Market Thinking November 2019
December 2, 2019
November saw a lot of book squaring which created some aggressive sideways trading before both bonds and equities resumed their bull trends. In politics, the theatrics of Impeachment and Brexit tended to overshadow the more meaningful events of the US Hong Kong Human Rights and Democracy Bill and the final green light for the Nordstream 2 gas pipeline from Russia direct to Germany. The former is a deliberate move in the new cold war between the US and China and will almost certainly accelerate efforts by China to break away from the $ trading system hegemony, efforts that will only be compounded by the latter moves which will place Russia, literally, as the power broker between Europe and Asia. Thirty years ago the fall of the Berlin Wall set in place strategic shifts that delivered the globalist driven, low inflation, stable growth environment that has created the Capital Markets we have grown used to. However, as we enter ‘the twenties’ there is set to be a new strategic shift, de-dollarisation and the (re)emergence of EurAsia as the world’s central economic zone. If we look around the process in well under way.
November is often a bit of a strange month for markets as for many international investors, particularly those in the US, books tend to be squared by the end of October and certainly by the Thanksgiving Holidays at the end of November. As such November can be a bit ‘choppy’ as profits are booked and/or risk reduction strategies mean that winners are sold and losers are put to ‘neutral’ position against benchmarks. Accordingly we need to be careful not to over-interpret November trade patterns as signalling anything profound about market direction. With that caveat, we note that both major bond and equities indices seem to be having a strong close to the year, the traditional Santa Claus rally, while the US dollar, having flirted with its long term moving average on the downside during the last few weeks of October and into early November took support, stabilised and rallied mildly higher. This mirrored the behaviour in the US fixed income markets, which traded aggressively sideways for much of the month to end in resumed uptrends, caught between the desire to take profits after a double digit year and the reality of few other places to store cash. Within equity markets, we like to look through the prism of the Factor indices (Value, size, etc) and note that the last three months has seen a welcome broadening out away from the previously dominant minimum volatility and momentum factors towards a more balanced mix including size, quality and value.
On the major crosses, Sterling, having been the big story in October, moving from 1.22 to almost 1.30 in a little under 10 days, and has consolidated just below the 1.30 level, while the Euro continues its long term downtrend against the $ and may even retest the end September low of 1.089. The Yen meanwhile, having been strong in the May through August period, has backed up towards the 110 level and from a chart perspective has broken its long term moving averages to head higher (weaker). It is currently sitting right at the 61.8% fibonacci retracement of that summer rally. The other major cross we need to consider is of course the Yuan, as measured by the offshore CNY, which dipped briefly below the psychologically important level of 7 against the $ in the first week of November only to settle a little above there now. This is important we believe, for while the political theatre of Brexit in Europe and Impeachment in the US continue, November marked a clear shift in the emerging Cold War between the US and China.
Strategic Shifts are happening if we care to look.
In particular the month has ended with the US passing the Hong Kong Human Rights and Democracy act 2019 which was given a veto proof majority by the House of Representatives and thus signed by President Trump, regardless of what it may or may not do to his attempts at securing a trade deal. The dramatic upsurge in telegenic violence in Hong Kong during the middle of the month ensured that every member of the House of Representatives bar one was not only alert to Hong Kong as a hot button issue but voted for the bill. The true significance of this bill is that it means that the US has given itself and its allies, including UK, Australia, Japan and South Korea, the ‘right’ to promote freedom and democracy in Hong Kong. At the same time the US has also granted itself the ‘right’ to sanction China and, crucially, to alter the independent trading status of Hong Kong if China does not perform in line with US expectations about human rights and democracy. In effect, the US would destroy the Hong Kong economy to ‘save it’. As we have noted before, previous countries who have run large trade surpluses with the US; Germany, Japan and South Korea have all been kept in line with the help of the knowledge that they are all (still) host to a standing US army. Obviously China is different and, as we have observed, tariffs are not really a very effective weapon when there is little competition, so that the majority of the tariff burden is borne by US consumers. Moreover, given China’s role as an assembler in many instances, other countries are suffering as part of complex global supply chains, meaning a tariff aimed at China has a lot of ‘collateral damage’. The ability to sanction China over Hong Kong is thus a powerful coercive weapon should the US decide to use it.
The SDR could hold the key to unlock capital markets
China of course is very unhappy about what it perceives to be foreign interference in its country and from an investment point of view this can only accelerate China’s efforts to separate from the US $ trading system. As previously discussed, China is increasingly looking to settle its oil and gas import bill in Rmb with the Gold Exchange in Shanghai offering the option of converting to gold (backed by almost $1trn of gold reserves in China). Meanwhile at the latest BRICS conference, Russia, also looking to de-dollarise, was actively discussing some form of stable crypto coin for trading between countries as part of an alternative to the US based SWIFT payments system. One point that we made in the blog during November was to follow up on a suggestion from two academics (Matthew Harrison and Gang Xiao) for the Journal of Risk and Financial Management earlier this year about the prospect of China unilaterally embracing the SDR as a form of international trading currency – a de facto internationalisation of the Rmb without the currency flight risk. China could also issue debt in SDRs and this could kick start a whole SDR infrastructure, reducing the world’s dependency on the $. Their suggestion that, in the first instance, this is done in a limited fashion in the Greater Bay Area and facilitated by Hong Kong not only makes sense, but in the light of this month’s events leads us to another thought; why not peg the Hong Kong $ to the SDR basket?
Thirty years ago this month the fall of the Berlin Wall triggered a huge strategic shift in economies and markets that few people recognised at the time. Not only was there a peace dividend, but also a huge boost to productivity as millions of highly trained but relatively low paid workers from Eastern Europe came into western economies. The arrival of China as a low cost manufacturer in 2001 and the emergence of global platform companies were further contributors that were not obvious at the time, as was the flood of yield seeking capital leaving Japan after the collapse of their equity market bubble. All this combined to produce not only higher growth, but also lower inflation, leading to the 30 year bull market we have seen in bonds – extended by a significant period by the quantitative easing and unconventional monetary policy that resulted from the GFC in 2008. For the last decade now, many have predicted the ending of this environment and yet it has continued. As such we are loath to be a stopped clock, but for the first time it looks to us like there may be something meaningful happening to change this environment. As such, if we look beyond the next three month or even twelve month period as we end ‘the teens’ and head to the ‘twenties’ we should note that the forces of de-dollarisation are accelerating. As well as being a reaction to geo-politics and sanctions we should also consider the decline of the petro-dollar effect. For all the noise on renewables, the cleanest fuel available in any material quantities at the moment is still natural gas and the fact is that Russia and central Asia are sitting on trillions of cubic feet of the stuff. With Nordstream 2 , Turkstream and the pipeline to China, Russia and central Asia will be supplying most of Europe’s and much of Asia with their energy. And they won’t want to be paid in dollars.
Asia becomes ‘the west’ and ‘the west’ becomes Japan
As we look into next year and the prospect of a US Presidential Election and a rebalancing of the EU, it is also worth considering these longer term trends and their likely impact on capital markets. Regardless of who is President or the details of Brexit, it looks impossible for western central banks to raise interest rates without destroying their own financial systems and crushing their consumers with their extended balance sheets. As such QE forever looms in the west. However, something like a de-facto internationalisation of the Rmb via SDR issuance would be a meaningful contribution to unblocking financial markets, allowing a more realistic pricing of international capital for the growing economies of the world and leaving the US, Europe and the UK as ultra low interest rate economies in the manner of Japan post 1990. Savings could once again be linked to investment.
Transition means volatility
Thus China, Russia and emerging Asia look to be in the position that ‘the west’ was in the early 1990s, with the west in the position of Japan. The SDR as a new ‘global currency basket’ and a means of exchange also offers the ability to raise capital with less single currency risk than the previous $ regime, while the new technologies of blockchain offer the opportunity of a stable crypto exchange mechanism to match/supplant SWIFT. If, as we have suggested, the Chinese link the HK$ to the SDR, then it may well be more stable in the long run, but obviously anyone using the HK$ as a direct proxy for the $ will need to rebalance. As to what it means for the $, well to us at least it means volatility – certainly in FX, but probably everywhere – for as we also noted in the blog this month, the post QE world has led to unhedged $ carry trades everywhere and even though many have unwound, there are still pockets such as Taiwanese Formosa ETFs that are running unhedged carry positions.
If we take the Japanese Yen as an example – relevant to this discussion – from the Plaza Accord to end 1998 it rallied 40% to reach 120 against the $. In the following 18 months it sold off 30%, then the five year period after that it rallied a further 50%, ultimately reaching a high of 80 to the $ in 1995, before selling off again by a further 80%. By the end of the decade, January 1989 to January 1999, the Yen $ rate was essentially unchanged at 120, having been as high as 160 and as low as 80 over that period, a 40 Yen band. More recently, If we exclude the period around the financial crisis, the last 20 years has broadly seen the Yen trade in a 15 Yen range either side of 115 and the last 3 years a 5 Yen range either side of 110. For what it is worth, 6 month implied volatility in $ Yen is now at 5.8%, an all time low.
The volatility in the Yen back then was at least in part because of all the unhedged carry trades – borrow cheaply in Yen at the short end, invest in overseas assets at the long end. It was the unwind of those trades that produced the seemingly counter-intuitive strength of the Yen in the first half of the 1990s. A similar unwind of US $ carry trades may well have been partially behind the 25% rally in the DXY that has taken place over the last 5 years, particularly in 2014/15, when Emerging Market volatility was 10-15% points higher than the Vix. This is not to say that the $ will now crash 80% like the Yen did, rather that few at the time saw the five year rally in the Yen reversing the way it did. Yield hungry US and European investors chasing higher, SDR pegged, yields in Asia could easily be a phenomenon over the next 5 years.
Bottom line. As we close out books for 2019 and look forward to ‘the twenties’, we should recognise that while existing market trends will not suddenly reverse in the first few months of a new decade, there are signs of a long term shift away from the $ based capital markets we have grown used to. With the emerging concept of EurAsia accounting for over 70% of the world’s population, 75% of the worlds known resources and 70% of GDP, the fact that the countries in this bloc increasingly want an alternative to the US$ is only going to intensify. Capital markets are politically neutral, they will adjust. Investors need to follow suit.