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Made (and bought) in China

Fortunes of individual nations, having moved in lockstep for much of this decade, appear set to diverge dramatically. Growing strength in the US economy, a tight labour market and Trump’s fiscal boost, provide the backdrop to interest rate rises and quantitative tightening across the Atlantic. The US Federal Reserve looks poised to continue its policy of rate increases this summer, despite warning signs flashing in other regions of the global economy, not least Emerging Markets. The economic expansion, once led by China and the Eurozone appears to be topping out, while protectionism adds a potential gale-force headwind. Some analysts forecast a 3% impact on world growth, akin to a full global recession. Meanwhile, a strengthening US dollar is piling pressure on Emerging Market countries, particularly the most indebted.

June Index

Equity Market Returns June 2018 (July 2018)

Emerging Markets

The Chinese currency fell 3.3% against the US dollar in June, its most extreme single month fall ever. Importantly the weakness extended to a broad basket of currencies, not just the US dollar, as was the case earlier this year.  Part of the reaction comes from the narrowing interest rate spread between China and the US (as the US raises its interest rates), and the recent easing of monetary policy by the Chinese. Worries over trade wars do not help matters. The CSI 300 index of major stocks in Shanghai was off 20% from its highs earlier this year, marking a one year low. In Hong Kong, the reaction was to buy dollars in bulk. The Hang Seng Index fell to its lowest level since last August, prompting the Hong Kong authorities to attempt to stabilise sentiment – urging investors to avoid panic selling from an “irrational overreaction”.

Source: (July 2018)

Made (and bought) in China

While the timing of these dips suggest the threat of trade wars is to blame, the root cause seems more local. Chinese national wealth rests overwhelmingly on domestic consumer spending – estimated at circa 80% of GDP for the first quarter of this year. Only 18% of exports in 2017 went to the US, accounting for a mere 1.3% of GDP. Morgan Stanley estimate that the impact on exports from the tariffs announced so far will amount to a paltry -0.8%, leading to an insignificant 0.1% reduction in GDP growth. It is true that investor worries over trade wars has contributed to the recent retreat in Chinese stocks. However, a more significant concern is the slowdown in consumer spending. One indicator used by Ariel Bezalel, manager of the Jupiter Strategic Bond Fund, is highlighted below. Historically the correlation between Chinese Producer Prices and copper prices is fairly significant, with the implication of falling copper prices in the spot market that Chinese spending is on the decline.

Source: Jupiter Asset Management (June 2018)

Much of the perceived reluctance to spend from the Chinese consumer can be attributed to central policy. There is a drive to reduce leverage in the economy and this is impacting the availability of consumer credit. While consumer loans as a whole are still growing, the pace has dropped and so too has annual retail sales growth, up 8.4% in May, against 9.4% in April. China has worked hard over the past decade to shift the focus of its economy away from traditional export-led heavy industry, to long-term sustainability based on a more affluent consumer. This has naturally led to a slowdown in China’s growth rate but only to a more realistic level. Therefore, to understand the risks and returns that lie ahead we must focus attention on State policies that impact the Chinese consumer.

Turkish Decline

The weakness in the Turkish Lira evident from the past few years accelerated in June. Figures showed inflation hit a 14 year high in June, standing at 15%, aided by a 19% devaluation in the currency year to date. Markets are anxious about the policies of President Erdogan, and there is an expectation of an economic slowdown in the coming months. Unfortunately, there is not an easy solution. Higher interest rates protect the currency and control inflation but will slow the economy further.
Dollar strength and increasing short-term US interest rates have hurt other emerging economies too, with the Indian central bank calling for US monetary policymakers to consider the impact of its decisions on global economic health. The Indian Rupee has set a record low due to the ongoing trade jitters and rising oil prices. Meanwhile, the Argentinian Peso is in freefall. Soaring inflation and a falling currency have led the central bank to raise rates to 40% despite the risk of recession.

Source: (July 2018)

In contrast developed market equity returns have been relatively positive. Moderate local currency gains achieved at the start of June were slowly reversed as the month progressed, ending all square. Signs of a global slowdown in economies outside the US are perhaps capping equity markets’ exuberance.

Hints from the Bond Market

While equity markets mull over the current outlook, fixed income markets continue to respond. Traditionally they react ahead of equities in response to changing macro conditions, and so can offer useful insights. The credit market has been highlighting concerns over corporate strength. Even US companies are not immune despite their economy’s momentum. Credit spreads have widened markedly from a post-recession low at the start of the year, and this implies concern for the wellbeing of corporations. We need to be wary that ultra-low borrowing rates and a tailwind from tax cuts could mask all manner of problems. In fact, the tightening cycle, driven by the US, will stress companies globally but particularly in the States. As Jupiter Asset Management has pointed out almost 15% of businesses in the S&P 1500 cannot cover their interest payments from their earnings. A modest reduction in demand and/or further increases in interest rates could bring to the surface weakness in corporate business plans, at which point you may expect the stock market to catch up. It is worth reminding ourselves that economic strength and financial market returns are not very closely correlated. Today’s US macro strength and the consequent pattern of increasing rates could be the catalyst for equity market weakness tomorrow!




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