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Storms come and go

The global markets seem calmer after a rough August.

As we enter springtime in the southern hemisphere, things seem calmer on global markets after a very stormy August. But the weekend’s attack on a Saudi Arabian oil refinery suggests it is not yet time to pack the umbrellas away.

The market chaos that began with a tweet from US President Donald Trump at the beginning of August also receded with a Trump tweet. In an attempt to ease tensions, Trump postponed the imposition of a fresh set of tariffs by two weeks so as not to coincide with the October 1 celebration of the founding of the People’s Republic of China.

Trade talks between the US and China have also resumed, while China exempted some US items from its retaliatory tariffs. This follows a by-now standard pattern where Trump escalates his trade war when US equities are strong, and backs off when the markets are spooked.

Chart 1: US S&P 500 since the start of the trade war

Source: Refinitiv Datastream

While this latest thawing in relations between the two economic superpowers has been cheered by markets, it does nothing to ease the uncertainty of businesses that have to plan months ahead, and still don’t know what the tariff levels will be. In fact, all this zig-zagging on tariffs only increases uncertainty. Even if no agreement is reached between the US and China, moving production to a third country, such as Vietnam, could be risky, as there is no guarantee that Trump won’t target it next. Or even turn his attention to traditional allies in Europe and Japan.

The global manufacturing sector, which is most exposed to trade wars as well as structural challenges in the auto sector, remains very weak. So far, this has not spilled over to the health services sector, but the risk that it could do so exists. The Eurozone economy is particularly exposed, given that it is more dependent on manufacturing and global trade than the US.

Geopolitical risks ebb and flow

The attack in Saudi Arabia potentially affects up to 5% of global oil output.

Read: What the Saudi drone attack means for global markets

Predictably, the oil price spiked around 10% when Asian markets opened on Monday. This is a knee-jerk reaction and it will take a day or two for the price to settle at a level that reflects the new realities. On the one hand, the sluggish global economy and record US output means there was probably an oversupply of global oil. On the other hand, the price will probably now reflect a larger risk premium as investors worry about the vulnerability of oil infrastructure in the Middle East, and the potential for conflict to escalate. Ironically, this happened just as it seemed that the prospects for conflict in the Middle East were easing somewhat following the firing of Trump’s bellicose national security advisor John Bolton.

Other geopolitical risks do seem to have receded. In the UK, parliament voted to block a no-deal Brexit and an early election, in a blow to Prime Minister Boris Johnson. This does not mean we know how the Brexit debacle will unfold – the October 31 deadline has not been extended yet – but the likelihood of an extreme outcome has receded. In Italy, a new coalition government has been formed without the populist League party, which paves the way for better relations between Rome and the European Commission in Brussels. Italy’s problems run very deep, and this does nothing to address them, but here too the risk of an extreme outcome, namely Italy abandoning the euro, has been reduced.

Bonds down, shares up

All this has seen a jump in equities and a sell-off in bonds (leading to rising bond yields) over the last two weeks. Other safe havens such as the Japanese yen and gold are also weaker. However, bond yields are still lower than at the start of August, and we are in a declining global interest rate environment as central banks continue to ease policy.

Chart 2: Developed market 10-year government bond yields, local currency

Source: Refinitiv Datastream

QEnfinity

In what is seen as the first of a set of easing moves, the People’s Bank of China recently reduced the amount of funds banks have to hold in reserve, potentially freeing up billions of dollars of new loans. Last week, the European Central Bank (ECB) cut its deposit rate by 10 basis points to -0.5% and relaunched a €20 billion monthly bond-buying (quantitative easing or QE) programme. It also introduced a tiered system to avoid the negative impact of sub-zero rates on banks. Notably, for the first time, the ECB said it will maintain QE and negative interest rates until such time as inflation “robustly” converges on its 2% target. Both negative rates and QE are now open-ended.

Whether this will help the struggling Eurozone economy is another matter. If negative interest rates did not spur economic activity up to now, slightly more negative rates are unlikely to do the trick in the future. On the QE side, the problem is that the ECB could run out of bonds to buy within a year, since the largest economy in the bloc, Germany, runs a budget surplus and therefore the outstanding stock of German bonds is declining. Germany’s tight fiscal policy is therefore not only holding back growth on its own, but also impeding monetary policy. This has not gone unnoticed at the ECB. Both Mario Draghi and his successor as ECB president, Christine Lagarde, have called on easier fiscal policy (more spending by governments) to do the heavy lifting of preventing a recession in the Eurozone. 

This week, all eyes will turn to the US Federal Reserve (the Fed), which is expected to cut rates by 25 basis points on Wednesday. The SA Reserve Bank’s Monetary Policy Committee will announce the outcome of its meeting the following day. 

The odds of a local rate cut have increased somewhat, but the oil price spike complicates matters.

However, in both rand and dollar terms, the oil price is below where it was a year ago.

Central banks here and abroad are unlikely to respond to the jump in the oil price, but if it increases further and remains elevated, they will have to reassess their inflation forecasts. Having said that, the bigger risk is probably to growth, as a fragile global economy will struggle to handle much higher fuel costs. A sustained increase in oil prices could therefore be deflationary, not inflationary. Time will tell.

Ratings reprieve

One bit of good news came from rating agency Moody’s, the last ratings agency with an investment grade rating on local currency bonds. At a conference in Johannesburg, its analyst for South Africa noted that a downgrade in November is unlikely. Moody’s has a stable outlook on its rating, and would first cut its outlook to negative before downgrading the rating. This means the government still has time to reassure Moody’s by implementing reforms.

Once again, Moody’s voiced concern over the rapid increase in government debt (the absolute level is not very high), but noted the importance of our strong institutions in supporting our rating. The independent SA Reserve Bank is particularly important. Sorting out Eskom is important too, but ultimately to protect our credit ratings, we need faster economic growth. Moody’s now expects growth of only 0.7% this year. Faster growth should result in higher tax revenues for the state and less borrowing. Since the bond market is already pricing in a dire fiscal situation and downgrades, there is a chance for a positive surprise. Yields remain very high relative to inflation and what is available anywhere else.

Local equities up

Local equities followed the rest of the world higher, despite more gloomy news on the local economy. The JSE is ultimately influenced more by global markets than local economic conditions. Business confidence declined to a 20-year low of 21 index points in the third quarter, according to the Bureau for Economic Research’s long-running survey. Confidence declined in four of the five cyclically sensitive sectors that constitute the survey (wholesalers, retailers, building contractors and manufacturers). Dealers of new vehicles were only slightly less pessimistic than in the second quarter. Stats SA data on mining and manufacturing production signalled a weak start to the third quarter after the second quarter bounce.

Chart 3: South African business confidence

Source: Refinitiv Datastream

Things can change quickly

The rand is now stronger against the US dollar than a year ago, and this will drag on the returns of global equities. It is ironic and frustrating that as soon as local asset returns pick up, global returns dip. That is why diversification is important, especially as there is so much uncertainty globally and locally. But there is always uncertainty, as the events of the weekend demonstrated again. The trick is to manage exposures through proper diversification and to manage our behaviour by sticking to a plan.

The other important lesson is just how quickly things can turn around on markets. Markets always price in all available information. If new information comes along that is only marginally more pessimistic or optimistic than what was thought, it could lead to a substantial market movement. So while we don’t know how long the September equity rally will last, investors who sold out in a panic in August have missed out. Markets move up over time in such fits and starts, it is never a smooth ride up. Unfortunately, missing out on such upward lurches will greatly reduce long-term returns from equity markets.

Dave Mohr is chief investment strategist and Izak Odendaal an investment strategist at Old Mutual Wealth.

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What does it tell us when markets are not driven by good old profitability metrics any more, but by competitive devaluation, tariffs, sanctions and share buybacks instead? The country that is first with the new round of QE or new record-low rates of interest, gains the competitive advantage. The USA is unable to weaken the dollar against the Yuan, so they implement sanctions against Huawei and tariffs against Chinese imports. The Chinese react immediately by further weakening the Yuan, to negate the effect of the tariffs.

The USA manufactures all kinds of instability in the Middle-East in order to enforce the petrodollar system, which is the foundation of the demand for the US bond market and serves as the de-facto backing for the dollar.

S&P500 companies will buy back $940 billion of stock in 2019 alone. They will buy on credit and finance these loans at record-low interest rates. Companies are setting a trap for themselves by increasing leverage at record-low rates with shares at record-highs. Traditional vanilla investors who are under the false belief that they are not trading on margin, actually own highly geared instruments when they buy shares of listed companies.

QE and interest rate manipulation adds layer upon layer of new risk in the system. It leads to “malinvestment” or the misallocation of capital. Retirees own geared positions in their share portfolios while they themselves are under the false impression that they are merely invested in vanilla stock positions. What better example of misallocation of capital can there be when geared instruments are stealthily forced upon novice investors by Reserve Banks?

With new rounds of QE on the horizon, this trend is set to continue, the music hasn’t stopped…..yet…..

Sensei:

Refer my post here. One would imagine the goal of QE is to supply cheap money to them that need capital for expansion, machinery, working capital. Low interest bonds only harm fixed income investors when it still costs a US mom&pop small business 8% to finance an equipment overhaul. The bankers in the middle may be the problem? Looking locally, one can possibly maybe on a good day at the credit committee and their Basel rules, get 10% finance on a 50% loan to value asset, if there is 300% operating cashflow cover AND the owners sign full surety.

The question we have to ask ourselves is this – what kind of business model needs record-low rates of inflation in order to be profitable? When the discount rate is near zero or even negative, the lousiest business plan is profitable. Take the fracking-industry for instance. They rely upon a steady supply of cheap credit from pension funds who buy their bonds. The pension funds are in a desperate search for yield and are forced to support unprofitable business plans to get that yield. In the quest for a return on capital, they forget about the return of capital. A farmer in the USA or Canada can access financing for below 2% per annum. He can buy a tractor interest-free and produce to compete with a local farmer who pays 10% on a production loan.

The most efficient farmer in South Africa does not stand a chance against the Federal Reserve Bank, which is his ultimate competitor.

When the yield on the US 2-year Treasury Note is below that of the 30-year bond, then the cost of money is below the long-term rate of inflation, the cost of money is negative in real terms, or credit is for free. The fact that the international markets experience a crash every time the 2-year goes above the 30-year (inverted yield curve) tells us that the markets are hooked on cheap credit, or free credit. The business models don’t work when money has a price that is positive in real terms. That is shocking!

In the first sentence, I meant to say – record low rates of interest(not inflation) in order to be profitable. I apologise.

Sensei : we might be saying the same thing. My point is that the actual cost of capital is not reflected in the QE efforts. Money is not getting cheaply to where money would have an economic impact.

Johan
I agree. The Fed is “pushing on a string”. The declining velocity of money means that Fed action does not benefit the real economy. This situation can only begin to improve once banking regulations are scaled back. Then the money multiplier can kick in to excelerate the velocity of money.

Both of you have absolutely brilliant posts. I literally log on each day to see what you have said. Thank you!

No man, I don’t have a microscope on my desk. Please fix the graph sizes. When I click on them to enlarge, it becomes even smaller…

IMHO the problem with QE and virtually zero % supply is that the money costs, in the US, normal businesses about 9%

Why is nobody asking the question about the difference in cost of capital for a midsized business needing asset or working capital finance, and the virtually free cost of capital that governments are creating?? I would love to see a graph of US or German prime rates plotted against money supply rates.

That is the handbrake on growth that needs addressing

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