Strategy update: tested faith
Tristan Hanson, Head of Asset Allocation, Ashburton Investments.
Recent developments in Europe and China pose important questions for investors. They test two widely held faiths: the first is the ‘whatever it takes’ commitment to the euro among Europe’s leaders; the second is the ability of the Chinese authorities to control their country’s economic destiny.
Through the crises of recent years, investors have comforted themselves with these two beliefs. Europhileshave frequently warned sceptics not to underestimate the political commitment to the euro project. Meanwhile, China pessimists have been encouraged to remember that the authorities have over $3.5 trillion in foreign exchange reserves, the government has room to stimulate and central planning is more efficient in an authoritarian, one-party state. Whatever goes wrong, the Chinese authorities know which levers to pull.
The Greek bailout negotiations and China’s heavy-handed efforts to stabilise the stock market give pause to reconsider these beliefs.
Greece: stuck in a debtor’s prison?
It went to the wire, but one might conclude the current phase of the Greek crisis is over – after all, a €7bn bridging loan has been made ahead of a longer term dealto be negotiated over the coming weeks. Expectations are that the Greek government will comply with the conditions required to enter negotiations and that a three-year ESM financing deal will be signed in August. If all goes to plan, ‘Grexit’ risk should be off the table.
But to think Greece is completely out of the woods would be wrong.
The situation remains desperately fragile. Prime Minister Tsipras will support a deal he objects to only because the alternative of leaving the euro seemed too awful to contemplate. His party, Syriza, has fractured, with a significant number of its MPs opposed to the creditors’ terms. Curiously, therefore, the Prime Minister is reliant on opposition support to obtain the three year bailoutwhile much of his own party is sceptical. So the best case outcome here is that Greece signs a tough, uncompromising deal with creditors to which there is limited commitment from the ruling government. Therisk of political instability is evidently high. The status quo of Tsipras managing to balance internal conflict with ESM negotiations hangs by a thread.
The sustainability of any bailout deal appears dubious, not only because of a lack of political commitment but also the likely impact further austerity will have on the Greek economy. The proposed deal will place heavy emphasis on structural reforms (specifically dictated by the creditors), some of which will be welcome; but one conclusion to the failed austerity of recent years appearsto be that there wasn’t enough austerity. Most likely, it would seem, is that the Greek economy will remain locked in depression, imprisoned in the policies dictated by Germany-led Europe with regular visits from the wardens, i.e. the Troika (EC/ECB/IMF). It is unclear how long Greeks will put up with this.
Greece is a small economy and, from a global investor’s perspective, matters only to the extent the country creates financial contagion elsewhere. The bigger issue relates to the truths applicable to the wider currency union, highlighting its vulnerabilities and exposed by recent developments.
First, while fair to argue the creditors’ stance might reflect a democratic balance of opinion at a Europe-widelevel, developments have sharpened national divides along creditor-debtor lines, a conflict between democracies made worse by the single currency.
Second, debtor nations have lost national sovereignty, as the Greek referendum illustrated – the deal on the table was publically rejected, only for the Prime Minister (who had campaigned ‘No’) to sign up to something as tough a week later. The creditors will dictate all economic policies in Greece if the country wants to remain in the euro area.
Third, we have learned that commitment to the euro is not absolute. ‘Whatever it takes’ might not apply. The hard line attitude of certain creditor country governmentswas predictable but German finance minister Wolfgang Schaeuble’s public desire to force a ‘Grexit’ wasremarkable.
Fourth, in case you ever doubted, the euro area does not have a proper lender of last resort, as Greek depositors will testify. The ECB’s refusal to provide additional liquidity to banks which were deemed solvent at its own Comprehensive Assessment less than a year ago is another twist in this sorry farce. Rather than act as lender of last resort, the ECB has played the role of European enforcer – it is the ECB’s decision to freeze liquidity that made ‘Grexit’ the only alternative available to Greece, a decision which the central bank did not have to make.
None of the above observations are to absolve the present or previous Greek governments from blame. Rather they are highlighted to illustrate the fragilities inherent to the wider euro project. The uncompromising stance of the creditors with insufficient focus on stimulating growth and (so far) remarkable intransigence on debt relief (an inevitability one way or another) has hardened nationalist sentiment, widened the creditor-debtor divide and once again called into question the long-term viability of the euro area.
How policymakers and citizens subsequently respond to recent events will shape the future of euro area. There may be good consequences as well as bad. Let us hope for the former.
Some have summarised the crisis as a race between economics and politics – can economies recover quickly enough to prevent political backlash? Can euro nations move closer together, or is a common currency pulling them apart?
As Martin Wolf of the Financial Times puts it, the Greek people elected a “dreadful government produced by desperate times”. But the creditor nations have played a risky game. By adopting a tough, imposing stance with Greece they hope to present a credible threat to any other recalcitrant governments. The danger is they have made the euro project a much less appealing idea altogetherand opened Pandora’s box by hinting at its reversibility.
China’s ‘visible hand’
The sharp decline in China’s equity market (after a colossal rally) has provoked widespread attention, not least among the nation’s policymakers.
In a dramatic turn of events, the Chinese authorities unleashed a number of measures to stem the stock market’s decline, which even after the -33% rout in the Shanghai Composite, remained close to 3,500 compared to just over 2,000 a year ago. The government wasn’t so blatantly intervening last year, yet has deemed it necessary to do so now after the recent retracement.
In late June/early July, the authorities cut interest rates, increased liquidity provision, loosened margin requirements, supported a market stabilisation fund, instructed direct government investment, halted IPOs and banned major shareholders from selling shares.Meanwhile, as the market plunged, half of the listed companies were suspended from trading on request of company management in order to stem the panic.
These are extraordinary steps for any government to take, yet alone one which is espousing a shift to a more market-based economy. Having effectively sponsored a bull run in the equity market starting last year, recent actions expose just how concerned the Chinese authorities are that any negative financial spiral could unfold. So far the measures have stabilised the market, as one might expect - if you cannot sell it is hard for prices to fall.
The heavy-handed government response may indicatehow difficult it might be for China to transition its economy. If nothing else, it does not make for a healthily functioning stock market.
Some may rationalise events as of limited significance. China ‘A’ shares listed in Shanghai and Shenzhen are owned primarily by domestic investors as foreigners have been restricted from investing. For a long time this market has been viewed from afar as the Wild West of the East, a punter’s market dominated by retail investors.
The bigger risk is if recent action shakes confidence in the ability of the Chinese authorities to determine their fate. They might not be all-powerful as some assume.
Observers should by now realise the paradox of how much – and how little – power economic policymakers have in general. It would be hard to find a central banker or finance minister today who is entirely satisfied with their country’s economic performance, in spite of actions they took in the hope of a better outcome. Important policy choices such as QE might have large financial market impact, but still prove disappointing in terms of economic results. What is true for policymakers in the rest of the world has relevance to China.
Most investors have maintained faith in the Chinese authorities to pull off a gradual economic slowdown, while transitioning the economy to a more sustainable footing in the long-term.
We too share this view. We would also consider the achievements to date as successful in the face of immense challenges related to the property market and local government infrastructure financing. We believe easing measures over the past year will help support a stabilisation in near-term growth in China, although we expect a prolonged further slowing in the future growth outlook, driven not least by demography. Together with the implementation of various reforms, we expect monetary and fiscal easing will avert a hard landing and financial crisis.
China does have immense financial resources, centralised control of policy and a captive and repressed financial sector, all of which give it firepower to prevent an economic crisis. At the same time, we do not blithely assume the authorities will pull all the right levers. We are therefore watching developments closely and reassess our views regularly with regard to both the short- and long-run outlook for the Chinese economy.
Positioning & strategy
We have been more active lately in response to increased market volatility. This applies to our bond positioning in particular, but also European equities and currency exposure.
Having been light on duration across our Multi Asset Fund range, we have increased exposure to longer-dated US treasuries, UK gilts and added some German government bond exposure. At the same time, we have reduced exposure to US treasuries in the 3-5 year space. We hardly find developed market (DM) bond valuations compelling at current yields, but the proposition is now much better than it was following the ~70bps increase in 10-year yields from the lows. Overall, we remain below benchmark duration, but less so than before. Our stance will remain opportunistic in these markets if current levels of volatility persist.
Equities remain our preferred asset class over the coming year and beyond. While global equity valuations have increased over recent years and generally sit above long-term averages, we believe stocks remain more attractive than cash and fixed income. We expect a stronger global economy to support revenue and earnings growth over the coming 6-12 months, which we believe should be enough to sustain rising markets.
Regionally, we continue to underweight the US market and prefer Japanese, Indian and European equity markets. During the height of recent ‘Grexit’ fears, we increased exposure to European equities using an options strategy on the basis that any weakness was likely to be temporary. This reflected our view that either a deal would be struck or that ‘Grexit’ would be followed by a vigorous ECB response – we felt either outcome would be met with a positive investor response on a short-term view. This strategy worked well. We have since switched the call option exposure into direct equity exposure. In addition, we have modestly increased cyclical exposure within our European stocks having decided our equity exposure in the region was too skewed to defensive sectors.
We expect the Federal Reserve to raise interest rates sometime later this year. We believe the market is complacent over the potential for US interest rate hikes in 2016. A rising interest rate environment may create periods of volatility across financial markets. So long as the US economy is growing solidly, however, we expect any rate-induced setbacks in global equities to be temporary. Bonds would face more risk in such a scenario, although we expect the US yield curve to flatten. Conversely, interest rate increases in the euro area and Japan remain a long way off and we expect central banks in these regions to continue providing significant global liquidity via their QE policies.
As gyrations in a number of markets – German bonds, Chinese equities, gold – would suggest, volatility appears to be rising. So long as this is not a precursor to a large sell-off across financial markets, increased volatilitybrings opportunity for active investors.
It also places additional focus on risk management in order to avoid large swings in portfolio performance. We maintain that the greatest risk an investor cares about is a permanent impairment of capital and this remains more important than daily volatility stemming from short-term noise. We emphasise our desire to reduce such risk by diversifying portfolios and avoiding assets which we think are overvalued.
The greatest risk to most diversified approaches – our Multi Asset Funds included – would be a material rise in real interest rates, which would send both bond and equity prices lower. While we believe the market is somewhat complacent on US interest rates over the next year, we only expect those rate hikes to occur if US economic growth is robust, thereby supporting corporate revenues and equity fundamentals. Moreover, with little immediate inflation risk we believe the Fed tightening cycle will nonetheless remain gradual compared toprevious cycles. Conversely, much weaker than expected economic growth would likely impact equities negatively, but DM sovereign bonds should rally in response and provide some offset.
With upside risk to interest rates more likely in the USthan other developed economies, in our view, we expect the dollar to resume its strengthening trend against most major currencies. Having pared back US dollar risk in early June, we more recently increased exposure in July on the sell-off in expectation of future dollar strength. Across the Multi Asset Fund range we selectively retain some currency exposure to the Indian rupee, Mexican peso and Brazilian real as well. We have also added Japanese yen exposure, funded with euros and Swiss francs, in certain funds (UCITS Multi Asset range and the Replica Euro Asset Management Fund).
