US economy

Picking sides is not ideal for investors

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Hope of an interim trade deal between the US and China is the latest carrot dangling for market sentiment ahead of negotiators starting two-days of talks in Washington.

FILE - In this Sept. 16, 2018, file photo, American flags are displayed together with Chinese flags on top of a trishaw in Beijing. China on Thursday, Oct. 18, 2018 criticized Washington’s decision to leave the United Nations treaty that regulates international postage that comes amid a worsening trade dispute between the world’s top two economies. (AP Photo/Andy Wong, File)
© AP

A proposal of greater purchases of US agricultural products by China represents an effort by Beijing’s lead trade negotiator, Vice-Premier Liu He, to delay American tariff increases scheduled to start on October 15.

That has duly tempered market angst after a bruising trading session for equities on Tuesday, but this misses a key point. Unless the US retreats from focusing on the issues of intellectual property and unfair subsidies, the latest tidings from China won’t secure even a “skinny” trade deal.

Beyond what does transpire on Friday, tension between the US and China shows little sign of abating. The bigger concern is one of further escalation, and also assessing the longer-term implications for financial markets and investors. Politics matters and is shaping the world economy and markets. A global split between the US and China in terms of supply chains is already under way.

Howard Wang at JPMorgan Asset Management says:

“Given the hardening in attitudes on both sides during this protracted trade dispute, we’ll likely continue to see China trying to self-develop links in what used to be global supply chains and US companies continuing to develop non-China supply chains.”

During the past 18 months relations across the Pacific have evolved from tit-for-tat tariffs and now revolve around technology and the extent of Chinese investment in the US. The next stage could well result in restrictions being placed on US capital flowing towards China or what some dub a “capital war”.

Oliver Jones at Capital Economics says at this stage (given China remains relatively closed to the global financial system) “neither the Chinese government nor the country’s corporate sector (except some major firms listed in the US) are especially reliant on US or other foreign investors for funding”.

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That leads to this conclusion:

“China’s mainland financial markets might be surprisingly well-insulated from any attempt at ‘financial decoupling’” and highlights that for Beijing’s policymakers, “the structural slowdown in its economy and the ongoing trade war remain far greater threats to them”.

Indeed, the pressure of cleaning up the legacy of China’s credit binge and a short-term hit to the economy from trade protectionism are considerable challenges.

Analysts at Société Générale warn “in the event of more than targeted [US] actions against specific firms”, they see negative implications for China’s stock market and Beijing’s efforts to reduce leverage within its financial system.

While SocGen is not alone among investors with a favourable long-term view on Chinese equities, the French bank says:

“At the core of our positive view on Chinese equities is our belief that the risk premium, still one of the highest in the world, is normalising and converging to global levels as the functioning of the market improves.”

The bank makes the following points about why the opening up of China’s equity market to the rest of the world matters for Beijing:

“China needs a steadily rising market to support its corporate debt deleveraging effort; foreign capital flows, which in onshore equities rose by 30 per cent a year in the last five years to $250bn, would collapse; equity risk premia, which have been compressing and converging to global levels in the last five years, would rise again.”

China is currently only slowly opening up its financial markets to foreign-based investors, which in turn reflects a gradual relaxation of capital controls. A US strike against this trend would resonate, but not necessarily derail China’s gradual and growing integration into the global financial system and its eventual importance for investors around the world.

Plenty of analysts view China as being well beyond the current broad stamp of emerging markets, with an economic and financial heft (the world’s second-largest equity and capital markets) that warrants being ranked in portfolios as a distinct asset class. Chinese equities are seen comprising almost half of the MSCI benchmark EM index, up from around 30 per cent at this stage.

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Aidan Yao and Shirley Shen at AXA Investment Advisors write there is “an increasingly compelling case to separate China from other EMs and manage it as a standalone asset class”. They cite the scale and depth of China’s markets, while also highlighting how the country “has a monetary policy more anchored around its domestic economy” and as a net importer of commodities, does not exhibit the same common business cycle for others in the EM club.

The current rivalry between Washington and Beijing does not entail investors picking sides. Both are too big to leave out of portfolios and represent important sources of investment returns and opportunities into the next decade and beyond.

Quick Hits — What’s on the markets radar

US high-yield bonds are cruising for a bruising if recession forecasts are vindicated.

Marty Fridson at Lehmann Livian Fridson Advisors notes:

“The present high-yield spread is woefully inadequate for the prevailing risk of recession, as estimated by economic forecasters.”

Marty pinpoints the hunt for yield by investment managers as a “likely cause of the present, nearly unprecedented gap between the high-yield market’s actual and required spreads”.

But there are signs of caution, when looking at the performance of the lowest-rated credits within the high yield market. In the past, strong periods of performance for high yield has been led by triple C rated and lower credits setting the pace.

At this stage in 2019, Marty notes “the year-to-date gap between triple C and lower, at 6.13 per cent, and the full ICE BAML US High Yield index, at 11.5 per cent, is unprecedented”.

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He reckons:

“Investors have been willing to chase yield, but only down to the single-B quality range. Investors are wary of potential defaults in the bottom-quality-tier, where defaults almost invariably occur.”

The latest Fed meeting minutes have been front run to some extent by chairman Jay Powell’s remarks on Tuesday, which signalled an expansion in the US central bank’s balance sheet. The Fed meeting minutes are also dated by the recent weakness seen in US survey-based measures such as the September ISM reports. The minutes released today did highlight concern for the US economy, but also provided little discussion about expanding the balance sheet or even introducing a standing repurchase facility.

Now that Mr Powell has opened the door to expanding the Fed’s balance sheet through the purchase of Treasury bills, so the prospect of future stress in the repo market should be lower.

Lou Crandall at Wrightson Icap notes “bill purchases will do more to relieve pressure at the front end than purchases in the coupon sector would”, but he adds:

“There is a limit to how many bills the Fed can purchase in the short run without creating significant market dislocations.”

Expanding balance sheets at the Fed and the European Central Bank from November will probably leave the currency market stuck in the middle, or the euro at around $1.10.

Analysts at TD Securities note:

“Based on the overall sizes of the Fed and ECB asset purchases, our initial take is that these two efforts should largely cancel each other out.”

But given the “eurozone’s deteriorating growth and inflation outlook”, TD expects “an eventual test of the crucial 1.0820/40 support zone in the weeks ahead”.

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