Watch out for the rise!

Sorry if you thought we mean stockmarkets rising.  We don’t.  We mean liquidity.  Here end-June data from our friends at CrossBorder Capital is showing a significant jump, much in line with our predictions over the last few months.  It’s happening where investors aren’t looking – in Asia and the private sector.  In Asia, the PBoC has clearly taken its feet off the brakes again, perhaps in consequence of the slowing economy as per yesterday's headline.  There’s a sub-theme we’ve mentioned before here too – the Bank of Japan seems to be easing in line with China, bearing out our view that Japan has for several years now targeted currency stability first and foremost rather than foreign currency. The real theme of the latest data is the surge in private sector liquidity around the world but particularly the US.  This is not all good news, as it may be corporates building up cash before an economic downturn.  But it does increase the likelihood of steeper yield curves.  In theory that fits neatly with our general view predicting a bullish steepening with short term yields falling alongside US rate cuts.  However, the facts don’t all fit.  Historically, this late-cycle environment is associated with rising term premia, suggesting that longer term bond yields may in fact rise, and a bearish steepening.  At the same time, one of the worries we have had over the past few months, the fragility of corporate bond markets, seems to have eased off a bit, so the bulls expecting the US to cut rates may be premature.  So, while we expect the curve to steepen as liquidity supply increases, we are less confident which end of the curve will move. QE4 is starting but it seems that the US Fed may be the laggard rather than the leader this time round.  It suggests that Emerging Markets will, at some point quite soon, have a run of some sort but once again not all the facts fit.  CrossBorder flows of capital are running clearly away from emerging markets, and particularly the larger ones such as China, into safer havens mainly in Developed Markets.  Liquidity may well be on the rise, and highly valued US equities may be underpinned by that, but we’re not sure that adds up necessarily to further gains in global indices. If you’d like to see the underlying data, please contact the team.​

William looks at the prospects for 'value' if there is more qe

Regular followers of our blog will be aware that we think the Federal Reserve has given up on interest rate normalisation, and will meet any serious threat to either the economy or the financial system with rate cuts.  It’s noteworthy that US 10-year yields have fallen from 2.7% to just above 2.0% in the past three months and we expect them to go lower. What does that mean for equity investors and value investors in particular?  They have suffered from QE, as lower discount rates have pushed up the valuation of longer duration assets such as growth stocks, and also from investors’ desperate search for income in an ultra-low bond yield world.  In May 2019, some 11% of global stocks traded at more than 30x and a further 12% at below 10x.  In Japan, the numbers were 16% and 22% respectively. That tells a story of investors buying quality and growth and shunning value.  Will it continue if we do indeed find ourselves staring down the barrel of QE 5, 6 and 7?  At the moment, we don’t see much to stop the trend continuing.  The shortage of safe assets is pushing bond yields down and we suspect that genuine ‘quality’ equities, i.e. those which can credibly promise steady income growth over the long term, will benefit in turn. However, no trend lasts for ever and there are things in the offing which will ultimately lead to change.  The first is that, almost universally, the highly rated companies are large global entities in sectors such as consumer goods, pharma and increasingly technological.  The threats will come from increasing friction in global trading, and determination by governments to clip their wings and stop them becoming too powerful.  Who remembers the currency controls in place in the UK until 1979? The second, at the other end of the spectrum, is the growth of private equity.  The FT reported this week that there is US$3.5 trillion of ‘dry powder’ waiting to be invested.  Some of that will be aimed at the unloved and lowly valued tail of listed companies, which should in time give valuations a fillip. In conclusion, another phase of loose monetary policy may look like the 2009-2017 period to start off with and indices may well carry on rising.  But we believe it will be just a little more friendly to the value end of the spectrum too.

Does Abenomics need a reboot?

My favourite commentator on Japan, Peter Tasker, has written a blog asking whether it’s all about to go wrong for Japan.  His evidence is an interview on Reuters by the guru of Koichi Hamada suggesting that ‘the public is better off having prices fall, not rise…’ and that now is time for the next consumption tax rate rise.  If you don’t follow Japan, all you need to know about that is that previous ones have proven highly contentious. Hamada may just be accepting reality.  Nominal GDP growth in Japan has been negative again over the past two quarters and the country is also flirting with deflation anew.  As the employment participation rate (16-64 year olds) stands at 77%, his comments are consistent with what’s happening – if you are in employment, deflation is beneficial. The bigger point Peter makes is that Abenomics needs a reboot.  After six years the effects are fading, along with QE round the world.  Peter’s recipe is to cancel the consumption tax rise, to target bond issuance rather than the yield curve, and to wait patiently for tight employment to have its effect on inflation.  I’d add to that the boost that the Rugby 2019 World Cup and 2020 Olympics will give Japan.  And the stockmarket?  I’ve been lukewarm for the past 12 months and remain that way.  There’s scope for upside if some of Peter’s suggestions are followed.  And in the long-term there’s still plenty of good news on corporate governance, despite the Nissan/Ghosn furore.  However, I suspect some patience is required.  At home, corporations are still saving rather than spending, and abroad economies are slowing and the yen looks like strengthening.  Plus, of course, if the Bank of Japan were to target bond issuance, it might sell some of the equities it has purchased over the past nearly five years. ​

Too early to put the pedal to the metal in Japan?

We’ve had our feet off the pedal on Japan for much of 2018, as regular readers will know.  It’s not that things were going wrong with the economy, more that stockmarket investors - or was it really buying by the authorities for political rather than investment reasons – had gotten ahead of themselves. We pointed out in 2018 that there was a structural change for the better in profit margins and that the very low level of leverage meant that could be boosted significantly by borrowing.  We also pointed out that Japanese valuation disparity was relatively greater than other major markets, indicating an inefficient market.  Add in Prime Minister Abe’s seemingly secure tenure and relatively looser monetary policy in both Japan and China, and the combination should have made a profitable hunting-ground for active investors. It didn’t turn out that way and we now have the added weight of the Nissan saga - casting doubts on corporate governance improvements in Japan - as well as a sharp increase in the yen.  We are not surprised that on Christmas Eve the Nikkei index fell to a bear market territory reading of more than 20% below its 2018 high. We are still refraining from treading hard on the metal but our reasons are more macro than micro.  Our biggest concern is that investors will use the yen as a safe haven if global markets take another leg down.  Currency volatility has been suppressed over the past few years and investors are probably underestimating the risks. The positive story on Japanese earnings is still very much in place, notwithstanding the gloss may have come off governance.  Active investors will probably enjoy good profits from Japan over the next couple of years but our hunch is that there will be a better entry point coming up quite soon. To find out more about our specialism in Japan please click here.​

China smelling of roses?

One of our themes over the past few years has been to pay more attention to China when trying to predict the future market environment and less to the USA.  That’s not just because the Chinese economy is now 70% the size of the US (compared to just 11% in 1997) and its central bank’s balance sheet is 1/3 bigger than the Federal Reserve.  China has also been extending its hegemony across the world in many ways, from its Belt and Road infrastructure vision across western Asia to its policy of encouraging use of the yuan rather than the US$ for global trade contracts. The contrast between the monetary policies of the two countries is particularly stark right now.  The Federal Reserve, followed by most ‘western’ nations, is running very tight policy, whereas the People’s Bank of China and most Emerging Markets (EM) are relatively loose.  In data terms, provided by our friends at CrossBorder Capital Limited as at 30th September, the DM index is at 6.5 (range 0-100) whereas the EM is at 54.7. For markets this has a strong implication that the US$ is likely to strengthen against the Chinese yuan, because other things being equal central bank easing equates to more supply.  We’d expect the Japanese yen to move somewhere in between the two, as another long-held thesis of ours is that Japan’s orbit is now at least as much influenced by China as America. It is also a much more positive background for EM.  Many commentators assume that the strong US$ will continue to be a negative for them, but we’d comment that yuan weakness will be a just as large, if not larger, positive for them (and incidentally Japan).  We also note that crossborder flows into EM have rebounded sharply since the low point in June 2018, suggesting greater confidence than newspapers would lead readers to believe. Given the dire liquidity background just now, we continue to expect a more substantial correction in markets than we saw last week.  If China continues its current loose monetary policy, those countries connected to it economically may just come out smelling of roses, at least in market performance terms. To learn more about CrossBorder’s research on liquidity please click here.​

Value investing in Japan will have its day in the sun again

A Nomura report claimed a couple of years ago that ‘Japanese value investors are extinct.’  That is not quite true but, since the Global Financial Crisis, only the most determined investors have kept going.  Relative returns from value stocks actually bottomed out in 2016 but there is little sign of any escape from the value trap which scornful commentators like to refer to.   The cause is not hard to seek: Japan has endured ultra-low interest rates for nearly 30 years and negative nominal economic growth for the first 20 of them.  Investors have responded by putting a huge premium on those stocks who have been able to demonstrate growth and/or a sustainable yield.  The dispersion between growth and value has therefore risen to extreme levels. And yet, and yet… since 2001 Japan Inc. in aggregate has consistently generated positive free cash flow, the economy has generated positive real growth over the past three years and where else in the world can you find thousands of companies on a Price to Book of less than 1.0? One clear message from history is that when relative valuation measures become stretched (for example 2001 and 2008) there are excellent returns for value investors who are prepared to stick to their last.  We believe that will happen again but, as ever, patience will be required to benefit. Our friends at Arcus Invest, one of the Japanese value survivors, have written a further instalment of their regular white papers - Fortune Rota Volvitur (loosely translated as ‘value investing will have its day in the sun again’) - on this subject with much more detail.  Please let us know if you would like to see a copy.​

Hold on to your hats!

We make no apologies for returning to the same theme as two weeks ago, when we commented that the global tide of liquidity was rapidly retreating.  The US 10 year Treasury yield has fallen from above 3% to 2.87%, which in our view is further corroboration that investors are moving back to safe havens.  It is all the more interesting that this is happening while Japan and China have stopped investing in US Treasuries.  The two countries’ combined holding is just under 36%, compared to 40% three years ago and 46% seven years ago.  China is recycling excess cash into its Belt and Road policy, while the driver in Japan is a recognition that China is now its most important trading partner.  The more rapid escalation of trade sanctions driven by Trump is further exacerbation. China’s action over the weekend to cut bank reserve requirement ratios by 0.5% is further evidence of the stresses which are building up.  The PBOC is attempting to deleverage over-exposed parts of its domestic economy, while avoiding too much of an economic slow-down, much as it did in 2016. The signal from global liquidity levels is unambiguously negative, as we commented in our last blog.  We said then that what happens in China would probably determine how quickly the next major economic downturn would hit the world.  The latest action can be seen as a positive in that it is effectively monetary easing, but negative in that it highlights the problems. At Linchpin, against the background of tightening liquidity, we are bracing ourselves for a much more serious market downturn than the one experienced earlier this year, and are firmly Risk Off. Expect US rate rises to be muted, and possibly a bearish inversion of yield curves (ie. where short rates are higher than long term bond yields). Linchpin provides experienced advice from our 35 years of investing including how to invest successfully in market downturns.  Find out more here.

Could Asia be different this time?

That the rise of China is leading to shifts in the tectonic plates which link economies together is broadly acknowledged by most.  And yet most presentations I hear about global economics barely, if at all, make mention of Chinese influence. Our friends at CrossBorder have published an interesting strategic paper making the case that the trajectory of Asia will differ significantly from the West over the next economic cycle.  While Asian markets may not be immune to a downturn in markets, they expect them to behave differently and recover much more quickly.  Their first piece of evidence is the rise of a distinct Asian liquidity cycle.  This can be seen statistically in the collapse in the correlation between US and Asian liquidity, and is a result of a clear change in Chinese priorities.  Beijing’s long-term objective is to have the yuan replace the dollar as the major global trading currency.  Today they have switched to spending surplus cash on their Belt and Road project in Asia – effectively their version of the post-war Marshall Plan – rather than investing it into US Treasuries.  This is a factor behind the rise in US yields over the past year and can be seen in the fact that aggregate Chinese holdings of Treasuries have flat-lined over the past 18 months. The Bank of Japan has reacted by switching from its traditional targeting of liquidity to targeting the yen’s currency rates against a basket of currencies including the yuan.  The yen has traditionally been highly volatile against the US$, for example almost halving between 2012 and 2016.  Over the past two years it has traded in a much narrower range.  Tokyo has, like Beijing, stopped purchases of US Treasuries over the last two years.From a market perspective, we think this makes Asia relatively more attractive as a long-term investment, albeit Japan in particular will be more pro-cyclical because it will now be more closely aligned with China.  Lower correlations are also attractive from a diversification perspective, even disregarding potential returns.  On the negative side US Treasuries continue to be vulnerable to further ‘buyers’ strikes’, let alone selling, and the US$ is potentially vulnerable. As background to the interactions between the US, China and Japan, I thoroughly recommend Richard McGregor’s book ‘Asia’s Reckoning’, which gives a sense of the three-way power games these nations have been playing since the last war. Find out more by purchasing the report here (and spot the mis-spelling of linchpin in it!).​

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