Have we turned into a lemming?

Earlier this year, I found myself in a spat in the FT comment columns because I offered some investor sentiment data (as usual from my friends at CrossBorder Capital) which was at odds with the Bank of America (BoA) Fund Managers’ survey. As a reminder, BoA’s is a subjective survey of 174 (this month) large institutional investors’ investing intentions, whereas the data we use at Linchpin is an objective measurement of all financial assets.  We don’t know who owns them but if the aggregate held in equities is a relatively high weighting (for example) we’d expect that to revert to the mean in due course, much as a portfolio manager overweight in equities relative to his/her benchmark will find a way to bring it back in line. Today the main sentiment messages from both data sets are more similar: risk appetite is declining but investors are still overweight equities and underweight bonds.  They are weighted towards US equities, Japan is also favoured, and there is convergence in the expectation that economies will slow down and that US treasury yields are expected to rise further. At Linchpin we share the sober view about the economic outlook and are likewise concerned about rising bond yields.  We are probably not far from the consensus in our view that equities need to go through a market correction of some sort in the near future.   As natural contrarians, however, we are not particularly comfortable being with the masses.  We begin to think that our fears or hopes are already discounted.  Having said this - unlike many - we are firmly of the view that Emerging Markets are likely to be the best performers over the next downturn.  It is an interesting reflection that over the 2008 Global Financial Crunch that was also the case, at least until central banks i) succeeded in stabilising the financial system and ii) continued to print money.  We’d expect the same to happen this time round. If you think we are turning into another lemming, please tell us.  If you would like to find out more about CrossBorder’s investor sentiment data, 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.​

Central bank liquidity at lowest since early 1980s

At the end of August, central bank liquidity was at its lowest level since the early 1980s, according to the data which our friends at CrossBorder Capital monitor.  The index stands at 13.8 (range 0 to 100) and only the People’s Bank of China is still following a relatively loose policy. We shouldn’t perhaps be surprised by this, coming after nearly ten years of Quantitative Easing (QE).  But an environment of tight money undoubtedly heightens the risk that someone somewhere is unable to pay their bills and the first domino falls. In contrast investors are relatively sanguine and ‘risk-on’ in aggregate.  CrossBorder’s measure of this metric is at +33 on a scale of -50 to +50, which is consistent with what we hear on the street.  Many professional investors are preferring to remain invested for the time being. Although there are pockets of light in the liquidity environment (China and, surprisingly, the UK where corporate cashflow is strong), at Linchpin we would argue strongly for a defensive ‘risk-off’ stance.  The overall levels of liquidity are pointing unambiguously to, at best, soft economic growth and, at worst, a recession if Central Banks tighten further.  Given investors’ positioning, that is unlikely to end well for those exposed to too much risk.To learn more about CrossBorder’s research on liquidity please click here.  

Here we go again... or not? Emerging Markets are a bit different this time

The virus affecting Emerging Markets is spreading this week.  Like most previous occasions (1982, 1997, 2008 et al) the transmission method is currency weakness.  Historically, the causes have been largely to do with economic mismanagement in the EMs.  This time, with a few exceptions such as Turkey and Argentina, the problem appears to be dollar strength.  It is still hurting EMs as much but it may well not lead to the same cathartic volatility in global markets as previously. Why do we say that?  First, we do not believe the Chinese economy, so important to EMs, is about to implode.  The PBoC is still providing plenty of liquidity, and China is embarking on major fiscal initiatives such as its Belt and Road initiative.  Readers may argue about the longer term prospects for a controlled economy but we’d suggest that in the short to medium term there’s no reason to expect it to derail. If you look at EMs excluding China, four key measures of financial health all look robust by historical standards.  These are current account surpluses, net inward Foreign Direct Investment, the level of forex reserves and the volatility of financial inflows.  Data comes from our friends at CrossBorder Capital Ltd and is available from us on request. That’s not to say there may not be further drops in markets, both EM and DM, over the next few weeks and months, but our point is that China is still on track and most other EMs are in reasonable financial health.   We’d argue that there is a buying opportunity coming up in them.

The canary in the coalmine again?

The 2nd quarter US earnings season has produced a 24.6% increase in quarterly earnings, with 79% of companies reporting positive surprises (91% of companies reported, source Factset).  This is close to the strongest result since the Global Financial Crisis, only tempered by a more modest revenue increase of 10%.  We suspect the difference comes from earnings repatriation following the Trump administration’s tax amnesty.  As a result, US valuations are looking less stretched: the forward PE on the S&P is 16.6x, still well ahead of the long-term average but broadly in line with the more recent past.   The bulls see this as evidence that equity markets can cope with recent rate rises, signs of distress in the Emerging Markets, and the opening shots in what looks more and more like a trade war.  At Linchpin we beg to differ.  The liquidity data at the end of July, as provided by our friends at CrossBorder, continues to be at its lowest level since 2007 or 1989, both of which presaged major downturns.  The only major central banks continuing to expand their balance sheets are China, India and the UK, and each of these has their own peculiar problems. The problems – admittedly neither unexpected nor surprising – rearing their heads in Emerging Markets also cause us concern, as they so often turn out to be the ‘canary in the coalmine’.  We see some parallels between the current Turkish situation and Thailand in 1997 in that both followed a major US monetary tightening.  Turkey has exacerbated the situation by printing money to solve its liquidity shortage.  The situation may not be contagious for Emerging Markets, as it was in 1997, but for the time being and despite the US earnings numbers we remain very firmly risk-off on all risk assets. Find out more here.​

Pencil in 2019 for the next economic downturn

Our friends at CrossBorder Capital have released end June liquidity data and it shows the same very tight conditions as we have highlighted for three months.  They normally - I hesitate to say always - presage a significant downturn in risk appetite and markets, and then economies.  The overall liquidity index is 17.3 (range 0-100) but that hides a more positive picture for Emerging Markets (58.3) than Developed ones (12.7).  The former appear to be letting their currencies weaken rather than tightening monetary policy in line with the US Federal Reserve. Investors’ appetite for risk also appears to have declined, albeit the confidence collapse is largely within Emerging Markets and specifically China.  This tallies with our anecdotal evidence, where many western investors we speak to remain invested in largely DM risk assets in the short term, despite their worries about the longer term.  Our own view is that there is a lot of complacency around after nearly ten years of rising markets, and we are firmly in the ‘Risk Off’ camp right now across the board. With the liquidity cycle clearly in a downward trend and the risk cycle looking like it has peaked, we would expect the economic cycle to follow and peak quite soon.  We are therefore somewhat sceptical that the train of rate increases envisaged by the US Federal Reserve will all happen.  If they do, we suspect they will prove the exogenous shock needed to precipitate a change in market direction and economies will slow sooner rather than later.  Either way, we now have visibility of how the next economic downturn happens and, increasingly, when.  Pencil in 2019. To purchase the full CrossBorder Capital report with the end June liquidity highlights, please click here.​

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.

The liquidity tide is going out!​

There is no doubt the liquidity tide is retreating fast.  It has been falling since last August and the series monitored by our friends at CrossBorder Capital shows that the global level has only been this low twice in the last 40 years.  Once was ahead of the Savings and Loans crisis in the late 1980s.  The second was in 2007 – I need say no more.  Worse than that, three measures which are the strongest predictors of a bear market are all at extreme levels: investors’ risk appetite is high, central bank liquidity is low and cross-border flows, particularly those out of the US, are weak. That’s not to say it will happen tomorrow.  There are still some positive signs coming out of China in particular, where in a Trumpian world the People’s Bank is rapidly taking over from the Federal Reserve as the global liquidity provider of last resort.  But if they turn the taps off too, it really will be a case of battening down the hatches. When the tide retreats, who will turn out to be swimming commando?   They will almost certainly be found in the Developed Markets and it probably won’t be the banks this time round.  It’s worth noting that markets lead the economy by at least nine months, and it could just be a good old-fashioned recession in 2020 or 2021, with companies which have extended credit to consumers in the forefront.  Think auto and phone service agreements, store cards, travel companies and anybody else who has extended credit unwisely. Find out more about the end May numbers here.      ​