26th June 2015 by Mark Tinker
The situation in Greece continues to dominate the headlines in Europe and cause headaches for European officials, with the (honestly this time it really is final) deadline approaching. On balance it still looks like some form of ‘extend and pretend’ rather than a so called Grexit is likely, but as someone pointed out this week, perhaps we should just recognise that these are not loans, rather they are some form of state aid? Slightly tongue in cheek, but developed countries extend considerable aid to less developed ones with little or no expectations of return. So one may ask, why not Greece?
As discussed last week, I remain nervous that any further haircut/default could expose some clever leveraged strategy gone wrong. If we remember Long Term Capital Management (LTCM), which should by rights have been called Short Term Leveraged Trading or STLT instead, since it was not really in the business of LTCM, but rather involved STLT, which blew up in 1998 in the wake of the Russian default without any Russian exposure. It was short Treasuries and a long and wide basket of spread trades, which according to the Nobel Prize winners behind the fund were sufficiently diversified as to be low risk and thus were ‘safe’ to put on huge leverage. Of course the risk was on the funding side and when Russia caused a flight to quality, the price of US Treasuries spiked higher forcing a dramatic unwind of positions. The expression ‘picking up nickels in front of a steam roller’ may not have been coined at the time, but it was certainly apposite. So rather than a ‘Lehman moment’, perhaps we should be thinking about a potential ‘LTCM moment’? Watching the moves in the spread trades – Germany versus Spain, or US versus Germany or Spain, has certainly been something of a volatile ride in the last few months.
If we want to look around for some distressed selling, then perhaps we need look no further than Shanghai, where we look to be capping off another bad week as the index failed to hold its bounce and has broken to a one month low, which doesn’t sound so bad until you realise that is around a 18% drop. The proximate cause in my opinion remains the restraint on margin, which is likely squeezing a lot of day traders very hard. The medium term moving average has just broken, although the long term uptrend remains intact – while given the speed of the rise, that is still another 30% down to take us back to where we were just in March.
The other area that remains a concern to me is the high yield bond market. Just as the third world were re-branded as emerging markets, so junk bonds were rebranded as ‘high yield’. Last week we noted how emerging markets had been trading sideways for three years – showing little inclination to either bull or bear trends – but that commodities were in a bear trend. So too are high yield bonds if we look at the performance of the high yield bond ETF, HYG and interestingly, both commodities and HYG peaked out almost exactly a year ago. High yield overshot in the end on concerns over shale oil producers, which represent a significant proportion of the benchmark, but the recovery they saw in Q1 has all been given back, similar also to emerging markets. Leveraged plays in down trending markets are rarely a good idea unless you are a very astute trader. Normalising US interest rates and even boosting GDP forecasts does not look likely to cause a spike in commodity prices, and without that, too many of the traditional cyclical stocks are still exposed to too much supply even for a higher level of demand.
With the idea that interest rates in the US will now (finally) be going up, there has been a slew of econometric driven strategy pieces telling us to buy cyclicals and sell defensives. For the reasons just outlined, I am not so sure. Historically, higher interest rates meant rising nominal economic growth, as rates moved up to a new ‘neutral ‘ position so cost of capital equalled the return on capital. Such an environment would tend to be good for mid and late cycle equities, as higher economic activity delivers operational leverage, while banks benefit from wider net interest margins, and insurance companies from higher long term bond yields. On the other side of the coin, interest rate sensitive stocks, particularly ‘defensive high yielders’ would be less attractive compared to high(er) yielding bonds and defensive stocks with large amounts of debt on their balance sheet – utilities, telecoms and real estate investment trusts (REITs) would become less attractive due to a higher cost of debt. The problem I have with this ‘I remember last time’ approach is that it really is different this time. If US interest rates were following the economic cycle they would already be 2.5% at the short end, rather than at zero, so a 25 basis point or even a 50 basis point rise is not going to put rates anywhere near neutral, nor with bond yields at 2% is there any reason to switch from an equity yielding two or three times that. Insurers are still struggling to match assets and liabilities at current yields. Bank net interest margins are not only not the driver of profitability at the moment as credit creation remains low, but after the 78 months of zero interest rate policy (ZIRP), too much of the profitability of many banks is within the financial sector itself and vulnerable to a shift in the marginal cost of leverage.
Econometrics really struggles where there is a structural change, such as is happening in China. It is not without precedent and Japan and South Korea offer many lessons, but the differences are as numerous as the similarities and they can only provide a guide, not a template. Last week we discussed how ‘new China’ was in a bull market while ‘old China’ was in a bear market and how this presents a problem for international investors. Previously many global funds (including the one I used to run) would get proxy exposure to China via emerging markets or via mining companies such as Rio Tinto, Vale and BHP Billiton, but as we discussed, slowing growth in demand for raw materials combined with overcapacity has led to collapsing commodity prices and bear markets for commodities and raw materials companies. This is bad for the companies, but also for those that lent to them. A second proxy for exposure to the Chinese consumer were the luxury goods brands, but these have struggled over the last two years under the anti-corruption drive, while western fast food such as Yum Brands (Kentucky Fried Chicken) and Pepsi are struggling with competition as first mover advantage disappears. Meanwhile, as noted last week, the big fast-moving consumer goods (FMCG) brands such as Unilever and Nestle are also struggling not only with heightened competition, but also with shifting consumption patterns and changing distribution channels. The remaining two proxies were Macau and the Chinese American Depositary Receipts (ADRs), most of whom were in the internet space. Clearly the former have been seriously damaged by the clamp down on corruption and the further opening up of the capital accounts, leaving the latter as the only proxy left available now.
This obviously presents a problem since, to repeat the phrase from last week, ‘you can ignore China, but China isn’t going to ignore you’. A survey by Asian Investor published this month (the survey was conducted in April and the results published in the June 2015 issue of the magazine) gives some insight into how global investors are looking at Asia over the next 12 months. An overwhelming 41% of respondents listed China (including Hong Kong) as their first choice based on location, with first, second and third choice votes for China adding up to 65% as opposed to 50% in the same survey last year. Pension funds and family offices were the segments with the highest first choice preferences to Asia, while retail and mass affluent were overall less enthusiastic than last year. In terms of how they propose to invest, overall direct exposure via equity capital markets remains the preferred way of allocating capital to Asia, but using ETFs garnered the most first choice picks, probably reflecting the preference for a semi passive, beta gathering style. It is interesting that the highest number of third choice picks went to infrastructure projects and funds as a way of getting capital exposure to Asia, highlighting the importance of this sector, reflecting no doubt the excitement about one belt one road, but also the potential for unlocking the local government debt into quality infrastructure bonds.
In terms of local institutions, the biggest pick up in expected exposure is Asia excluding Japan, from a total of 38% first, second and third choices in 2014 to 54% in 2015, largely at the expense of US equities (28% versus 37% a year ago) and REITS (28% v 38%). Japan picked up (14% versus 6%) as did global (36% versus 30%) and Europe has picked up slightly as well (26% form 24%). The regulatory changes, increased access via stock connect, other initiatives and the rapid changes to the index and benchmark providers are making China an increasingly urgent issue for Asian investors to get to grips with.
I spent part of this week down in Australia (again) meeting up with some of the CIOs of some of the super funds and we discussed the importance of China, along with many of the more direct issues facing the investment industry in Australia. In many ways, the Australian superannuation fund industry is at the forefront of the defined contribution or DC world and has much experience to share with the rest of the world who are only just getting there; either through a shift away from defined benefit schemes (DB) or a start from scratch self-invested approach. The point I made in Sydney and Melbourne was similar to that made in the note last week – a world embracing DC is not going to focus on the risk metrics employed in the world of DB, which through a focus on volatility and benchmarking tend to perhaps unconsciously focus more on the risk to the manager or agent rather than on the risk to the customer or principal. The DC world is focussing more on drawdown risk, accumulation risk (how to accumulate enough wealth), and personal inflation risk (healthcare for example is likely to be a far higher proportion of a retiree’s costs than is represented in a Consumer Price Index or CPI basket). Creating products that can fit those profiles is the big challenge.
I continue to see China as an opportunity set, providing the spectrum of potential return vehicles for long term investors searching for yield. In this sense, China can provide a disinflationary pulse for asset prices in the same way as it did for goods prices. To elaborate on this theory a little; if we track the baby boomers over time, wherever they go, they take an inflationary pulse with them. In many ways this should not be surprising since they tend to produce a demand shock relative to supply, which then tends to produce a supply response, but with a lag. Once they move on then we have the opposite, disinflation as the new supply exceeds demand. We know that technology is also a big contributor to falling prices, particularly if it is quality adjusted, but for the purposes of this argument we might also suggest that the demand for tech stocks in the ‘baby boomers’ 401ks in the late 1990s drove up the price and thus lowered the cost of funding for much of that technology. Now, they want/need fixed income and, not surprisingly the price of fixed income assets has gone up sharply as supply has not only fallen short of demand, but official policy has both increased demand via regulation and shrunk supply through Quantitative Easing (QE). If however, an unbundling of the banking system and debt structure in China creates several trillion dollars’ worth of new income bearing assets, then a form of disinflationary pulse ought to set in to these markets as higher yielding income bearing assets from China crowd out the lower yielding ones from the west. Higher yield plus potential capital gain in the East (as yields converge) versus lower yielding, but potential capital loss in the West, looks remarkably similar to the great bull trade in the European Union (EU) peripheral bond convergence of the 1990s.
This week’s latest announcements on the Chinese financial sector restructuring and development include suggestions that the renminbi (RMB) will be effectively convertible within the year and a removal of the old Loan to Deposit Ratio (LDR) for the banking sector. This was a relatively crude measure designed to stop the banks from over-expanding, but general consensus suggests that in fact, it is no longer needed and was acting as a potential constraint on growth. This is not the same as saying that its removal will stimulate growth however. Just as lower interest rates or injections of liquidity require credit expansion to turn them into economic activity, so it is with quota systems such as this. We doubt the removal of a cap will lead to reckless lending this time around. It should be seen on yet another twist of the Rubik’s cube on our way to the final liberalisation of China’s capital markets.
Elsewhere in the UK it was good to see a line finally being drawn under the banking crisis with the announcement of the sale of RBS shares. It was interesting to see that, according to Rothschild, the government has made a profit on the various stakes of around GBP 14 billion. This mainly comprises a GBP 5.3 billion profit on the stake in Lloyds Bank and a GBP 9.6 billion profit from loans held inside the state run ‘bad bank’. Rather like the US Federal Reserve, the loans bought in distress in 2008/9 were in distress because of the institutions that held them (in this case Northern Rock and Bradford & Bingley) rather than any problem with the loans themselves. Some might argue that this profit does not include the cost of funding the asset purchases however, which would be around 18 billion for the 107 billion invested on gilt rates of average 3%, according to the National Audit Office, but then nor does it include almost the same amount received in ‘lending fees’, nor the billions raised by the UK bank levy, originally (2010) set to target 2.5 billion a year, but recently upped to 5.3 billion. It won’t stop bankers being treated as pantomime villains by many, but hopefully it is a sign that some of us at least can move on.