Australian Market Strategist
Summary: The gloves are off, and the US and China are in the ring punch for punch, from the trade war, to the tech war to now a currency war, this full-blown spat continues to drive a flight to safety.
The Trade war escalation has hit markets hard as the onshore and offshore Yuan punched through 7.0 for the first time in over a decade and in response the US Treasury moved to label China as a currency manipulator earlier today. Labelling China a currency manipulator is clearly retaliating to the Yuan breaching 7.0 and marks a rapid deterioration in relations but the actual impact is limited so the move is more for signal value. Ironically, if the PBOC let market forces determine the yuan’s level, it falls even faster, so the PBOC have actually been doing the opposite in limiting depreciation to date, but this point seems to have missed the US President.
Risk sentiment rebounded somewhat this afternoon as the PBOC delivered a stronger yuan fix and sold yuan bills in Hong Kong, signalling that the yuan is not a one-way bet. But we still haven't seen a real defence from the PBOC, squeezing the market as we know they can, suggesting that the current range is acceptable for policy makers.
For markets, which have run hard on the fumes of central bank stimulus, the news is ill-timed and ASX200 is reeling in the wake of the escalating trade tensions. The ASX200 having just hit a fresh record high, propelled higher to the tune of a dovish symphony from central banks around the globe, rather than a healthy economy and robust corporate earnings outlook as one might expect, was vulnerable to a retracement as we wrote last week.
As escalating trade tensions cause growth expectations to be altered lower, risk sentiment will remain fragile and volatility will likely persist, remember volatility is prone to cluster. The VIX curve is in backwardation and spot is 24.59, which is a short-term negative for equities. However, when volatility picks up larger trading ranges are driven by falling liquidity and the expansion in trading ranges is not only to the downside, but to the upside as well. So even falling markets tend to fierce upside rallies.
The implications of a permanent shift in the US/Chinese relationship are hard to fathom as globalisation has profoundly entwined supply chains, but investors should not dismiss the notion of a splintering US/China relationship and the effect this has on risk premiums. The impact on global growth will be pervasive, non-linear and lagging. Even if there is eventually a superficial deal on trade, which seems a long way off at this stage, the ongoing relationship between the and US/China will be fraught with difficulty, and any deal will only provide a temporary relief from long term tensions surrounding tech dominance and hegemony. And Europe could easily be next in the firing line, hence trade and protectionism will be a persistent theme of this US administration.
It is also important to note that the cyclical slowdown in global growth pre-dates the trade war and as trade tensions continue to escalate, financial conditions tighten, business confidence is dampened and supply chains are forced to unravel, dovish central bankers will not be enough to support growth. The bond market sniffed this growth slowdown out sometime ago, but equity markets continue to put unrelenting faith in the ability for central banks to pivot the cycle.
Equities have been priced for a perfect execution of FY2020 uplift in earnings growth and have largely ignored the deteriorating growth outlook to focus on central bank easing, with multiple expansion driving the year to date rally. Against the current economic backdrop with a myriad of factors weighing on revenue growth the v-shaped recovery in earnings growth through to FY2020 looks far too optimistic. Economic growth in Australia remains below trend, a manufacturing slowdown drags on global economy, global PMIs are in collapse and growth in both China and Europe is languishing with Germany teetering on the edge of recession. The latest trade war escalation has served as a reminder that stocks were priced for perfection, and deaf to the many omnipresent risks that remain, with valuations stretched relative to historical averages and growth continuing to slow, leaving very little margin for error. On that basis risk sentiment will remain fragile, equities can correct further, and bond yields will continue their fall. Thus, an element of caution is warranted in asset allocation decisions with defensive positioning and a focus on capital preservation likely to be rewarded.
Tech stocks are amongst the worst performers today, with the sector falling the most in 4 years. This sub-sector includes blue sky growth stocks, like Appen, Afterpay and Altium which have been bid up significantly year to date as bond yields have collapsed. A lower discount rate increases the present value of future cash flows, justifying higher valuations as interest rates fall, and fuelling multiple expansion driving gains to date. But these high growth cohort of stocks are hit hardest when volatility strikes as they are higher beta and lofty valuations leave no margin for error.
Gold miners are amongst the top performers as investors seek out safe havens to protect against volatility. Heightened geopolitical risks and a trade war escalation set to weigh on global growth increases the probability of an aggressive easing cycle from the US Fed, with a further rate cut set for September. This spurs demand from gold and dividend paying gold miners as a store of value in an environment of cheap money against a backdrop of the return of central bank largesse. Real rates also continue their collapse, which means that gold remains attractive.
The RBA also delivered their Monetary Policy decision today where as expected the cash rate was left unchanged at 1.00%. However, the RBA maintain an easing bias and we still maintain that the terminal rate for the RBA this cycle is likely to be sub 1% at 50BP by Q1 next year, but the risk is this comes sooner - end of 2019. There is sizable spare capacity remaining in the economy and it is likely labour demand will soften in coming months given persistent below trend growth, the external risks remain high and this will only add to the slowing growth environment. Labour market slack needs to be reduced substantially before wages, the largest component of household incomes, can rise and take the pressure off debt laden households. Unemployment at 5.24% remains well above the RBAs updated NAIRU estimate of 4.5%, thus preventing material upward pressure on wages and prices needed for the RBA to meet their inflation target. The RBA have outlined they will use monetary policy in order to achieve their objectives and the case for continued rate cuts remains.