We opened our March quarter Macro Overview with the following summary of issues that had led investors to return to a more cautious stance:
- rising interest rates in the US;
- the impact of China’s financial system reform on that country’s economy and on asset markets both inside and outside of China; and
- the potential for a trade war between the US and China.
Today, these issues continue to be at the forefront of investors’ minds, and continue to drive a growing risk aversion by investors globally. As such, it is worth returning to these issues, even at the risk of repeating oneself.
Any analysis of the impact of a “trade war” is far from straightforward. Modelling by various economists suggests that China may lose up to 0.5% in economic growth in the more extreme outcomes. This may sound dramatic, but for an economy growing at around 6% to 7%, the potential impact is limited. In assessing the prospects of any given company, this macroeconomic effect is largely irrelevant. However, the tariffs that are being applied to imports by the US and by their trading partners in response most certainly will impact product prices, demand, and ultimately profits, which will be felt not only by the companies facing tariffs, but potentially also by their customers. A Chinese manufacturer may be hurt, but so will be a US retailer who potentially has to increase prices on the products it’s selling. A US company now paying more for aluminium and steel faces a cost disadvantage against its competitors elsewhere in the world. US soybean farmers, whose production now attracts a tariff when sold to China, will most likely respond by selling their produce elsewhere, potentially suppressing prices for soybean growers in other countries. There will be many unintended consequences from the trade war. From the US perspective, one example is Harley-Davidson who have announced that they would move some production to Europe.
Exactly where the costs of these measures fall will become more apparent in the months ahead. Consumers will be paying higher prices for products, some companies will see an impact on their profitability and competitiveness, and jobs will be lost. Secondary effects such as the loss of business and lower consumer confidence impacting spending may also become apparent in the US and elsewhere. What is not clear though is how severe and widespread these impacts will be. Nevertheless, it will be an interesting test of the US administration’s resolve to maintain their trade policies once the costs are known. Changes to any system (for the better or worse) are usually very difficult to implement because entrenched interests are very effective at opposing them!
Last quarter we discussed the reforms in the Chinese financial system. To briefly recap, the regulator has required the banks to bring the assets and liabilities of the shadow banking system back onto their balance sheets. One of the goals in doing so is to ensure compliance with the lending restrictions that have been put in place. For example, following the GFC, regulators banned banks from lending to developers for land acquisition, but the shadow banking system provided a way around these rules. As the amount of loans a bank can issue is limited by its level of shareholders’ funds, bringing these “shadow” loans back onto the balance sheet reduces the banks’ capacity to issue additional loans, and some may even look to recover outstanding loans. As such, the availability of bank credit has been much reduced, and credit growth has fallen to just over 8%, a level much in line with the nominal growth of the economy.
While these reforms are undoubtedly a long-term positive for the Chinese financial system, the immediate question is whether this tightness in credit availability impacts the growth of the economy. Clearly, it has impacted the Chinese stock market, with the A share market down 22% from the highs reached in January, but indicators such as construction equipment, auto, and property sales still suggest robust levels of activity through to the end of May. Of course, the impact on the broader economy may yet become apparent, but policy makers in China certainly have the ability to respond if and when this happens. The People’s Bank of China (PBOC) cut reserve requirements for banks in June, which freed up their ability to lend, and further cuts can certainly be made, if necessary.
In the US, the Federal Reserve raised interest rates again this quarter. As we have noted numerous times in our reports, rising interest rates will eventually bring about a slowing in the economy and a fall in stock prices. The difficulty is assessing exactly at what point interest rates will have risen far enough for their impact to be felt. One indicator often used is the steepness of the yield curve. This refers to the difference in short-term and long-term interest rates. When short-term rates rise up towards the level of long-term rates, referred to as a flattening of the yield curve, it is usually indicative that the economy will soon start to slow. During the last quarter, the yield difference between the 10-year and 2-year US government bonds continued to narrow, reaching levels last experienced between 2005 and 2007.
The flattening of the yield curve certainly supports the view that we are starting to enter the final stages of the current US expansion. Nevertheless, for the moment, economic indicators in the US point to ongoing robust growth, undoubtedly buoyed by this year’s tax cuts. One should also expect that at some point President Trump will announce his infrastructure initiatives which would add further fuel to the economy and reinforce upward pressure on interest rates.
Fears around trade wars, tightening credit in China and rising rates have resulted in increased risk aversion and significant divergence in stock price performance over the last six months. Asian markets have been particularly weak with the China A share market down 22% from its high point earlier in the year, Japan down 10% and Korea down 11%. Emerging markets also performed poorly during this period. While the US market was flat over the last six months, within this market, performance varied dramatically across sectors with investors favouring a narrow group of growth stocks in the technology and biotech sectors while financial and industrial stocks generally performed poorly. While in aggregate the MSCI All Country World Net Index indicates that global stock markets are up slightly year to date in local currency (+0.8%), though down -0.4% in USD terms, this narrowing of markets where a smaller number of stocks are responsible for holding up returns is often a signal that higher interest rates may be starting to impact the markets.
The Chinese A share market, as noted above, has been particularly hard hit by the issues outlined in our commentary. Of particular concern for local investors in this market has been the tightness in credit availability as a result of the financial reforms. The topic has been part of daily news and commentary in China for the last six months and the fear has been well and truly expressed for some time, though it has only recently been reported in the foreign financial press. Similarly, given that China is the prime target of President Trump’s trade war and it has become clear that there wouldn’t be a negotiated outcome, the trade tension weighed heavily on the Chinese market towards the end of the quarter.
Currently the Shanghai A share index is back to the lows reached in January 2016. As you may recall, at that point the country had just been through a period of capital flight, heavy industry was plagued by excess capacity and many companies were loss making, and there loomed the possibility of non-performing loans triggering a banking crisis. Today, while the economy may be experiencing some slowdown as a result of changes in the financial system, supply side reforms have resolved the issue of excess capacity, profitability of heavy industry is much improved, and while the banking system is likely to have to work through some problem loans, the likelihood of a fully blown banking crisis is much lower. Risks have been reduced substantially, profits are higher, yet stock prices in aggregate are at the same level as they were two years ago. At an individual stock level, we see extraordinary value in a wide range of companies.
Of course, it is hard to know when these various fears will subside, allowing the market to move higher. One would expect the credit tightness created by the financial reforms to recede in time and it is likely that PBOC will take measures such as further cutting reserve requirements to ease the problem. The impact of tariffs at a company level should start to become obvious in the weeks ahead, although one can’t predict future moves by the US administration. Overall, a combination of negative sentiment and attractive valuations are indicative of strong future returns from this market in coming years.
In other markets such as Japan, the divergence between the most highly valued and the least valued stocks in the market is at a record level. Elsewhere, outside of the much loved high growth technology and biotech stocks we are finding companies at interesting valuations. All this, we believe, bodes well for future returns. However, it is possible that before these returns can materialise, we may first see a correction in the prices of the high flying stocks, potentially precipitated by rising US interest rates.
 Referencing respectively the CSI 300, TOPIX and KOSPI indices, from their respective peaks in January 2018 to 28 June 2018.
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