Category: Geld Zug

22^nd September 2016

On 21 September the US Federal Reserve decided not to raise interest rates, but fourteen of the seventeen board members indicated that they expected one more rate rise in 2016. This has pretty much telegraphed to financial markets that, so long as economic statistics remain reasonable, the Fed will go for a rate rise at its December meeting.

This December is an excellent time for a rate rise, regardless of the state of the US economy, because it is a period of low public scrutiny. It has the advantage of being after November’s Presidential election but before the inauguration of the new President on 20 January 2017. Hence a rate rise at this time is much less controversial: the Fed is unlikely to attract criticism from either the lame-duck incumbent or his not-yet-installed replacement… [see more]

15^th September 2016

It is now two years since oil prices halved in the second half of 2014. The chart below reminds us that this fall was far less severe than the oil price collapse during the GFC, when prices recovered very quickly. Why aren’t prices beginning to recover now?

The causes of the two price falls were very different. The 2008 collapse was triggered by factors outside the oil market – specifically, the GFC’s liquidity crisis which shut down bank lending and trade finance, followed by lower demand as a result of the recession in developed countries. But when central banks pumped up liquidity, global oil demand recovered… [see more]

14^th July 2016

It is legally possible for the EU to split up into its constituent countries, but – as Britain is finding out – the process is laborious and complex, needing several years. More to the point, for almost all EU members there are major economic advantages to staying inside.

These advantages are obvious to all the smaller members, such as Greece, Cyprus, Latvia, Romania and Portugal. They are net winners in the EU’s subsidy games, as is clear in Chart 3 showing countries’ net contributions per capita… read more

29 June, 2016

Marcel von Pfyffer joins Switzer TV to reveal how he intends to play the market following the Brexit vote last week.

29th June, 2016

Arminius’ global macro hedge fund recorded a modest positive return on the Brexit vote, even though we do not make bets on political events. We invest our clients’ money on the basis of quantitative statistics about the market, and our quantitative models told us in mid-May that risk in global markets was too high. Therefore we shifted 95% of our fund to the safe haven of cash, which is where it will remain until at least 01 July. As a result, we have avoided the market falls which followed the Brexit vote, and the Fund made profits on some market neutral short positions in the US equities market.

The Brexit vote has triggered a regional crisis, not a global crisis… read more

28th June, 2016

To be clear, not everyone had an uncomfortable Brexit. What is being referred to now (and no doubt in case studies at Harvard in years to come) as “Black Friday”, was in fact quite a Good Friday for investors in Arminius’ global macro hedge fund.

So how did we manage to not lose money through Brexit? By obeying our models.

… read more

Every diligent student in Economics 101 learns how to use supply and demand curves to show that legislating for minimum wage rates tends to reduce total employment… …what these diligent students don’t know yet is that the real world is often reluctant to behave the way that economic theory says it should. Supply and demand curves are theoretical abstractions, and the straightforward conclusions of economic theory depend on several simplifying assumptions which usually aren’t true in the real world… …in recent earnings guidance from US retailers and restaurant chains, management has suggested that rises in the minimum wage will cut CY2016 profits by 2% to 3% and CY2017 profits by 3% to 4%… [see more]

CHINA

• China’s GDP growth met its CY15 target, but it keeps on slowing down. It would be a lot lower if the authorities weren’t pumping up the money supply, applying fiscal stimulus to key sectors, and fudging some of the statistics.

• China’s wealthiest citizens are continuing to ship their money off to safer jurisdictions. This is one of the main reasons why the China’s currency is weak even though its trade surplus and its incoming direct investment are both rising.

• We don’t see any likelihood of a hard landing in China this year, but the downward drift of the Chinese economy is negative for resources exporters in general and for Australian resource stocks in particular.

One of the constant themes in our commentary on China since 2011 is that Chinese economic growth is slowing down. Global share markets had an attack of nervous tremors in early January before the 2015 Chinese GDP data came out, but their fears seem to have subsided again. We take this opportunity to review the Chinese economy, summarize the near term outlook, and assess the implications for Australian investors.

In 2015 Chinese GDP grew by 6.9% in real terms, i.e. after adjusting for inflation during the year. This was not only below the 2014 figure of 7.3%, it was also China’s slowest growth rate since 1990. It was, however, in line with consensus forecasts and the government’s official target. A negative indicator was that growth appeared to be decelerating over the year, because growth in the December quarter was only 6.8%, but this figure is acceptable because the government’s official target for CY16 is only 6.5%. So we can conclude that the Chinese economy is slowing as expected.

The composition of the 2015 national accounts suggests that the economy is responding to the government’s efforts to re-balance it away from investment-led growth and towards consumption-led growth. The main cause of the slowdown was secondary industry, which grew at 6.1% real during 2015, whereas the services (tertiary) sector grew at 8.2% real. This trend is consistent with a slowing in the growth rate of fixed asset investment (FAI) to 10.0% year on year, its slowest rate since 2000. The rise of the services sector is evident in the fact that, for the first time ever, it made up more than half of GDP – 50.5% compared to 48.1% in 2014.

The high growth rate of the services sector is in part a consequence of government policy, but also due to the fact that the services sector does not rely on external inputs as much as secondary industry. In particular, the small businesses which are common in the services sector have very modest capital needs, so they are not dependent on credit growth. The services sector also uses less energy and less materials, so that its growth is better aligned with the government’s policies to reduce environmental pollution, given the rising public concern over many obvious examples of pollution of food, water, soil, and urban air. As the services sector is labour intensive, its rapid growth will help absorb the labour made redundant by factory closures in secondary industry.

Most importantly, the average citizen is enjoying a higher income: average income per capita rose by 7.4% year on year, faster than GDP. Consumption accounted for 66.4% of GDP growth in 2015, up from 51% in 2014. China’s household consumption spending, however, was only 38% of GDP in 2015, compared to the typical level of about 65% in developed countries.

The slowdown in secondary industry has been a major factor in the collapse in global commodity prices. Steel output fell 2.3% and electricity generation fell 0.2%, so it is hardly surprising that China’s imports of industrial commodities also fell, e.g. coal imports were down 30%. This is the explanation for the slide in coal prices which has been killing Australian miners.

Falling prices are a key feature of the Chinese economy. China’s nominal GDP grew by only 6.4% in 2015, which was less than its real GDP growth rate of 6.9% because of the effect of deflation. Lower commodity prices are the main reason why China’s Producer Price Index (PPI) has been falling for the last four years, although the Consumer Price Index remains positive. Another deflationary factor is the over-capacity which has built up in many sectors, such as steel production, mining, and oil refining.

Although deflation is not intrinsically bad, it does have the unpleasant effect of increasing the real value of any nominal debts. As China’s debt to GDP is one of the highest in the world at 209%, continuing deflation will represent a problem for Chinese companies unless they have the active support of a local, provincial or national government. The four-year decline in the PPI has pushed corporate revenues down, making it harder for companies to service their interest and principal obligations unless they have some form of state support, e.g. subsidies or government contracts. This is one of the main reasons why the central government continues to provide fiscal stimulus, such as building more infrastructure, and monetary stimulus, such as interest rate cuts and reserve ratio cuts. A recent change to tax levels on new cars sparked an 18% increase in car sales in December alone.

The most urgent policy problem facing the Chinese government is capital flight. In the decade from 2003 to 2013, the Chinese yuan rose steadily against most major currencies, so investors and speculators got used to treating the yuan as a one-way bet. China steadily built up its foreign exchange reserves, reaching a peak of USD 3.99 trillion in June 2014. The gentle decline which began in 2014 accelerated in the second half of 2015, reducing the foreign exchange reserve level to USD 3.33 trillion at December 2015. The problem is not one of declining investment, as foreign direct investment (FDI) reached a record USD 124 billion in 2015. The 2015 capital outflow of USD 676 billion represents the decision of portfolio investors, currency speculators and Chinese residents to reduce their exposure to China.

Considering the whole picture of China’s national accounts, it is clear that growth is continuing at rates which the rest of the world would envy. There are a number of problem areas – such as the rapid rate of credit growth – but it is unlikely that China faces a hard landing in the near future. In the wake of the CY2015 figures, the consensus forecast for GDP growth is 6.5% in CY2016 and 6.0% in CY2017. It is, however, far from assured that China’s growth rate will reach the average of 6.5% which is forecast for the period of the Thirteenth Five Year Plan, from 2016 to 2020. Nor is it likely that the Chinese yuan will remain as stable as it has been under the last two decades of tightly managed exchange rates.

The implications for Australian investors are clear. Exports to China represent 5.1% of Australia’s GDP, which is by far the highest exposure among developed economies. The continuing slowdown in China is a negative for Australian resources companies, and – apart from tourism and education – the Australian services sector has been slow to engage with the growing Chinese services sector. Accordingly, we remain cautious on the prospects for Australian economic growth and the Australian dollar. Although the Australian resources sector will bounce from time to time in sync with commodity prices, we regard it a long term value trap.

Last month we addressed investor concerns about slowing growth in China. This month we look at how trends in other emerging markets might affect Australian investors.

The core of the problem is that growth in emerging markets, which has been strong for a decade, is now slowing down, mostly because of the way that the China slowdown and falling commodity prices depress the value of commodity exports from low income countries. Although GDP growth in the developed economies remains stable (albeit uninspiring) at 1.6% pa in aggregate, growth in emerging markets has been falling steadily for the last three years. The absolute level at present is still 4.1% pa, but the downtrend is clear.

Should we fear a re-run of the 1997 Asian crisis? No, because the Asian economies involved have made sure that they don’t have the same risk exposures this time around. The 1997 Asian crisis was triggered by high levels of USD borrowing by companies in Thailand, Malaysia and other east Asian countries. When local borrowers had difficulty repaying their USD debt, their local currencies fell against the USD, making the problem even worse. This time around, thanks to better regulatory oversight, foreign currency borrowing is much lower, and most of the countries involved have built up significant foreign exchange reserves as a precautionary measure.

Should we fear a re-run of the 1998 Russian crisis, which ruined Long Term Credit Management and led the US Federal Reserve to intervene to prop up the US financial system? Russia now is a lot smaller and less important than it was then. We tend to think of Russia as globally important because of its past role as a nuclear superpower. In 2014 Russia’s GDP was only USD 1.86 trillion, ranking it at number ten in the global league tables, after India and before Canada according to the World Bank, and equivalent to only 2.4% of world GDP of USD 77.87 trillion. The state of California, by comparison, is much more important: its 2014 GDP was USD 2.31 trillion. The current recession in Russia is unpleasant for Russians, but of no importance for the rest of the world because Russia’s exports are mostly oil and other commodities. (In the GDP league tables Australia comes in at number twelve with GDP of USD 1.45 trillion.)

But there are many other low-income and middle-income countries whose economies have been buffeted by the collapse in commodity prices. In its October 2015 Global Financial Stability Report, the IMF warned that emerging markets should prepare for an increase in corporate failures. In the last year, the resources giants Glencore and Petrobras have seen their share prices fall 60%-plus, and there are plenty of similar examples among Australian resource companies. Brazil and Russia are already in recession, and last year’s oil price slide has driven the oil producer Saudi Arabia to repatriate more than USD 50 billion from its overseas investment portfolio.

It is clear that investors are taking emerging market risks seriously. Capital flows to emerging markets turned negative in late 2014 for both bonds and equities, and current trends suggest that 2015 may be the first year of net capital outflows since the 1980s.

For Australian investors who have no exposure to emerging markets, all this turmoil might seem irrelevant. But the global economy and global financial markets are very much interconnected, so recessions in emerging markets do have an adverse impact on the economies of the developed world. First, they  reduce demand for the exports of the developed world, which tend to be goods and services with high value added, such as expensive cars, airplanes, information technology, pharmaceuticals, medical instruments, telecommunications equipment, sophisticated machinery, and complex services such as insurance. In short, if a low-income economy is suffering falling exports or a falling currency, it cannot afford to buy as much from rich countries.

A second effect works by making the exports of low-income countries cheaper as their currencies fall. Cheaper exports tend to displace competing goods made in rich countries, whether in their home markets or in export markets. Neither of these effects has much impact on the US economy, because the US is much less dependent on trade than most other developed economies. In 2014 US exports accounted for only 14% of GDP and imports only 17%, well below the levels typical of developed countries.

The fact that many of the largest listed US companies are transnational companies suggests that problems in emerging markets should have a negative impact on the US share market, but data deficiencies make it difficult to estimate how serious this impact might be. It is true that global sales accounted for 47.8% of total sales of S&P500 companies in 2014, according to S&P Research in July 2015. But this figure conceals wide variations: 186 of the 500 companies had zero foreign sales, 46 had 0% to 15%, and 22 had more than 85%. The limitations of the reported data meant that 22.2% of total sales were simply ascribed to “foreign countries” without any regional detail – that is, we don’t know which countries nearly half the sales went to. Nor do the statistics capture change of domicile by companies.

In addition, the term “global sales” does not distinguish between exports from the US, local sales by a subsidiary operating in a country, and intracompany “sales” between, say, Australia and a nearby jurisdiction which just happens to have low tax rates. These three forms of “global sales” have very different implications in the real world. Export sales may rise or fall depending on exchange rates; sales by in-country operations are a matter of foreign currency translation; and the level and location of intracompany sales are decided at the discretion of management. As a consequence of these holes in the data, the aggregate effect on the S&P500 is impossible to calculate – the best we can do is identify the individual companies which are most or least affected. For example, the US equipment maker Caterpillar generates 60% of pretax profit outside the US: its sales have been falling since 2012, and it has closed 20 plants outside the US.

For financial markets, the most important consequence of recessions and falling currencies in poor countries is that the companies in these countries find it harder to pay the interest and principal on their debts. This effect becomes much more severe if the debts are denominated in foreign currencies rather than local currencies. Nonetheless, any large default causes problems locally and globally. The local consequences are obvious – job losses, flow-on insolvencies, and GDP losses which are not easily recovered. The consequences for financial markets follow from investors’ losses of principal or interest, which motivate investors to re-appraise and re-price the risk in corporate bonds. Credit spreads will widen, making debt more expensive for risky companies at the same time as it becomes cheaper for “safe havens” such as US government debt and top-rated companies’ bonds. The re-appraisal of corporate debt risk will eventually flow through to equity investors’ perceptions of these companies.

The implications for Australian investors are straightforward. We continue to favour the US and Europe, and to avoid all Asian markets. We expect that the resources sector will continue to underperform, and all companies with global operations should be assessed on a case-by-case basis for their exposure to emerging markets. As we noted last month, the short term outlook for China is not as bad as global investors seem to think it is, and this view has positive implications for the Australian share market. Investors who are not risk averse could look at opportunities in Australia outside the banking and resource sectors.

Neill Colledge

November 2015