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making sense of the narrative

Well that didn’t take long.

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Short term Uncertainty

Well that didn’t take long. At the start of the week we noted that the noise traders had been making one of their periodic forays  into equity markets and pointed to a number of ‘red flags’ suggesting that fear was turning to greed. Almost exactly on cue, Thursday saw a 6% drop in the S&P as the overstretched markets ran out of upward momentum and the traders jumped out rapidly as stops were triggered. Naturally the pundits explained it in terms of economic numbers and an uptick in virus numbers in certain US states, but in reality it was greed turning back to fear again – fear of losing the trading profit you had just accumulated. From a technical perspective, the S&P broke up through its long term trend at the end of last month, got itself 6 or 7% ahead of that in short order and has just returned back to almost exactly that level. There is an old saying of “don’t confuse brains and a bull market” that while more correctly applied to the longer term trends we discussed in WWW this week – the one big thing that is really driving your returns – is more frequently used in periods like the last month, when everyone is suddenly an investment genius. Until they are not. For a month ‘everyone’ was ‘not uncertain’ as Dollar Bill would say that the market could only go up and that they had a special insight. Now a sensible level of uncertainty has returned.

The next, likely, stage will be for the professional traders to see if they can squeeze the amateurs further. The hot stocks of the last month will now start to be shorted so expect the rhetoric to be ramped up too. Those employment numbers will be re-examined and found to not be as good as first thought, bad PMIs will be highlighted and so on. The glass will go back to being half empty. 

From our own analytical perspective, we note that globally the size and the value factor indices had a strong start to the month but are now fading somewhat, while the momentum factor is also strong in the US, but less so in Europe, probably explained by our earlier point on US day trading. Value and size (effectively small and mid cap) ETFs saw reasonable inflows, suggesting some asset allocation over and above the stock specific noise trading discussed earlier and the fact that the large amount of institutional and non speculative cash on the sidelines is starting to make its way back into equity markets. While the professional traders will be looking to shake out the amateurs over the next week or 10 days, for longer term investors this actually looks like a return to a buy the dips market. Bonds meanwhile saw a little bit of rebalancing in terms of price and flows, with High Yield bonds meeting quite solid long term resistance at the start of the week and producing some rotation into ‘safer’ areas such as TIPS and long bonds.

Medium Term Risks

We also feel that it is no coincidence that the level achieved at the end of May and again now, of around 3000 on the S&P500 is where the market had sensibly adjusted to in mid February, ie when the economic impact of Covid-19 was already being priced in to the cyclical stocks and those likely to suffer from an operationally geared downturn. We noted that with the arrival of all the day traders with their shiny new Robin Hood trading accounts that the markets were likely to get more volatile and so it has proved. While there are many other example, the two stocks we highlighted on Monday as evidence of a the noise trading bubble, Carnival and Boeing, were picked because both were stocks where the earnings had been downgraded and the risk premium escalated, rightly in our view, early in the wake of Covid. And yet, many day traders saw them as oversold and ‘value’, believing they had seen something the market had not. As we know, Liquidity can become self fulfilling and momentum began to run such that Carnival had more than doubled in the last 30 days – as had Boeing. Since Monday, the bubble has burst and Carnival is down 30% and Boeing down 27%. From our perspective there is little to show why the medium term earnings prospects of either of those companies (and of course many others) has actually improved.

The next phase for asset allocators and longer term investors remains trying to establish the real winners and losers from the current situation and also to remind ourselves of the broader environmental changes going on that have may have got lost in the noise. With the Fed having backstopped US corporate bonds and effectively underwritten the illiquidity risk of the alternatives markets, our biggest medium term risk concern now is geo-politics and Emerging Market Sovereign debts. In particular we need to be considering the news emerging from emerging markets that is not being given much prominence at the moment while all talk is on daily deaths from Covid and BLM. For example, in response to Covid, tens of millions of migrant workers in India have lost their jobs and effectively been forced from the cities and are having to quite literally walk home hundred of miles as all public transport has been shut down. There are some trains being put on, but scandals around the workers with no jobs and no money being forced to buy train tickets are emerging as are stories of freight trains running over and killing migrant workers sleeping on the train tracks. Meanwhile, in Africa there is the additional threat from the locust swarms we discussed recently and now they too are heading to India.

Don’t forget the locusts…..

Source FAO

India is not the only country with problems obviously, but perhaps is a little more pertinent given the renewed “India is the new China’ discussions, which are, as ever, as much about trying to dismiss China as about honestly assessing the potential of India to emerge from the (not even) middle Income trap. It may well be the case that US multinationals are looking to switch production from China to India – rather than bring anything back to the high cost US – which means watching beneficiaries in and around those goods and services (the English language has long been an advantage for US outsourcing of services). However, the concept of a booming India consumer remains as distant today as it was a decade ago. Meanwhile, the elevation of India to the status of new best friend of the US in the region is also likely connected to the recent rise in tensions on the India/China border which also need monitoring.

Elsewhere, another overlooked ‘story’ that is pushing to the fore is the events that have been taking place in the Lebanon, where following a corruption and banking scandal last year the banking system is now on the verge of total collapse. It’s no secret that Lebanon is basically a bank and thus the systematic risk is also something of an existential one. The currency is officially pegged to the US$ at 1500 which provided confidence for expats to repatriate $ and sterling which were then used to essentially finance the country. However, in recent months and following a scandal, the authorities have suspended access to these accounts and only started allowing small withdrawals at rates closer to the black market rate of 3500. In the last few days that has collapsed to nearer 6000 as a combination of uncertainty about government policy, including the fact that they could be abandoning the peg, the excess money printing to cover the budget deficit, uncertainty about new US sanctions on neighbouring Syria plus of course the economic impacts of Covid-19, have all combined in a perfect storm.

Long term Trends

We should not lose sight of the fact that the reality of the New Cold War between the US and China is that Made in China 2025 has highlighted how the US risks slipping behind its great new economic rival. For perspective, we should remember that as recently as 1980, the US economy was 15x the size of China and China had an income per head 60-70% below that of places like Kenya and Pakistan. Now, as previously noted, while India has closed all public transport, China has more km of high speed rail track than the rest of the world combined, it has more than half of the world’s fastest super-computers. China has also introduced the concept of ‘the China Price’; whatever China needed went up in price and whatever they manufactured went down in price. They have been the great disruptor and will continue to be so. Western economists struggle with this since most ‘normal’ emerging markets follow a cyclcial pattern of boom and bust but rarely actually emerge (eg India and most of Latin America) while western economies do little at all. Because of this, economic models and the narrative that go with them rarely need updating, but China is evolving so fast from an economic modelling perspective that perceptions – and models – are often lagging considerably.

In this context, there are a couple of interesting points on China it is worth revisiting in the light of the current propaganda barrage against China and the ongoing perception that the economy will collapse if the US stops trading with it. We have said this many (many) times, but it is perhaps worth repeating that this particular image is of a China from perhaps 15 years ago. If we were to list countries in descending order of exports of goods and services as a % of GDP, then out of 162 countries China would rank 138 at just 19.5% of GDP. Sure, both Japan (18.5%) and most notably the US at 12.2% are lower, but the Chinese level is down from 30% plus only 5 years ago – incidentally the sort of level where most of the EU countries currently still are.

The second key point is that should the US continue in its push for countries to be ‘with US or against us’, it will face some awkward moments given just how large a trading partner China is for most of the rest of the world. As this graphic from Visual Capitalist shows, China is the largest trading partner for 124 countries, the US for 56.

China is the world’s #1 trade partner

China trading partners outnumbers US by a factor of two

Image courtesy of: Connectography

This will present some challenges for US foreign policy if it tries to force its ‘allies’ to drop China. Europe and Germany in particular look likely to if anything become closer to China and Russia. Odds still favour an emergence of a Eurasian bloc and a bi or multi-polar world.

To conclude. Short term uncertainty is recovering to ‘normal’ levels as the momentum traders got hit with a reset this week and likely the professionals will try and squeeze the amateurs out a little more next week. Meanwhile as the noise from Covid dissipates and the distraction of a frothy equity market evaporates, the bad news lurking in emerging market economies will start to attract more (and deserved) attention.

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