Friday, 5th of April 2019
“An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.”
– Evan Esar
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Markets were buoyed this week by positive economic data out of China. But leave the champagne in the fridge for now, this is likely to be a policy-driven bounce. On Monday, equities rallied after March PMI surveys for Chinese manufacturing and services showed that growth in both sectors had beat estimates by quite some margin. The reading for services was particularly strong at 54.4, but 50.8 for manufacturing was the best reading since July 2018 and is consistent with a return to growth for the sector after months of contraction. Although good headline figures, they are arguably the product of short-term stimulus measures taken to stabilise the economy rather than unambiguous evidence of a rebound in fundamentals. Since the end of last year, the People’s Bank of China has cut the Reserve Requirement Ratio (i.e., the minimum capital that commercial banks must hold in reserve rather than use for lending) five times, while the government has hugely front-loaded debt issuance (which always tends to pick up in Q1) with a flurry of approvals for infrastructure projects across the country. The result has been greater employment and output. However, with industrial profits falling 42% year-on-year through January and February this is not a definitive signal that capital is being allocated efficiently by businesses flush with opportunities. In the short-term, stimulus policies may be prudent to smooth the pathway for growth, but they are likely to be unsustainable if China wants to tackle its soaring corporate debts. One notable characteristic of the easing measures this time around is that they are being implemented through formal bank channels and not by allowing more off-balance sheet financing, an unregulated funding source that the government has rightly sought to clamp down on. This offers a ray of hope that China will be able to smooth the business cycle without resorting to high-risk methods in future. So too does the news last night that US and Chinese officials have edged that bit closer to an agreement to end the Trade War, perhaps by May. Nevertheless, we recommend patience before calling the bottom on the Chinese economic slowdown.
If China data is perhaps not what is seems, what next for emerging markets? Many are tied to China’s success, selling the Celestial Empire the raw materials and cheap manufactures once produced in the country’s interior. And if China gets worse before it gets better, South East Asia could well suffer. However, many emerging markets re-trenched and implemented painful structural reforms to pull themselves out of recession the last time China slowed meaningfully in 2015. Those companies that survived are battle-tested and likely to be much more resilient to slower growth today. Moreover, the Fed’s decision to pause further rate hikes will reduce some of the pressure on countries like Argentina that borrowed heavily in dollars when the mood was more positive without matching those liabilities with offsetting dollar assets. We still believe that the dollar, which is back at its highest level for the year, will appreciate further given the weighty interest rate differential with other DM currencies and the benign US outlook as compared to other regions. (Non-farm payrolls out this morning showed that the US added 196,000 jobs in March, beating estimates.) However, a wider differential through more rate hikes could have spurred the dollar faster and further, inflating dollar debts in vulnerable EMs. Instead, many countries are now in a position to cut rates and stimulate demand, having seen off inflation that built up last year; indeed, March was the second consecutive month which saw net cuts overall. There will always be outliers like Turkey, where the President is facing a tough re-election campaign and is relying on credit-fuelled growth to get him over the line come what may thereafter. But the overall picture gives us cause to be optimistic about, if selective in choosing, our EM equity and debt exposures.
When it comes to global equities as a whole, we continue to recommend a more defensive posture going into results season given the run-up year-to-date. After all, the S&P 500 has seen the best start to any year since 1998 and such moves tend not to repeat themselves in subsequent months. Notwithstanding that fact, we remain more bullish on the fundamentals for the US and EM than many of our industry comrades and see no imminent US recession, despite all the contortions of the US yield curve. The Fed has been much criticised for not feeding off the sour mood that developed last year, but they are right not to be guided by the weight of myopic pessimism that hangs around after a correction like that in Q4. The high rate of growth achieved in 2018 was always going to be temporary given the contribution of tax cuts passed in late 2017, and a decline to trend growth this year is nothing to fear. Moreover, Central Banks have itchy trigger fingers when it comes to flexing their monetary authority, and we expect both the ECB and Fed to operate as a backstop for global equities whenever data turns south. Thus, we are positive on the asset class but mindful of short-term volatility.
Last but not least, we turn to the spectacle of Brexit where the relentless procession of new ministers, arcane procedural debates, policy jargon, internecine warfare and general flailing have created a kind of carnival at Westminster, only without the positive atmosphere. Amid the noise and confusion, there have been a couple of important developments this week. Firstly, after her deal (or at least the Withdrawal Agreement bit) was voted down by MPs for the third time at the end of last week, PM May has decided to sit down with the opposition Labour Party in a bid to find a cross-party consensus on Brexit. Labour want the UK to stay in an EU Customs Union, enshrine EU labour and environmental standards in a treaty to prevent their erosion in future, and to have a confirmatory referendum to boot. All of these proposals breach the PM’s ‘red lines’ in negotiations with the EU, as well as manifesto commitments from the 2017 election, and many Tory MPs, from all tribes, are incensed with rage. Meanwhile, Labour is fighting its own civil war over the referendum proposal, which is seen as toxic in their Northern heartlands. The cross-party talks could be a genuine attempt to find a Brexit solution, but Mrs. May could also be using them as a way to apportion blame for a ‘no deal’ outcome when the two sides fail to compromise, as a final attempt to scare Tory Brexiteers into backing her deal, or simply because she has no idea what to do but needs time to think. The second piece of important news this week is that the UK has requested a further delay to Brexit, until 30 June. The EU has responded by offering a 12-month flexible extension (which the UK can leave early) if and only if the UK Parliament ratifies a deal before 12 April. We will soon know if that is even possible.
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