry and investment, and has become the world’s best consumption story.

Understanding this dramatic shift is key to assessing the impact of China on the global economy, and on your portfolio.

Ampliar

We are All China Investors

Even if you never own a Chinese equity, you are effectively a China investor. China accounts for about one-third of global growth—greater than the combined shares of the U.S., Europe and Japan.

This helps explain why U.S. exports to China have increased by more than 600% since it joined the WTO, while U.S. exports to the rest of the world rose by less than 100%.

 

Ampliar

Most GDP Growth from Consumption

The rebalancing is driven by Chinese consumers, with consumption accounting for 58% of GDP growth during the first three quarters of this year.

Shrugging off the mid-June fall in the stock market, real (inflation-adjusted) retail sales actually accelerated to 11% in October and November, the fastest pace since March.

Spending Driven by Strong Income Growth

Unprecedented income growth is the most important factor supporting consump¬tion. In the first three quarters of this year, real per capita disposable income rose more than 7%, while over the past decade, real urban income rose 137% and real rural income rose 139%. Some of that increase was driven by government policy: the minimum wage in Shanghai, for example, rose 187% over the past 10 years. (In the U.S., real per capita disposable personal income rose by about 8% over the last 10 years.)

And it is worth noting that one reason that the fall in the A-share market didn’t depress Chinese consumers is that although the market is down sharply from its recent peak, the story isn’t quite as bad as some make it out to be. As of the December 15, 2015 close, the Shanghai Composite Index was down 32% from its June 12 peak. But the index was up 9% from the start of the year, and it was up 20% from a year ago. Thus, the Shanghai Composite Index is outperforming the S&P 500 Index on a year-to-date basis (with the S&P 500 down 1% as of December 15) and on a one-year basis (with the S&P 500 up 6%).

Rebalancing needs time

We need to accept and understand, however, that the necessary restructuring and rebalancing of China’s economy, along with changes in demographics and the law of large numbers (two decades of 10% growth), does mean that almost every aspect of the economy will continue to grow at a gradually slower year-on-year pace for the foreseeable future. The strong consumer story can mitigate the impact of the slowdown in manufacturing and investment, but it can’t drive growth back to an 8% pace.

Ampliar

So while the growth rates of most parts of the economy are likely to continue to decelerate gradually, keep in mind that this year’s “slow” pace of 6.9% growth, on a base that is about 300% bigger than it was a decade ago (when GDP growth was 10%) means that the incremental expansion in China’s economy this year is about 60% bigger than it was back in the day.

Larger Opportunity

In other words, the lower growth rate is generating a larger opportunity for companies selling goods and services to Chinese, and for investors in those companies.

Andy Rothman is Investment Strategist at Matthews Asia.