Australian Market Strategist
Summary: Risk assets have been struggling to decipher fact from noise amidst a barrage of contradictory tweets and phon(e)-y calls from the dependably mercurial President Trump. Competing themes have taken the stage each battling to dictate global risk sentiment. Without a circuit breaker there are a number of catalysts in play that could precipitate a correction in equity markets.
As we have said prior, without a circuit breaker there are a number of catalysts in play that could precipitate a correction in equity markets, with each disruptive tweet/trade escalation the marginal buyer becomes more scarce making it difficult for equities to trade materially higher. The 2H rebound which was promised by the bulls and touted as the justification for loading up on growth assets proves ever elusive, leaving markets vulnerable to a shake-up.
On one hand, the escalating trade tensions and downwards recalibration of growth expectations agitates, but on the other the perceived ability for central banks to step in and pivot the economic cycle placates.
While Trump has backtracked on his aggressive China trade rhetoric, that has not transpired to a backtrack from the planned tariff hikes starting September 1st. As we have said before, there is no deal at present and we need to tune out the noise/rhetoric and look at the path of continued escalation in actions. The planned tariff hike on October 1st, the 70th anniversary of the PRC, is something the Chinese are unlikely to look past so it will take a much larger olive branch from the US administration than just dialling down rhetoric to see a de-escalation before that date. For now, Trump has overplayed his hand and underestimated the capacity for China to dig their heels in rather than kowtow to US demands. China has the upper hand given Trumps poker face does little to conceal how unpalatable a pullback in the equity market is, which he views as a real time indicator of his success.
For more tactical traders reducing risk into this weekend seems like a prudent course of action. With the tariff hikes set to go into effect Sunday September 1st and the US Labor Day holiday September 2nd, we could see some wild moves as liquidity drops when traders take off on holidays. A number of longstanding risks, not just the trade war, also stand at crucial points just as we enter a thin trading period. BoJo (UK Prime Minister Boris Johnson) has gone rogue, waging constitutional warfare with the intent to prorogue parliament from 10th September to 14th October. This alongside another representation of ailing geopolitical architectures as the anti-government unrest in Hong Kong escalates and Carrie Lam considers all laws, including the Emergency Regulations Ordinance. Although the basis of this ordinance is an outdated reserve power created as a last scenario approach, if invoked the Hong Kong government have authority to seize property, cut out internet, deport or imprison people. It goes without saying that from a human rights perspective endorsing a state of tyranny would need some serious justification to satisfy public interest not just in Hong Kong but the world also. To make matters even more concerning reputable China watcher, Bill Bishop, has noted on twitter that whilst the PLA garrison in Hong Kong conducts 22nd routine rotation, “The Xinhua announcement of the 2018 Hong Kong PLA garrison troop rotation specified that the number of troops and equipment did not change. The 2019 one so far does not have that language”. Perhaps increasing the probability of intervention from mainland forces, which would no doubt set of a calamitous ripple effect with broad reaching ramifications. Meanwhile SCMP are reporting that the Hong Kong police will ban a protest March this weekend, a move that is only likely to add to the ire of protestors. All whilst USDCNY continues to track higher, maintaining a slow and steady depreciation of CNY, despite the fixings being stronger than expected. The yuan will weaken to offset tariffs and remains under fundamental market pressures. But what is worrying is the actual USDCNY exchange rate remains +800bps above fix. This decoupling of the USDCNY exchange rate from the fix is unsustainable, and without PBOC intervention there is risk of losing credibility of the fixing and inciting capital outflows.
The continued trade escalations heighten the risk of recession concurrent with what is now becoming a synchronized global slowdown, as growth almost everywhere is slowing. And the more obvious it becomes that global growth is deteriorating faster than consensus has expected whilst trade tensions ratchet higher, the greater the onus becomes for central banks to act aggressively, central banks are being held hostage by the markets. Even in the face of monetary policy impotence, where monetary stimulus is ineffective for the structural challenge’s economies endure. All the while trying to counter trade-related uncertainties that their tools are ill-equipped address. Never the less, try again they will, doing whatever they can in attempt to sustain expansion. Or, perhaps more truthfully, seized by the unknown and the financial markets wants, so commandeered into doing whatever they can, because doing something is better than nothing. And the alternative scenario of denying the markets the liquidity they demand and not engaging in stimulus measures could result in a worse outcome.
The overarching message from Jackson Hole that lower rates will not be sufficient to counteract global risks, and not only inefficient but worse may exacerbate structural problems, was lost amidst the noise of the trade war and equity markets certainly did not get the memo being quick to rally off the back off a supposed thawing in trade tensions. With the powers of unconventional monetary policy also expended and marred by undesirable side effects like exacerbating inequality and structural imbalances, it seems that central bankers, particularly throughout the developed world, have little place to turn. The warning from RBA governor Philip Lowe from Jackson Hole who said, “We can be confident that lower interest rates will push up asset prices, and I think that later on we will have problems because of that,” is illustrative of the aforementioned that policy may not only unsuccessful but also worsen conditions. As central banks grapple with this dynamic, a recalibration of monetary regimes is by no means a bad idea but whilst globalisation and international cooperation ails it is hard to see policy makers stepping up to the challenge and delivering the necessary reforms. Monetary policy will never replace sound economic policy as we lamented in our Q3 outlook, hence why the world needs real focus on pro-growth productivity reforms, infrastructure spending and other fiscal measures in order to address structural issues.
Even without the trade war we still have a slowing economic cycle to contend with, a strong USD (arguably more destructive) which will be a significant hinderance to any reflation thus forcing the Fed to cut deeper, and central banks, who by their own admission are sceptical about the ability for monetary policy alone to promote a self-sustaining recovery in economic growth. Bunds were not wrong about impending German recession; US treasuries are correct in highlighting US growth is deteriorating more rapidly than the equity market/consensus believes. When equity markets finally understand the entire picture, putting aside the enduring optimism that central banks can quell all ills, one senses that the recalibration across stock prices will not be for the faint hearted.
At present, we do not buy the détente between the US/China touted by the US administration and expect tensions to continue to escalate. Despite the alleged phone call, which shocked not one person more than China themselves, if we look to CNY’s continued slow but steady depreciation and China’s moves to lock in 2020 purchases of soybeans from South America, we can see a true read on China’s intent.
Without a circuit breaker there are a number of catalysts in play that could precipitate a correction in equity markets, with each disruptive tweet/trade escalation the marginal buyer becomes more scarce making it difficult for equities to trade materially higher. Risks are currently skewed to the downside. Lower interest rates have held up valuations but as growth momentum continues to wain and trade tensions remain, falling profits/margin degradation should begin to counter that dynamic as earnings are evaporated. We also see significant risk of an earnings recession in coming quarters. US growth has peaked, the dollar remains strong, and last year’s cycle peak in earnings growth make for some formidable base effects. Consensus estimates are too high on the outlook for earnings over the coming quarters against the current economic backdrop with several factors weighing on revenue growth, the forecast recovery in earnings growth through to FY2020 looks too optimistic. Once this dynamic catches up it will be very hard for equity markets to remain complacent and place unrelenting faith in central bankers abilities to underpin earnings.
Since last year we have recommended that investors will be rewarded for positioning cautiously and overweighting defensive sectors within equities, tilting towards low beta/minimum volatility, and quality. Whilst this positioning, which we again reiterated in our Q1 outlook, was somewhat left behind in Q1 of this year, we now stand vindicated with defensive subsectors of the market having significantly outperformed others. Our view remains that we stay with an underweight allocation to equities with a focus on diversification and hedging. We look to maintain exposure to equities but more defensively positioned across REITs/Utilities/Consumer Staples and in low beta/minimum volatility/quality in terms of factor exposure as an indirect portfolio hedge.
In other assets the picture painted above is in full view, treasuries are gaining across the curve as the bond rally endures unabated. We have now seen the 3m/10yr inversion ongoing for 3 months, we highlighted back in March when the 3m/10yr curve first inverted that typically, the magnitude of inversion preceding a recession needed to be deeper and more persistent. Historically when the 3m/10yr inverts for 3 months that has rendered 100% odds of recession, although sample size is small, we cannot ignore this indicator which is sending a very strong message that things are likely to get worse before they get better, and global growth is slowing significantly. This is just one of the many reasons the Fed will move to cut rates as the yield curve inversion which historically signals that the risk of a recession is increasing, is an indicator which the Fed must heed, even if not publicly. Structurally the move we have seen in bond markets is far from over as central banks will need to move and get ahead of the continued degradation in growth and bleed from recessionary dynamics in manufacturing through to services and the consumer.