21st September 2015 by Mark Tinker
The Fed didn’t raise interest rates last week, despite the US economic indicators suggesting that they should, for the same reason that they haven’t moved for the last seven years (or increased for the last nine years) – global market instability. The difference this time is that the Fed appeared to have encouraged markets to believe that they really would do it this time only to pull back at the last minute. As the excellent David Malpass put it in the Wall Street Journal, ‘rather like Lucy in the classic Peanuts strip, pulling the football away at the last minute to leave the hapless Charlie Brown flat on his back’.
If interest rates were being set by economic data then the Taylor Rule model would work – which it hasn’t for years. The market knows this – currently the Fed futures, one year out are 0.56%, economists’ estimates are 1.25%, but the economic data model (the Taylor Rule) suggests 3.9%. So economists are embedding a policy inertia factor of 2.15%, i.e. almost twice the forecast rate. This qualitative assessment of policy inertia is so large that it seems rather a waste of time to look at the high frequency data, so as an investor rather than a trader I tend not to bother. The Fed also acknowledges that the stronger dollar has tightened monetary policy, so in a world of what they will do, rather than what an economic model thinks they should do; we need to acknowledge that there are more variables than just inflation, output and unemployment rates. This is not to say it isn’t important for currency traders and they are always the most active on ‘Fed days’. They duly sold the dollar and equity markets responded accordingly; the yen and euro went up and the Nikkei and the EuroStoxx went down, suggesting that there are a lot of dollar hedged positions in Japanese and euro equities, perhaps not surprising given the consensus trades to be long in quantitative easing (QE) countries, but short their currencies. It was also interesting to hear from the recent Bank of America Merrill Lynch survey that the perceived consensus of dollar bulls appears to have unwound – which might suggest that the dollar weakness last week will be short lived. As such, the short term noise in equities will reflect the gyrations in currencies and by extension, the attitude to the Fed, reinforcing the impression that equity markets react to high frequency data.
In the sense that the data drives currencies which have short term trading implications for underlying asset hedges this is certainly true, but we must always be wary of believing what the data is telling us about the underlying economy. My concern here is that Janet Yellen’s Fed might have been captured by the bond markets that are looking at what suits them, rather than the economy overall. What is good for Wall Street is not always what is good for ‘main street’. A small rise in rates would have little negative impact on the US economy and arguably could have a positive one. Meanwhile, lack of clarity on rates and poor return on cash has led to a lack of real world investment, particularly in the US and piles of cash sitting in repurchase agreement (repo) markets being channeled back into financial (bond) markets. Together with other so called macro prudential measures, these policies continue to distort market prices. The market reaction to the lack of a decision by the Fed will have made one point clear at least- for investors, doing nothing is taking an active decision, which is not always the case for policy makers. If that was not an active decision, then next month perhaps we might get one not least because ‘main street’ investors are holding off from capital investment until they see the real world impact of higher rates. The longer the Fed sit tight, the more cap-ex stagnates. There is currently a split between large, borrowers (including governments) with easy access to capital and smaller borrowers and savers who have no access to capital or return on capital at this price. This is, arguably, suppressing growth, not as bad as the Japanese experience perhaps, but definitely counter to the intention of having near zero rates. Winston Churchill famously said that the Americans always come to the right decision, after they have tried everything else. Perhaps the Fed will too?
The bond markets understandably worry about rates going up since the taper tantrum of two years ago when the threat of higher rates caused a sharp deleveraging of “China trades” – especially in commodities and EM. In fact, the taper tantrum was a first stage capitulation in these macro China trades as the prospect of a higher dollar led to a closing out of short dollar and long commodity/EM/commodity currency trades. A desire not to be blamed for a market sell-off is a classic failure of public policy economics and in my view figures too highly in the Fed’s decision on rates. In that sense a mis-reading of the taper tantrum appears to have delayed the Fed for two years too long already.
Short rates going up now are unlikely to cause the same problem as was seen in May 2013, but it does not mean there is not a problem. Not only have we had another two years of leveraged products being ‘invented’ within the fixed income markets, but emerging market assets – equity, bonds and currencies – are now in another round of capitulation as the investment committees contemplate one, three and five years of terrible relative performance and the buyers of normal and leveraged exchange traded funds (ETFs) to these areas ‘throw in the towel’. As long term investors we can observe that ‘Everything has changed in China’ is a plausible excuse, but we should not use it to frame our investment actions. Yes, China is slowing, but it is now a massive economy, so the law of big numbers comes heavily into play. China is bigger than France, Germany and the UK combined. If any one of these was growing at 4%, let alone 5%, 6% or 7% we would be panicking about inflation and demanding higher global rates. The investment themes of the last two years, consumer not producer, pricing power, internet shopping and distribution, the opening up of the capital account and the building of a financial service infrastructure are all still working – as are their counterpoints. It is just that the noise traders have grasped a China slowdown story to support their sell trades.
There is something of a feedback loop – EM slowing down is affecting China, rather than the other way around and the risk is that after a decade of capital feast, the fickle capital markets will now deliver a capital famine to EM. Here the ‘One Belt One Road’ infrastructure spend will act like a Marshall Plan without a war and both support excess capacity in Chinese manufacturing as well as providing an investment boom throughout the rest of Asia. This all makes us focus on stock winners versus losers rather than on the bigger index level.
A deleveraging caused by the Fed is unlikely, but I am concerned about the withdrawal of liquidity from repo markets by sovereign wealth funds and others running down reserves. Remember these reserves were accumulated in a time of commodity plenty and even if they are not running down, they are not accumulating the way they used to. There are literally trillions of dollars sat in repo markets as treasury and sovereign cash and this is being reverse ‘repo-ed’ by structured products seeking to match long-term liabilities of pension funds and insurance companies seeking 5% return by investing in bonds yielding 1.5%. The Wall Street magic is of course leverage (as usual) and a system that ignores the role of leverage in measuring risk. Liquidity is the raw material of this type of finance. If the ‘pool of repo’ dries up, then the ability to roll these products goes with it and if 2008 taught us anything, it is that liquidity not solvency is the big risk.
The other issue we have is volatility as a function of policy error. I believe QE1 and QE2 were necessary, but later moves seem to have made things worse not better. At the same time there has been some serious policy error in the Volker Rule and Dodd Frank which have in my view killed market making in bonds and equities. The regulators think that liquidity is better than it is because of the role of high frequency traders (HFTs), but I think this may be wrong. Short term markets are very momentum driven and the role of market makers is to provide a stabilising factor by buying from distressed sellers and selling to forced buyers. HFTs do not do this, in fact they largely do the opposite, they are also momentum investors and exaggerate rather than moderate the moves. The next wave of hedge fund heroes are likely to be those that can pick up JP Morgan etc. when they drop 25% in a matter of minutes.
The big CLSA conference in Hong Kong last week brought along its usual mix of company meetings and thought provoking keynote speakers. Some have obvious links to markets and investments, such as primers on the peer to peer lending markets or the coming revolution in battery storage. Others, such as an interview with the National Security Agency’s (NSA) whistleblower, Edward Snowden (via an onstage robot TV link to Moscow) raised more tangential, but nevertheless important issues about the role and behavior of governments. The rise of Donald Trump and the nature of the different candidates for US Presidency was discussed by political specialist and pollster Frank Luntz, who pointed out that Donald Trump seems to be making China a big issue and that fear of China as a result is increasing across all Republican candidates, which could be interesting ahead of Premier Xi Jinping’s visit this week. Luntz has also highlighted a more global movement of those who feel left behind and how populist movements are ‘turning politics on its head’. In his view, around a third of the electorate are feeling that they are being punished and betrayed by the elites and their response is to vote for a platform of anti-austerity and anti-free trade. The first upsetting for bond markets and the second for equities and growth generally. This was also picked up in an interesting discussion on the future of the euro by Mark Blyth of Brown University who highlighted some of the political aspects of the rise of anti-austerity politicians in Greece, Spain and now in the UK.
One aspect of Donald Trump’s call to “Make America great again” was a call to invest in infrastructure, something echoed by the proposed policies of the new UK leader of the opposition, Jeremy Corbyn. Leaving aside for the moment the practicalities of paying for this investment, it looks to me at least like infrastructure is an idea whose time has come. It is tangible, it is politically appealing to the left and right (if funded properly), it creates jobs and hopefully can lead to enhanced productivity. In effect, it is creating investment in a world where public sector actions on monetary and macro prudential policy such as interest rates, regulations and QE have created a world in which the private sector can feel unable to invest. Roads and houses are always popular for politicians, but in terms of projects, the CLSA conference threw up a number of ideas. For example, and as discussed in a recent note, China has essentially triggered an over-supply of almost everything and this is leading to problems right through supply chains and even into higher value added products as excess capacity limits pricing power. This is not only a problem for the commodity producers, it is a real issue for those providing the capital equipment. However, as we know China has announced its ambitious ‘One Belt One Road’ project to invest extensively across Asia in the next few years. Some of this will be funded by China’s policy banks, still more by the newly created Asia Infrastructure Investment Bank. This has an intentional by-product of using up excess capacity in China, but equally has a positive multiplier impact across the region based around increased trade. Second, as a fascinating presentation on battery storage pointed out, the west looks set to invest heavily in battery storage to replace peak power plants, not only allowing renewables (notably solar) to effectively be suppliers of peak power but to make all electricity generation more efficient. Some of this battery storage will be relatively micro – such as Tesla’s home storage units and some will be industrial scale – the cost reductions coming through in existing technology look set to make storing power rather than trying to manage a consumption cycle a genuine replacement for generating capacity. Intriguingly, as another speaker pointed out, the growth of electric cars will on the one hand create a huge increase in demand for electricity, requiring a lot of upgrades to the grid, but on the other hand create a giant (portable) battery pack that could be reconnected back to the grid providing enormous battery capacity. It would make sense for example if building owners to let their tenants park for free and hook their cars up to the building, enabling it to effectively run itself on off-peak electricity. Some, but not many, utilities appear to be understanding this upcoming fundamental shift to their business model. Rather than being in the electricity generation and distribution business, they are increasingly going to be in the storage and transportation fuel business.
By contrast a lot of the ‘new economy’ stocks presented do not need very much capital at all, being internet ‘platform’ companies such as Uber. Their Head of Asia spoke fluently (and excitedly) about the transformations in Asia and while he tended to gloss over some of the issues they are having with governments and vested interests there is no doubt that these disruptive companies are gathering huge momentum. I did however feel obliged to point out to him at the end of the presentation (he was posing for selfies in the lobby) that my attempt to impress my colleague from London by ordering an Uber ride back to the office had fallen embarrassingly flat with a ‘no cars available response’. More to do then, but as with so much in this region, we can argue about the speed, but there is no doubt as to the direction of travel.