Looking into the next decade we see some short term uncertainties, some near term risks and some long term trends.
Short term uncertainties. Falling in Europe and Asia, rising in US
The close of the twenty teens has seen some reduction in uncertainty, in particular around the UK leaving the EU, which is now as close to a certainty as we can expect. The first quarter in Europe will accordingly be about putting some detail to the actual arrangements rather than wondering if it will actually happen. Things look like finally settling down. Sterling has rallied back to the middle of its 3 year range and is likely to give up the mantle of the big speculative currency.
The biggest uncertainty for the quarter is then likely to be in the US where the process of choosing the Democratic Candidate is underway. The risk to markets of Elizabeth Warren as a candidate is that she has a radical anti Wall Street agenda, notably her call to ban fracking on day 1 of her Presidency would devastate the high yield bond markets in particular and seriously damage the competitive position of much of US industry in general. Bernie Saunders would require a similar risk premium. Perhaps more interesting to see will be the extent to which Donald Trump chooses to steal Democrat policies. After all he is know to be against Private Equity carried interest, high drugs prices and a number of other hot button issues. The fact that all candidates for President are railing against crony capitalism is something that should not be overlooked and is definitely an emerging trend suggesting that investors look to diversify outside of the US. To the extent that uncertainty tends to be traded by FX markets more than others, this suggests a pick up in $ volatility is likely.
In Asia, the first quarter is likely to be about reducing uncertainty over the trade issues. Ahead of the US Election, there are likely to be some settlements on Trade War 1 – the tariff war between the US and China (and everyone else to be fair). Trade War 2 however, which is the New Cold War between the US and China is likely to remain a near term risk for companies. A general Election in Taiwan in January means the anti China rhetoric will likely subside thereafter having served its purpose in getting President Tsai re-elected if the polls are anything to go by. Ironically if that, and a trade deal, boost the Taiwan $, that could cause some problems for the Taiwanese insurers, many of whom are currently running unhedged US$ investments. Meanwhile in Hong Kong, we would expect the mainland to grant universal suffrage for the LegCo elections next September, reducing the level of internal protests as well as denying the US any leverage under its new Hong Kong Human Rights and Democracy Bill.
Near Term Risks. Growth in Illiquidity and Leverage needs to be slowed and steadily unwound. The cult of ‘alternatives’ is dangerous for institutional investors.
The developed markets remain stuck in QE forever mode, with over-extended financial sector balance sheets unable to cope with higher short term interest rates. Inflation does not seem to be a threat, but rates are too low for efficient capital allocation. This requires extra vigilance on behalf of central banks as disruption from liquidity events is the biggest near term risk. The markets had a scare in q4 when the Fed appeared to lose control of the Repo markets, but now, like the ECB, the Fed will simply do ‘whatever it takes’ to ensure stability here. The biggest near term risk from market mechanics in our view is, as always, a duration mis-match; illiquid assets and liquid liabilities. The chase for a so called liquidity premium has driven large flows (once again) into assets deemed to be low risk on account of untested volatility and infrequent mark to market. Institutional investors have once again been gaming the system by allocating based on rules and capital requirements rather than common sense. There is in excess of $100bn to be allocated this year by VCs looking for the next unicorn to be sold on to mop up some of the $1trn in dry powder currently sat with PE funds, who in turn are increasingly looking to offload not to the IPO market, but rather to other PE funds looking to start the clock running on their dry powder. Meanwhile, in listed markets, investors are rightly shy of issues like weWork but are stuck with CEOs who continue to raise debt to buy back their own equity – many of them issuing more equity to themselves at the same time.
All of this suggests a bottom up focus and due diligence for targeted portfolios, limited leverage, strong cash flow and a focus on dividends rather than buy backs. Business to Consumer (B toC) looks better in many ways that a lot of B to B to C which is dependent on all the private market financing. With Asia having the world’s biggest and fastest growing consumer market it makes sense to diversify here.
Long term trends. US slows and becomes like Japan, Europe restructures and becomes like China. Asia continues to grow and becomes like post USSR West. ESG and Green become the transmission mechanism.
The fragility of western financial sector balance sheets requires monetary authorities to work on limiting their expansion, particularly in leveraged carry trades. As such, existing leveraged strategies will be discouraged from expanding if not directly shrunk. Pension funds and insurance companies still need to find yield however and it may be that the combination of greater public sector expenditure on infrastructure and a desire for ‘green’ investments can combine to square this particular circle.
To this point we would suggest that Europe, now ex UK, will start to become more like China, developing a ‘Made in Europe 2025’ type strategy as well as a variation on One Belt One Road in terms of rolling out high speed rail, smart grid networks and other infrastructure that not only connects the European continent to itself, but also to central Asai and the Far East. This can all be funded with Green Infrastructure bonds, underwritten by the EU and perhaps some of it available to retail investors only to support savings stick with negative yields. Meanwhile as Europe lowers its carbon footprint through natural gas, the importance of electric vehicles will continue to grow and the EU will likely boost European battery production as this is now 40% of the value of an EV. European car makers will rapidly embrace EV generally, particularly for urban environments. Similarly, with the New Cold War with China unlikely to diminish any time soon, the Europeans will be developing their own 5G champions to rival Huawei. With a new focus on directing strategic policy, the EU can have a role in unifying the EU than transcends populism.
In Asia we would also point to the suggestion that China embrace the SDR as a means of starting to internationalise its currency without risking capital flight. Allowing corporates and local governments to issue offshore bonds in SDR – perhaps limited to the greater bay area in the first instance – would provide a new role for Hong Kong as issuer, reduce the dependency on the US$, but without appearing to try and usurp it and allow a new ‘currency’ for the world to use to trade with China. China is big enough to kick start an SDR infrastructure and the notion of a crypto SDR ‘coin’ to settle transactions would be a massive boost for fintech, settlements and payments. In a way the SDR could do for Asia what the Euro did for the EU post the collapse of the Soviet Union. One early indicator would be if Hong Kong announced a peg to the SDR.
