Australian Market Strategist
Summary: The past 72 hours have left both financial markets and the global economy in a far more vulnerable position. Multiple geopolitical flashpoints have come to a head over the weekend just as the trade tensions ratcheted up another level in another tit for tat round of tariff increases from both the Chinese and US side. With each week that passes geopolitical ties fray further and the US and China move closer towards decoupling as Cold War 2.0 bubbles in the background.
From here, risk sentiment will continue to oscillate with trade headlines and growth concerns, thus volatility will remain heightened. It is important to remember that 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 can witness fierce upside rallies. A few positive trade headlines like a large soybean purchase from China, or a potential Fentanyl ban could see a wave of relief spread across risk assets and a pause in escalating tensions, but the true nature of the relationship between the US and China has fundamentally changed and even a trade deal will not solve for that problem. Continued deteriorating growth momentum across the globe, coupled with a fragile geopolitical environment could well be the straw that breaks the camel’s back and at some point, the markets and the real economy must converge.
This afternoon Chinese Vice Premier, Liu He, stated China opposes the escalation of the trade war and is willing to address trade disputes with the US via negotiations. These comments should be taken with a pinch of salt. China has consistently maintained the high road in terms of rhetoric, but the actions signal otherwise. Just look at the continued slow and steady CNY slide, CNY has depreciated 6.84% against the USD since February this year and the continued linear escalation of trade tensions with each round of tit for tat. The only certainty is that the disputes will drag on and uncertainty will continue to rise.
The geopolitical wall of worry is rising…
These events unfolding as global central bankers gathered at the annual Jackson Hole Economic Symposium and tipped their hats toward lasting trade tensions, a geopolitical recession and omnipresent mounting uncertainties as reasons behind the global slowdown and reasons why monetary policy tools will be inadequate in pivoting the economic cycle and arresting the current downturn. Policy rates fast approaching the zero-lower bound render monetary stimulus akin to feebly pushing on a string and there is little a lower cost of capital can do to pivot the economic cycle at this stage. The bigger picture? Central banks are out of ammo and monetary stimulus is ineffective for the structural challenge’s economies endure so governments must have realistic expectations about what central banks can achieve to stimulate the economy. Monetary policy will never replace sound economic policy. We need a real focus on pro-growth productivity reforms, infrastructure spending and other fiscal measures in order to reignite confidence and a self-sustaining recovery in economic growth. RBA governor, Philip Lowe, waxed lyrical about the inadequacies of monetary policy against a backdrop of heightened political risks and again echoed his prior sentiment that governments should play a far larger role in engendering a reacceleration in economic growth. Bank of England governor, Mark Carney, also opined about the potential for negative shocks to arise from economic policy uncertainty and warned that “blithe acceptance of the status quo is misguided,” as geopolitical fractures see a multipolar world replace globalisation. But perhaps more pertinently warned of a potential impending liquidity crisis and the end of the reign of king dollar as the world reserve currency. “In the longer term, we need to change the game,” Carney said. “When change comes, it shouldn’t be to swap one currency hegemon for another.” Whilst neither are wrong, the narrative was less than cheery, and only serves to add to the market’s woes as an irate President Trump, after announcing plans to raise all existing tariffs (prior and announced) by 5%, later in the weekend went on the confirm that he regrets not raising tariffs further.
The tensions in Hong Kong took a another turn for the worse as police fired water cannons and a Xinhua report stated the situation has now become a “color revolution”. Signalling Beijing’s patience is wearing thin and an intervention from China may be drawing closer. This would have huge implications on the world stage against an already fractious backdrop.
And as if this wasn’t enough for one weekend, the G-7 summit in France saw a continuation of the nascent geopolitical recession that has underpinned the wave of deglobalisation unfolding across developed nations. The playing field remains divided as the global order ails and we saw little progress on the EU/Iran/US rift. In keeping with the current trend, the agenda also failed to bring anything valuable to the table like a coordinated pro-growth policy response from global policymakers, productivity reforms, infrastructure spending and other fiscal stimulus aimed at instilling confidence and restoring growth momentum.
So, against this fragile backdrop it is easy to see why risk assets are being pummelled, with Asian indices down across the board, and safe havens bid with gold climbing to a fresh 6 year high. We see no reason to lean against the wind here and remain defensively positioned overweight haven currencies (Yen, Swiss Franc), gold, and treasuries as previously.
The most recent trade escalation increases the risk of recession on top of what is now a synchronised global slowdown. Growth is deteriorating and growth momentum is slowing, with monetary policy already at, below or approaching the zero bound there is very little central bankers can do to pivot the cycle.
The trade rhetoric is finally catching up to the true reality of the relationship. There is no deal and the China hawks within the US administration are in descent, President Trump seems determined to reset the relationship with China, rather than allowing them to buy their way out with large soybean purchases. But regardless, addressing the trade deficit is just a sideshow for the ongoing decoupling of the Chinese and US economies. We have always maintained that the tariffs and trade negotiations are just scratching the surface in a far deeper rift which is more akin to Cold War 2.0, and one that cannot be resolved in a “trade-deal”. This is a long-running economic conflict and battle for tech dominance and hegemony, and the gloves are now off. No economic tool will be off the table, as evidenced by the recent weaponizing of the CNY exchange rate by the PBOC and President Trump’s threat of invoking the 1977 Emergency Economic Powers Act to “order” US companies out of China. The threat of blocking market access will weigh greatly on investment and hiring decisions, only serving to add to the current environment where uncertainty prevails.
For investors the hope of a trade deal is entirely misplaced at present, and if there ever is one, which is getting more and more unlikely, it would be a superficial deal precipitated by a panic response from President Trump once the SP500 is trading a lot lower than present. Even then, the ongoing relationship would still be fraught with difficulty and the battle would rage on, so for businesses the outcome would likely be the same.
The uncertainty paralyses decision making for multinational companies, burdens capex intentions and forces supply chains to be unravelled in order to remove risk. Globalisation has created global networks and supply chains that are under assault as tensions ratchet higher, this dynamic is set to continue.
At present, Trump’s fallback position is berating the Fed into submission in the hope that an aggressive rate cutting cycle will bail him out of any negative economic consequences ensuing from the trade war. Wrong!
Zero interest rates now look like a conservative target
However, if Chairman Powell’s Jackson Hole speech and numerous academic papers legitimizing negative interest rates are anything to go by, Trump needn’t worry too much as zero interest rates now look like a conservative target (and by default a 10-year treasury yield at 0). Powell’s comments at Jackson Hole highlighted a number of factors that are key in forcing the Feds hand in adopting a full easing cycle. For one, global growth continues to slow and incoming data continues to deteriorate at an accelerating pace, trade uncertainty is rife and political risk is ubiquitous. These factors coupled with prolonged disinflationary pressures, exacerbated by negative producer prices in South Korea/China, falling commodity prices and a weaker Chinese Yuan, and a lower r* cements the view that the Fed are already well behind the curve and will continue cutting interest rates.
It’s the economy stupid …
As tempting as it is to blame our woes on President Trumps trade war, we can’t escape the cycle. At present the manufacturing and industrial sector are already in recession, not a single G7 economy has a Markit PMI above 51 and firms across the US, Europe and Asia Pacific have slowed business investment. Both as a cyclical downturn weighs and the uncertainty surrounding the trade war paralyses corporate investment and capex decisions. To date this slump has not yet fully permeated the services sector and private consumption which has been propping up the global expansion. Last week, the Markit US Services and Composite readings fell to a new low of 50.9, highlighting that the potential for recessionary dynamics in the manufacturing and industrial sector to permeate the services sector and knock on to the labour market and consumption is a very real risk. And one that policy makers must move to avoid as a hit to the labour market, private consumption and consequently consumer confidence would accelerate the end of the cycle and raise recession risk.
Key event risk
The daily Yuan fix will be acutely watched by trades as a barometer of risk and signal of China’s intent. Today’s fix outlined that the PBOC do not want to exacerbate volatility at present, if only for their own self-interest.
Whilst it is true that on the one hand China’s currency remains under fundamental pressure, depreciating as growth slows, monetary policy is eased, tariff measures impact and the trade war bites. And if CNY were floated the currency would be significantly higher today without PBOC intervention due to market pressures. On the other, the direct linkage between the USD/CNY breaching 7.00 for the first time since 2008 earlier this month and rekindled tensions has weaponized the currency. China can and will use the currency to mitigate the impact of tariffs on exporters.
Exchange rate stability will always be a key focus so as not to dent credibility, which would deter the long-term goal of internationalising the Yuan. Another hindrance to a significant CNY depreciation is the high levels of USD denominated debt held by Chinese corporates, Chinese property developers and other corporates who have international debt priced in dollars will struggle to foot the bill upon any significant devaluation as most of their earnings are CNY.
However, the signal of China’s intent is there, the Yuan is set for the second largest depreciation this month than any other since 1994 and has slid almost 7% since February this year. Chinese authorities have been allowing for more flexibility in the exchange rate and with further tariffs set to go ahead on September 1st it is likely the Yuan will continue to depreciate offsetting the fresh tariffs.
Life above 7 has just begun for the USDCNY pair. As long as the PBOC are comfortable the slow and steady depreciation can manage capital flight then they can allow the currency to gradually depreciate. Back of the envelope calculations suggest USDCNY will be headed upwards of 7.40 as the September and October round of increased levies comes into effect, if we assume the current level accounts for prior tariffs. And that is without accounting for potential non-linear impacts of accumulated tariffs and the hit to growth.
This will continue to weigh on the AUD and if the Yuan continues to slide in order to offset additional tariffs then Aussie, the trade wars whipping boy, will be well on its way to 65. In addition, last week’s minutes of the Reserve Bank Board meeting for August highlighted that the RBA are increasingly concerned about the deterioration in global growth and the mounting risks on the international front circling the Australian economy. These factors could be conducive in forcing the RBA’s hand to cut sooner than later, regardless of developments on the domestic front, which would also weigh on AUD.
Non-tariff retaliation measures from China are also a key risk from this point. China cannot match the US in dollar amount of imports to tariff so we could be looking at other non-tariff retaliatory measures from here. These include rare earth import restrictions, holding goods up in ports, license delays and stoking nationalistic sentiment to divert demand away from US goods.
Our view remains that until we see a more robust macro environment and confirmation of a self-sustaining re-acceleration in economic growth, we stay capital preservation mode with an underweight allocation to equities. We look to maintain exposure to low beta/minimum volatility and quality in terms of factor exposure as an indirect portfolio hedge, while staying clear of momentum and high beta factor exposure.
As we have said many times, the tariff impact on global growth will be pervasive, non-linear and lagging, yet equities have basked in complacency year to date. Placing infallible confidence in the hope of a trade deal and the ability for central banks to underpin earnings and pivot the economic cycle.
As previously identified, equities, faced with a deteriorating outlook for corporate earnings need continued valuation support from a prolonged easing cycle and a lower discount rate increasing the present value of expected future cash flows, justifying higher valuations as interest rates fall in order to cling to their complacent climb. US growth has peaked, the dollar remains strong (40% of SP500 companies generate a significant proportion of their earnings overseas) and the corresponding period last year represents a peak in earnings growth for SP500 companies that will make for some formidable base effects. On that basis consensus estimates remain too high on the outlook for earnings over the coming quarters, in fact we see risk of an earnings recession in the period ahead. Against the current economic backdrop with a myriad of factors weighing on revenue growth, the forecast v-shaped recovery in earnings growth through to FY2020 looks far too optimistic. In the near term, for equities to regain their highs the dovish rhetoric needs to be ramped up and a lot needs to go right on the trade front in order to fuel a continued complacent dash, otherwise a retest of June lows looks like the next move. To be clear, over the medium term as outlined above, risks to the bullish move we have seen off the December 2018 lows are rising, and current valuations are inconsistent with exhausted growth outlooks.
Precious metals and gold miners will continue to outperform as investors seek out safe havens to stave off volatility. Mounting geopolitical tensions and the return of central bank largesse eroding the purchasing power of currencies around the world combined with collapsing real rates remain supportive of gold. An ever-growing mountain of negative yielding debt and the premise of a Fed easing cycle together with the risk of renewed quantitative easing measures (QE) also continue to be key factors spurring demand for gold. For gold the party is just beginning, and we maintain a bullish outlook for gold, particularly AUD gold.
There is also no reason to lean against current bond market dynamics as yet, structurally the trend is in play and interest rates will remain lower for longer across developed nations. As a synchronised global slowdown takes effect and commodity prices roll over there is no reason that bond yields should be heading higher and there is a good chance the Fed must cut by more than the market is currently implying meaning treasury yields are heading lower over the coming months.