6 November 2018
Market volatility returns
Equity markets experienced a bout of volatility in early October from concerns about higher US bond yields. However, it could be argued that US yields have overshot underlying fundamentals and are close to peaking. First, the global manufacturing Purchasing Managers Index (PMI, a proxy of global growth) has declined for six consecutive months to its lowest level since November 2016. Interest rates have a tight relationship with the PMI, which would suggest that further upside in US yields is limited. Second, the Fed’s interest rate projection for next year is roughly equal to current rate for 10-year bonds, which suggests that much of the central banks’ hikes for this cycle have been discounted. And third, there is limited evidence that the US economy is overheating. Underlying US annual consumer price inflation surprised the market on the downside in September and has been slowing since peaking in July.
Moreover, the market sell-off came at a vulnerable time for stocks, as US companies are subject to a black-out period before they report their financial results for the third quarter. This meant there was a temporary reduction in company share buybacks and dividend announcements that lessened support for equity prices in October, but that should reverse in November.
Nevertheless, markets are likely to remain somewhat jittery about the uncertainty over potential regulation of big tech companies after the US midterm election next month, Italy’s standoff with the EU over its public spending plans and rising energy prices once US sanctions on Iran are implemented in early November.
Looking forward, global equities are deeply oversold. Provided there is no US inflation overshoot and economic growth holds up, it would be reasonable to expect equities to track the upward trend in company earnings, which is still intact.
A long-term opportunity for China and Emerging Markets
China’s Belt and Road Initiative (BRI) was officially launched on the 7 September 2013 by President Xi in Kazakhstan at the heart of the ancient Silk Road route. The BRI aims to link China with 69 countries across Asia, Europe, Africa and Oceania, and is the largest international development since the Marshall Plan rebuilt war-ravaged Europe in the 1940s. Beijing wants to use the BRI to reduce overcapacity at home and stimulate Chinese economic activity by developing demand from new markets overseas. Crucially, Chinese exports are anticipated to be invoiced in its domestic currency, the yuan. In other words, the BRI forms a key part of China’s long-term plan to raise foreign demand for its domestic currency.
China is also making use of the energy market to internationalise the yuan. Back in March, the authorities launched the first-ever yuan-denominated crude oil futures contract (the so-called petro-yuan) on the Shanghai International Energy Exchange. As the world’s largest net importer of crude oil, China has no shortage of countries willing to supply its energy needs. Russia and Iran have agreed to accept the petro-yuan to get around US sanctions. Ultimately, Chinese overseas trade in energy will create large pools of yuan that could potentially be reinvested into Mainland financial markets. Beijing has already made significant efforts to open up its bond and equity markets over the past few years. This has increased market liquidity and transparency to such an extent that Barclays and MSCI have begun to include Chinese bonds and equities, respectively, in their benchmarks.
Considering Beijing’s long-term objective is to offer the yuan as a reserve currency alternative to the US dollar, China will be keen to show potential overseas investors’ its credibility in the management of the economy. President Xi will also want to ensure officials deliver on the BRI as this is his flagship foreign policy. Finally, China may want to use the vacuum created by President Trump’s seemingly isolationist foreign policy, as a strategic opportunity to show global leadership and to lessen its dependence on US commerce following increased trade tariffs applied by Washington on Chinese exports.
Given this intent by the Chinese government, it would be reasonable to expect Beijing’s recent policy easing to feed through to faster growth, and lessen market fears of a sharp slowdown in the economy. Nevertheless, policymakers are likely to continue to maintain a tight control on murky off-balance sheet bank lending and implement policies to improve credit efficiency to lower the risk of a crisis in the financial system. At current undemanding valuations, a stabilisation in the mainland economy suggests a long-term buying opportunity for Chinese and related-emerging market financial assets is fast approaching.
Moreover, China’s efforts to internationalise the yuan comes at a time when there are growing risks over the major currencies of the US (from expanding public debt), the euro (i.e. Italy’s populist government backtracking against EU fiscal policies), UK (Brexit/a potential left-wing government) and Japan (ongoing quantitative easing and unfavourable demographics). A more stable yuan and the Chinese equity market could offer investors a way to diversify portfolio returns over the long-term.