Bedrock’s Newsletter for Friday 16th of August, 2019

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 Friday, 16th of August 2019

“Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice.”
– Adam Smith

 

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Panic has continued to spread through markets this week, sparking steep declines on all major indices and an extraordinary rally in safe haven assets such as US treasuries and, to a lesser extent, the Swiss Franc, the Yen and Gold. Since the start of August, a toxic cocktail of weak economic data, escalating US-China trade tensions, and political instability in Europe and Asia, together with paltry trading volumes on exchanges around the world has produced significant stock market volatility and a collapse of sovereign yields. The wild swings have struck fear into the hearts of some investors and convinced others that a global recession is imminent. Certainly, Western Europe is now teetering on the brink. This week Germany joined the UK in reporting negative GDP growth for the second quarter thanks to a pronounced slump in manufacturing (and without the excuse that ‘no deal’ Brexit stockpiling had merely shifted planned investments in working capital to Q1, at the expense of Q2). The inversion of the 2-year and 10-year yields on the US sovereign curve, widely-regarded as a harbinger of recession, has many investors expecting America to follow Europe’s lead.

 

But is the global economy really at risk of contracting in late 2019 or early 2020? Most US data suggests that weak external demand and an attendant decline in export orders and manufacturing surveys has yet to become a threat to jobs and the broader economy. Meanwhile, US consumer confidence is close to cycle highs, wage growth is supported by a healthy productivity expansion, and the services sector continues to perform in line with trend. Across much of the rest of the world the story is the same, with slower growth tied to the poisonous trade backdrop while domestic demand remains strong. In Japan, for example, which has long been a laggard and is highly vulnerable to deteriorating US-China trade relations, GDP still grew at +0.4% in Q2 as capital expenditures rose sharply and household spending jumped by the most in two years. In India (and in China if you believe the official figures), GDP continues to grow at >6%, while emerging powerhouse Indonesia is racing along at >5% despite its heavy focus on commodity exports to more developed Asian countries. Even in Europe, the gloom is largely confined to the Western countries, with most of the largest economies in Central and Eastern Europe including Poland, Romania, and Hungary growing at rates well above 4%. To be sure, Germany and other export-oriented economies have been savaged by the collapse of external demand and they have much to lose from tariffs already in place. In such countries, the recession in manufacturing is likely to bleed into other sectors and impact the aggregate economic prints so long as major global trade relationships are in jeopardy. In addition, China, which is significantly responsible for the softening of global demand, could yet face a more aggressive slowdown given the massive debt that looms over its transitioning economy and bloated heavy industries. Finally, there are a number of large emerging markets, such as Venezuela and Argentina, which are in total economic freefall with little hope of a recovery soon. Indeed, Argentina’s dire straits are about to get much worse: polls suggest that the left-wing Peronist challenger to market-friendly President Macri will sweep to victory in the October elections and then use that mandate to reverse his predecessor’s bold reforms. Nevertheless, these stark cases are outliers. There remains a much better fundamental picture than the bond market or media punditry would have you believe… just look at the positive spread of US numbers out today and yesterday, from retail sales to productivity growth.

 

Moreover, the yield curve contortions that have so frightened investors this week cannot be understood without reference to the unique monetary policy context in which we find ourselves. Since their inception after the 2008 Financial Crisis, the huge asset purchase programmes (i.e., QE) implemented by central banks around the world have weighed on the long-end of the US yield curve and have heavily distorted the global bond market. In the QE era, term and risk premia have been so compressed that the curve was naturally much flatter than it had been in the past, increasing the probability of an inversion if short-end rates ever rose off the floor. Today, the Fed is more hawkish than the market as a whole, keeping short-end rates higher than many believe they should be. Longer-dated bonds, meanwhile, have rallied sharply as pessimism has struck, with their yields collapsing in the process. (The 30-year yield dipped below 2% for the first time ever this week.) The result is that much of the curve has inverted, and people have begun to sweat. However, in this cycle, the 10-year yield has never come close to where it has previously peaked, barely scraping past 3% in 2018 before a wall of money pushed it lower. And with less far to fall, does the fall not mean less? Arguably, together with negative policy rates in Europe and Japan, QE has so trampled on the relationships between credit risk, duration and bond yields that the shape of the US yield curve has been rendered meaningless as a predictive instrument. ‘This time it’s different’ is a dangerous claim, but reason dictates that we look for evidence of an impending recession before we adopt the forecast – we are still waiting.

 

We believe that the biggest risk to the outlook is the stark geopolitical context and the risk that the US-China trade war deepens or ensnares more of the world in its chilling embrace. The latest news from the Trade War trenches came on Tuesday when President Trump back-pedalled on his decision of just two weeks ago to implement 10% tariffs on all Chinese imports not already subject to special measures from September 1. Instead, he now plans to delay implementation on certain goods until December 15 to avoid price rises on such things as smart phones and videogames before Christmas. This prompted a modest rally in the middle of the week, but China was unimpressed by the gesture and failed to make similar concessions on farm products, recently banned. Since then, the US President has tweeted some cheap flattery of Xi Jinping and offered to meet him in person to discuss the trade stand-off. Why Trump seems to think that pleasantries will encourage the implacable Chinese President to change his stance is bizarre. Lest we forget, while a young Donald socialised with wealthy friends in New York, Xi spent his early years digging ditches at a forced work camp in the Chinese countryside, his father having been purged, sister murdered, and home ransacked by student militants from a Party Xi would one day lead. We suspect that warm words alone won’t work. And the US-China trade dispute could yet escalate if negotiators fail to make progress when they meet for talks in September.

 

Another geopolitical accident waiting to happen is Hong Kong, where pro-democracy demonstrations have become increasingly disruptive. So far, the People’s Liberation Army (PLA) has stayed out of the matter militarily, preferring to leave it to local police to restore order. However, satellite images show that tanks and troops are amassing just across the border in Shenzhen and triad gangs linked to the mainland have carried out violent attacks on groups of protestors. Carrie Lam, the Beijing-friendly Chief Executive of Hong Kong, has warned that the demonstrators are pushing the island towards an ‘abyss’ without specifying what lies at the bottom. Chinese state media, meanwhile, is making direct threats of military intervention and portraying the protests as a violent rebellion inspired by foreign powers intent on dividing China. Despite all the rhetoric, however, the strategy appears to be one of intimidation – for now. The PLA would rather stay out of Hong Kong given the international backlash that would ensue if it were to intervene. Moreover, the ‘one country, two systems’ model under which Hong Kong is part of China but autonomous in key areas other than foreign and defence policy, is how Beijing wants to one day incorporate Taiwan. A military response to the protests in Hong Kong would wreck that plan and could create the conditions that lead to Taiwanese independence. China has pledged to invade Taiwan if it declares independence and this in turn would trigger a US military response under current treaty arrangements. That doomsday scenario is in no one’s interest. However, if the protests were to spread to the mainland or begin to threaten Chinese sovereignty in Hong Kong, China may well take the risk.