Looking for a few quick singles

Posted on October 1, 2015 by Greg

My family ticked one off the bucket list over the last week, we travelled to Beijing to visit the sites and walk the wall we had heard great things about. We managed to escape the smoke haze in Singapore that has been around far too long. As a friend of mine said yesterday, the haze is starting to get boring. Indeed the novelty has worn off. Beijing greeted us with its best APEC or Olympic Blue, at least for a few days before some drizzle.

I won’t attempt to claim any anecdotes on the state of the Chinese economy, a topic of much global discussion. I have visited Beijing a few times on business, but this was my first visit as a tourist. I will say that the traffic is just as bad as previous visits on those ring roads.

Before I went away, my mindset was getting more constructive for global markets. The Fed held fire, The ECB made dovish comments, Chinese President Xi Jinping was about to start a state visit to the USA, the Chinese Beige Book report emphasized the positive for the Chinese economy and Chinese property market data were also stronger, reported on Friday 18 Sep. In my previous blog post I noted that Australian could see a sustained confidence boost from the change of PM from Abbott to Turnbull. In deed I turned bullish anticipating a bounce in risk assets.

That proved to be completely wrong, global asset markets went into another spin, and I blame Volkswagen. Its revelations were a left field hit to the market generating considerable uncertainty for the broader auto industry, a major segment of consumer spending, employer and industrial metals intensive manufacturer. This may have long lasting repercussions for the auto industry, and it may energize retooling in the industry towards electric cars.

There were also some big losses in mining and steel sector shares around the same time. These problems may have more to do with the medium term weakness in Chinese and global activity coming to a head for some companies. Outokumpu, a Finnish steel company, on 22 Sep, warned that its Q4 deliveries would be down 10% from the previous quarter, driving its share price down 16% on the day and spreading the demise to global steel shares. Mining company Glencore shares also dropped sharply on the same day last week and experienced another beating on Monday this week; it has recovered in the last two days.

The bearish market action in the metals and mining sector was blamed mainly on China and yet another fall in the flash Chinese PMI reading produced by Markit, sponsored by Caixin, that fell to new low of 47.0 in Sep (reported on 23 Sep) from 47.3 in August, below market expectations at the time for an improvement to 47.5. That reading was revised up today from 47.0 to 47.3, helping stabilize market sentiment.

Overall global market sentiment remains fragile. The turmoil has been underway for some time now and the longer it takes for markets to settle into a stable period of recovery, the more the market frets that we face a more sustained bear market. The most recent bout of intense volatility has been frequently linked to the surprise 3% devaluation of the CNY on 10 August.

However, pockets of volatility have been developing and tripping other markets for the last year, catching investors unawares on several occasions; these include the fall in energy prices, the rise in German bond yields in April and June, and the Chinese equity market reversal that began in June.

An interesting article by Tony Crescenzi from PIMCO, called “In 2015, Volatility from a Phantom Rate Hike” discusses some of these events. The conclusion in this article is: “We believe the Fed as well as the rest of the world’s central banks are losing their grip on market prices and that markets are likely to remain volatile while they adjust for either the (slow) removal of crisis-era policies or the waning effectiveness of them. As central banks lose their grip, market prices will be on the move. Be alert and prepared to catch the movers!”

This is pretty bearish stuff and suggests that equities are unlikely to simply revert to steady recovery even if the Fed sits on its hands for a while, and it will distrust any recovery in asset markets driven by further quantitative policy easing that might arise from other central banks, such as the BoJ, ECB or Chinese government.

The IMF has certainly not been helping market sentiment tending to place more emphasis on the risks to its growth forecasts in recent years. The IMF and World Bank were discouraging the Fed from hiking rates over a month ago, suggesting this should be delayed until next year, even as the Fed appeared to gear up for a hike in September, and continues to predict a hike before year end.

In recent days, the IMF has released select chapters from its World Economic Outlook (WEO) and the Global Financial Stability Report (GFSR) prepared for the annual IMF and World Bank meeting that brings together Central Bank Governors and Ministers of Finance. This year the conference is to be held in Lima, Peru, October 9-11 (2015 Annual Meetings - Lima, Peru).

IMF Managing Director Christine Lagarde released a brief yesterday noting that “global growth will likely be weaker this year than last, with only a modest acceleration expected in 2016.”

The “good news,” Lagarde said, is a modest pick-up in advanced economies, but the “not-so-good news” is that emerging economies are likely to see their fifth consecutive year of declining rates of growth. “If we put all this together, we see global growth that is disappointing and uneven.”

Lagarde Calls for ‘Policy Upgrade’ to Combat Uncertain Global Outlook - IMF.org

Another theme unsettling market confidence is fear that liquidity in financial markets has been damaged by tougher regulations on and litigation against banks. In the wake of the 2008 global financial crisis, Eurozone crisis in 2010-12, LIBOR and FX fixing scandals, banks have been forced to exit many businesses, vastly cut back on their risk taking, and undertake a massive cultural shift that puts avoiding legal pitfalls above everything else to the point where most bankers are afraid of their own shadows. Throw into the mix that computer algorithms generate much of the daily turn-over, and even the most liquid markets may be vulnerable to the occasional flash crash.

The IMF and regulators have been warned by high level bankers of the dangers and are responding with their own research that admits some problems may now exist; although of course they are going to argue that increased regulation has improved global financial stability.

This was a theme explored by Federal Reserve Bank of New York President Dudley in his speech yesterday. He strongly argued in favour of the recent increased regulation, and thought the arguments that it may have reduced liquidity were “mixed, at best”. Nevertheless, he did note that “the FOMC's unconventional monetary policy may have affected recent measures of liquidity in ways that could make it more difficult to clearly discern any potential changes. To the extent that this may be the case, then a clearer picture on liquidity conditions may only emerge as monetary policy is normalized.”

Regulation and Liquidity Provision - William C. Dudley, President of the NY Fed - newyorkfed.org

I think the market is indeed holding its collective breath for how some markets that have been pumped up be QE, now respond when it is taken away. The corporate bond market in recent days appears quite vulnerable.

The IMF Global Financial Stability Report admits that, “Market participants in advanced and emerging market economies have become worried that both the level of market liquidity and its resilience may be declining, especially for bonds, and that as a result the risks associated with a liquidity shock may be rising.” Its report expresses more concern than Dudley.

Vulnerabilities, Legacies, and Policy Challenges, IMF GFSR October 2015 - imf.org

The divergence in the performance of high yield corporate bonds and US government bond exchange trade funds (ETFs) is at its widest since the 2008/09 global financial crisis and the same is true for an ETF dedicated the emerging market bonds. The risk premium in these markets appears quite significant indeed. These markets have been weakening since mid-year, reflecting concern over higher levels of corporate and emerging market leverage. Add in concern over market liquidity and it is hard to see a quick and sustained recovery in global risk appetite.

However, while we might expect a more turbulent atmosphere over the foreseeable future, it would be wrong to baton down the hatches and prepare for another global financial crisis. Global monetary policy is likely to remain extremely accommodative for a long time and even if its effectiveness may be waning, it will still tend to support global asset prices. After the recent period of weakness in global equity and higher risk bond markets, we need to consider the possibility of a period of recovery. Similarly, commodity assets and currencies have taken a considerable beating, we need to consider the argument that they have already adjusted for the new weaker environment.

Certainly it is the case, when most of the news and opinions you read are warning of more declines, then it is time to be wary of a period of correction. For instance, in Australia at the moment there are a number of positive developments that are being brushed under the carpet by most commentators fixated firmly on weaker commodity price trends. I am no longer keen to sell the AUD around 70 cents and it is looking pretty cheap vs several other major currencies.

The markets have been dragged into a more bearish mindset in the last week, but the economic data is many places is showing some improvement.

The recent Chinese indicators are mixed, and may be stabilizing. Consumer confidence rose for a fourth month in a row in September. Suggesting that the Chinese equity market rout is not having as big an impact on confidence as feared. The government sponsored PMIs data were better than the Markit Caixin sponsored versions. The manufacturing index rose from 49.7 to 49.8. The non-manufacturing index was steady at 53.4.

South Korea reported a solid uptick in its PMI from 47.9 to 49.2 in September, the third rise in a row. Korean exports, industrial production and cyclical indicators all improved in the latest data reported this week. Taiwan, which has been persistently weak, at least showed stabilization with an uptick in its PMI from 46.1 to 46.9.

The Japanese Tankan report also showed evidence of domestic economic strength. Even though the indices for large manufacturers, most exposed to global trade, edged down, as expected, the indices for non-manufacturers and small manufactures, more influenced by domestic activity, were better than expected. Furthermore, capital expenditure expectations were also firmer than expected rising to a high annual growth rate since 2006.

The improvement in these large industrialized Asian economies’ data will help alleviate fears of a faster slow-down in activity and demand in China.

Looking at Australia in particular, reading the number of fresh predictions about a rate cut, one might be surprised to learn that PMI data for manufacturing rose from 51.7 to 52.1 in September, delivering the highest three month average in this series since 2010. We await updates on the PMI for services in Australia next week, but this rose from 54.1 in July to 55.6 in August, and the construction PMI rebounded from 47.1 to 53.8 from July to August.

The improving trend in these data were consistent with the NAB business survey’s current conditions index that rose to 10.7 in August a high since October last year, despite the fact that the confidence survey was dampened by global market factors in July and August.

However, in the wake of the change on government leadership, it would not surprise to see business confidence bounce back in forthcoming surveys.

The case for a rate cut in Australia in some minds has been lifted by evidence that macroprudential persuasion may have contributed to cooling housing investor loan growth. Furthermore, many commentators are seeing a peak in housing prices after strong rises in the major cities in recent years. Strong demand for Australian housing from Chinese buyers may also be disrupted by Chinese government efforts to reduce capital outflow, and Australian government efforts to enforce foreign investment rules more stringently.

However, low interest rates are still a key driver of housing demand, and the RBA will still be reluctant to fuel excesses in the housing market by lowering rates yet further in pursuit of a weaker exchange rate. Evidence from the non-mining sectors suggests that the exchange rate is now weak enough to support growth. Credit growth for business is showing signs of steady improvement, running just under a 5% annual growth rate.

The RBA may retain an easing bias in upcoming meetings, but the recent trends in domestic activity suggest there is no rush to cut rates further. Considering the fact that the market is still pricing in one rate cut by March next year and the chance of another beyond that, the risk is that the market is surprised by a persistent improving trend in domestic activity in Australia.

While most opinions I have read in the last two days emphasize the risk of a rate cut and a lower AUD, one opinion that expressed a contrary view was from Philip Moffitt at Goldman Sachs Asset Management. I know Moffitt, he is a seasoned successful professional; he noted that the AUD is “struggling to go down” in an interview with the Australian Financial Review. He said that while he remains “cautious” he is increasing exposure incrementally in AUD, along with positions in emerging market sovereign bonds, such as Mexico and Brazil.

He said, “The Chinese economy’s weakening, we’d sign up to that, but it’s not weakening across the board, there are some parts that are actually doing quite well.”

He further said, “We did interpret that [Fed] decision in September as introducing something new, which was an eye on the markets and risk assets”… “The Fed’s now saying we’re actually looking at all those risk assets as a guide: That’s probably a nice window for those things to have a bit of a rally.”

Of the RBA’s rate outlook, Moffitt said “You’re quite likely, probably, to sit for quite a while if you can, particularly as though its looks like the housing market’s softening up, and just take your time to assess, unless your hands forced by some really weak data or some really low inflation indicators or something” … “Sit back and wait, I think that’s where we’re at now.”

Goldman's Philip Moffitt says $A set to rebound as China fears begin to wane - AFR.com

I can see a period of recovery in the AUD, on the basis that it has been showing resilience to the downside, despite a spike in global risk aversion in recent weeks. Chinese data is mixed and better than recent market commentators and global market reactions suggest. Australian economic data is better than commonly perceived and showing evidence that the currency is weak enough to generate a sustainable recovery. The new Federal government leadership is likely to further boost business confidence.

However, it is indeed a tricky environment and probably not a time to swing for the fences. But it is worth looking for a few quick singles.

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