Summary. The markets began the year anticipating uncertainty falling in the UK and Asia, thanks to Brexit and trade talks finally making progress, with the anticipated rise in uncertainty being focused around US politics and domestic policy reactions in an Election year. That didn’t last long. Having been knocked off balance by an escalation in Middle East tension at the start of the month, the emergence of a SARS like virus in China mid month has dominated events since. Markets have nevertheless followed relatively standard protocol for a spike in uncertainty; leverage has been taken down, asset allocation has reverted to benchmark – as have geographic and sector allocations and high beta and cyclical positions pulled back or cut entirely. In factor terms, the rotation towards value and small mid cap that was running in q4 has been reversed, while geographically the anticipated shift to Asia has been postponed if not altogether cancelled. Traders have since been pushing a narrative of economic decline based on rough estimates from SARS, but while there is an undoubted threat at the micro level to businesses with balance sheets unable to withstand a pause in economic growth, in macro terms this is likely to be a pause not a collapse. As such, there will be opportunities to pick up strong companies at attractive valuations in the near future. Our medium term risk concerns and longer term thematic trends remain the same as a month ago, but for now this virus related uncertainty dominates. As such we are watching two areas; first, the appearance of decline in the rate of growth of new cases of the virus and second, how the markets respond to this. Avoiding distressed selling remains an important discipline when trying to buy into oversold markets.
The monthly Market Thinking is intended as a longer form piece that brings together the messages from the blog posts over the previous month and puts them in more of an investment strategy context. For a variety of reasons, blogging was light in January, which makes this more of a stand alone piece. Hopefully service will return to normal for February which will enable us to be more timely on observations around both the virus and markets. The blog now has a (free) subscription button for email notifications.
The framework that we like to use for the monthly is based around short term uncertainty, medium term risks and longer term trends and obviously given the time frame the former tends to dominate the other two for the purposes of Market Thinking monthlies. We began the month, year and decade with a broad expectation that uncertainty was falling in the UK and Asia thanks to finally achieving Brexit and some resolution of US/Chinese trade tensions, while it was rising in the US due to the Presidential Election year and increased uncertainty over US domestic policy. However, the markets were almost immediately bounced into a new uncertainty trade as the US dramatically upped the tensions with Iran with a targeted assassination of a senior Iranian general that also killed a senior Iraqi general. Traders bought oil and gold and sold cyclical stocks, only to decide several days later that nothing much was going to come of this and take off most of the trades.
They didn’t have to wait long for another bout of uncertainty to trade, this time in the form of a SARS like virus originating in China. This Coronavirus is a different level of uncertainty to geo-politics and unsurprisingly markets have taken greater notice, unwinding any of the New Year gains across Asian markets and retreating to neutral positioning. This is a standard playbook for medium term asset allocators facing increased uncertainty; take down leverage and pull back to benchmark positions. The next stage for markets is for the shorter term traders to try and ‘trade’ the uncertainty. As we noted in the blog, far from hating uncertainty, for short term traders it is their basic raison d’etre, to help the asset allocators reduce their perceived risk in the light of rising uncertainty. The traders are the ones that then form the narrative. In this case it is that, as we saw with SARS, the impact of the CoronaVirus will be on certain stocks and sectors and as such they ‘offer’ the opportunity for asset allocators to put on some active positions. These would include, selling trade and travel related stocks, cyclicals such as Oil and energy and buying healthcare stocks. As an example, a trade buying Ping An Healthcare funded by going short the XLE ETF of US energy stocks would have returned 35% over the last month. This is not a hindsight portfolio trade, rather it is to add the caveat that this particular pair returned 30% over one week between the 15th and the 22nd of January and has since gone sideways. Traders invested in the pandemic narrative in the fashion naturally have an incentive to drive the noise to enable them to get out of the trade and as such we need to be careful of the ‘newsflow’. History tells us that abandoning long term or even medium term strategies to chase short term narrative trades is highly dangerous for most portfolios.
What we do know is that the uncertainty premium will remain high until the rate of growth of new cases starts to slow and the virus is seen to be under control. There are in fact tentative signs that this is starting to happen, but for now we wait. The fact that Wuhan, where the virus started, is a central railway hub for China and that over 400m people travel at Lunar New Year, mostly by train and with many connecting through Wuhan makes this extremely complex. As such the response to date, where most markets have retreated to their long term supports seems appropriate, until we get some clear new information beyond speculative trading. In the meantime, following the principle that to a man with a hammer everything looks like a nail, bond bulls are highlighting safe havens and suggesting that the Fed will now cut interest rates due to the virus while Gold, which remains in a positive uptrend has profited from both bouts of uncertainty. The dollar, which was looking very weak from a technical point of view at the start of the year has rallied sufficiently on a flight to safety argument to ease some concerns about its potential impact on unhedged carry trades.
The crisis means that the market’s schizophrenic love hate relationship with China continues. As I noted at a speech in Australia this time last year, the markets have spent the last 5 years getting China completely backwards; at the start of 2015, they loved it and it subsequently boomed then crashed. In 2016 therefore, bruised from the previous six months they hated it and it promptly rose sharply. Loving the market going into 2017, they subsequently ran for cover when the trade war started, only to see China rise dramatically throughout the year such that it was everyone’s favourite market going into 2018 when the trade war re-emerged as an issue and it subsequently fell sharply. Undeterred the markets went into 2019 hating China, only to see it as one of the best performing markets in the world last year.
A contrarian then would by now be thinking that the best thing to do is to shun the crowd and avoid China for 2020 and certainly that would have paid off year to date thanks to Coronavirus. Since the China markets re-opened, they are down 10% or more. However, while not rushing to buy just yet, it is worth considering that this could be similar to 2017, where love turning to hate presented a value buying opportunity. We shall be watching, as noted, both the rate of change of infections and the response of markets to the new information.
As it currently stands, around two thirds of the Chinese economy is ‘closed’, which from a market perspective means that the high frequency data traders will find their normal activities disrupted – although to be honest a few months break from over-obsessing with PMI data would be no bad thing. The narrative that China is collapsing because its GDP growth falls from four times that of Europe to only two and a half or three times was dubious analysis at the best of times and putting an economy ‘on hold’ simply leads to a rebound at some point. Think 2008/9. The long term trends in China will not be much disrupted by this.
However, while GDP data will rebound at some point, we do need to be wary of serious, even irreparable, damage being done at the corporate level, particularly in Hong Kong, where business was already struggling thanks to last year’s protests. The dependency on the mainland for a number of sectors and companies has tended to be played down in the last few years, but the travel ban is making itself felt, for example retail in general and Luxury goods in particular are suffering badly and strong balance sheets are needed to survive. Less obviously, companies previously benefitting from insurance sales to the mainland have been hard hit. The market has already taken down many of the affected share prices quite heavily, also travel and gaming stocks. If well capitalised there could be some value opportunity appearing soon. Similarly for mining and minerals stocks, hit hard on a ‘collapsing growth’ story, there could be some opportunities, especially where there are strong balance sheets and good dividends available.
Beyond this short term uncertainty, our medium term risk concerns remain principally around alternative markets and any resumption of dollar weakness and issues around liquidity. The China IPO market has, understandably, also been put on hold due to the virus, but there were already signs last year that the production line everywhere between Venture Capital, private equity, private credit and IPO into public markets had ceased to function properly. At least as far as VC and PE continuing to extract vast amounts of economic rent goes. We would also remind ourselves of our principal source of expected uncertainty this year – US politics. The upcoming Iowa Caucus will be a key test – especially if Bernie Sanders wins – and we would also caution that impeachment proceedings aside, there is every chance that President Trump could embrace some of the big business bashing rhetoric of Sanders and Warren, especially if he thinks Biden will win the Democratic nomination.
In terms of longer term trends, the pre-occupation of the governing (and chattering) classes remains climate change and in the markets that translates to ESG. As noted before, while the science remains far from settled, the politics basically is and before the CoronaVirus took over the media agenda was all about ‘Carbon’. The annual Davos convention of the self anointed great and the good of globalisation was already playing down the conspicuous consumption and private jet usage before the virus and while its immediacy disrupted their pronouncements on the urgency to do something on a fifty-year timeline, this is their clear direction of travel. The globalists were also somewhat knocked back by the IMF predictions that the UK would be among the fastest growing economies in the west this year ‘despite Brexit’, something value investors will be considering closely as post Brexit Britain announces policies over the next 12 months. One aspect that may enhance the growth difference between the Uk and Europe is the exclusion for the UK from the ‘Green Deal’ just announced by the European Parliament. This involves spending over 100bn Euros to ‘encourage’ sustainability and renewables and a clear push to kill off coal, and ultimately gas. While this may benefit the Green Industrial Complex and related stocks, the implied greater concentration of power, increased regulation and higher input costs have, to our understanding, never produced economic growth. More worrying is the increased centralisation of capital allocation, essentially away from investors to politicians and lobby groups.
Finally, a short section on some of the things that could matter but probably slipped under the radar. First, the US is under increasing pressure to pull its troops out of the middle east post the assassination of the Iranian and Iraqi general, but worth noting what has been happening in Afghanistan. According to defence specialist Jane’s https://www.janes.com/article/93916/us-records-highest-airstrike-rate-in-afghanistan-for-a-decade last year saw the highest number of US airstrikes in a decade, at 7,423 missions, up slightly on 2018, but massively higher than in 2015, the year after the war officially ended, when the figure was ‘only’ 947. We spotted this in the light of an erroneous report of a passenger jet coming down in Afghanistan in late January. It turns out it was a US military jet providing sophisticated communications to ground troops and was apparently shot down at high altitude by the Taliban. There are further suggestions it included the CIA’s top man in the region. In addition there are reports of a number of US helicopters being downed, reminiscent of the shift in fortunes that enabled the Afghans to drive the Russians out previously. If, as this suggests, the Taliban have access to sophisticated surface to air missiles, then Afghanistan could emerge as a black swan topic in the US Presidential Election. Meanwhile, there are also some suggestions that the Houthis have attacked Aramco installations again.
Second, also in the Middle East, there has been a largely unremarked upon banking crisis in the Lebanon over the last few months. In order to attract enough $ to fund its massive trade deficit, Lebanon had been offering high rates of interest, particularly to its overseas diaspora. A financial scandal and an ensuing shortage of $s has triggered mass protests and a collapse in the currency. Still officially pegged at 1507 to the $, black market rates are nearer 2500. In mid January a new cabinet was announced and there remains serious concern about sovereign defaults and a bail out.
Third, while the world looks at fires in Australia and pestilence in China, we have the worst swarms of Locusts (another of the seven plagues of Egypt) in over 70 years hitting East Africa and particularly Kenya and Ethiopia, where the mass of insects is now so large it has been compared to the city of Moscow. After years of drought, last year was exceptionally wet, producing ideal conditions and the swarms are migrating north in search of food. The Food and Agriculture Organisation at the UN are highlighting the serious threat to regional food supplies.
Overall not the cheeriest of starts to the decade, but as the Chinese say “May you live in interesting times”!
