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Growth and expectations have been reined in during the last month
as the short-lived Chinese stimulus – which briefly led to improved
economic data – came to an end and Europe slowed, not least
because of Brexit fears in the run-up to the EU referendum on 23
June. Leading indicators across the globe are all showing soft GDP
growth and the global growth slowdown is leading to expectations of
rates being lower for longer, which in turn is providing support for
risk assets.
In Europe the mediocre economic and company data we are seeing
would usually be alarming, but with low levels of productivity this
level of economic activity still represents above-trend growth. So
we’ve seen equity markets rally off their lows at the first part of the
year, not because the news flow is improving but rather on the
expectation that interest rates will stay low as a result of the low
growth environment.
Core bond yields have rallied and that discount
rate has provided support to long-duration assets and risk assets
more broadly.
But this fragile rally has not made for a robust investing environment.
Nevertheless, it is the environment that we have. Clearly, in a lowgrowth
world we are always closer to the fear of recession, which
we saw earlier this year. Corporates are navigating through the
terrain relatively well, although this is against significantly revised
earnings expectations
Our equity strategy has been to favour the UK, Europe and Asia exJapan
and, while we are well-positioned for a low growth, low return
environment, we have recently decided to take some risk off the
table by paring back our overweight position with regard to Asia exJapan.
China is an ongoing theme. Clearly, markets became concerned by the absolute levels of
Chinese debt and China’s ability to both sustain its growth and engineer a soft landing without
prompting a credit crisis. It has taken on more debt to keep growth growing and markets have
perversely accepted this – perhaps this is another case of extraordinary fiscal and monetary
policy becoming ‘the new normal’.
It is difficult to call when China’s credit issue will become
more immediate, though recent rhetoric indicates there is an increasing clamour for the
People’s Bank of China to address the ‘credit binge’.
Not least with the publication of an article
in People’s Daily citing an ‘authoritative source’ that was critical of the debt-driven growth
strategy employed by the Chinese authorities.
Any departure from a strategy of growth through credit issuance would have significant
implications for markets. It would focus the spotlight on the number of bad loans in the Chinese
banking system and lead to rising corporate defaults. This could bring to an abrupt end the
change of fortunes that has lifted commodity prices. Though I don’t believe we are yet at the
point where the People’s Bank of China will turn off the credit taps, we are keeping a close eye
on it and I am not hugely confident about China’s ability to get through this without doing too
much damage to itself or the global economy.
It is not only China that has a debt issue – net debt to GDP is near or at all-time highs in most
countries. This has not been an issue for corporates due to massive monetary stimulus and low
interest rates, but the underlying macro backdrop is not one that suggests rampant market
returns. There are huge amounts of fiscal debt in the system and generally three ways to tackle
it. Growth is one way, though as we’ve seen this is proving difficult across the globe, while you
can inflate your way out of debt or you can default. Monetary policy has so far failed to result in
inflation working its way into the system, while defaults will do little to buoy markets. Countries
may well try to use all three mechanisms available to them, so we might expect defaults to rise.
We have recently discussed whether any country might seek to write off its debt and what
impact that would have. While this is largely a thought exercise, it is interesting to imagine what
the market reaction would be to, say, Japan writing off its debt, which it largely owns itself. With
no-one to pay back, a write off might not have a hugely negative impact, but it could lead to
currency implications and a knock-on effect on the markets.
In the US, inflation data is ticking upward, with wages rising in most areas, yet markets had
been relatively sanguine until the publication of Fed minutes indicating a June interest rate rise
could be on the cards gave markets the jitters.
Even so, the prevailing market sentiment is that
the magnitude won’t be high enough to prompt a strong market or central bank reaction, which
could be right given the number of deflationary shocks we have experienced.
The US economy needs to create around 80,000 jobs a month to maintain the employment rate.
Job growth has been running faster than that level for over five years, and it appears that job
openings are becoming harder to fill. While wage growth has increased from the 1.5-2.0% range
in which it sat for many years, its recent rise to a 2.5% growth rate still appears tentative.
Against that backdrop, the dollar may have started a much anticipated bull run, with the wellknown
consequences for emerging markets and other asset classes.
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