An inflection point?
At the turn of the year, the first period of synchronised global growth since the financial crisis – with all major regions accelerating in tandem – prompted the International Monetary Fund (IMF) to conclude that the legacy of the financial crisis had finally been shaken off.
Barely six months after extrapolating 2017’s purple patch for the global economy, the IMF has been paring back the optimistic forecasts for global growth made at the turn of the year. In its latest World Economic Outlook, it snipped 0.3% off German, French and Italian growth for 2018, while it pruned forecasts for the UK and Japan by 0.2%.
Meanwhile, the world’s major central banks, led by the Federal Reserve (Fed), continued to tighten policy throughout 2018. Concurrently, Beijing reined in support for the economy, with the focus shifting towards the maintenance of financial stability. The continued slowdown of the global economy since the start of the year is directly a result of this continuing policy tightening.
The IMF’s reappraisal of the outlook has been echoed across most financial markets. Over the year to date, returns from few asset classes have beaten cash, with the notable exception of US equities. The rational exuberance that prevailed at the start of the year – the belief that despite rich valuations, a continuation of synchronised global growth would underpin handsome returns for investors – looks increasingly suspect.
Testament to how far the consensus has shifted, by August investors were asking whether the authorities in China were getting ready to make a return to fiscal and monetary largesse in a bid to arrest the economic slowdown and rising financial stress. The summer saw increasingly vociferous calls for renewed stimulus from China’s fiscal mandarins and vested interests. Not to disappoint, the National Development and Reform Commission announced a fourfold increase in infrastructure project approvals in August versus July.
At the same time, the People’s Bank of China announced a softer stance on loan quotas, with banks ordered to raise lending for infrastructure and one small bank receiving a 50% increase to its quota for August. Bank loans are predicted to rise more in the second half of 2018 than in the first half, whereas loan quotas are typically frontloaded into the first half of the year. The question then is whether the third quarter marks a policy inflection point that will in due course reflate financial markets.
Can China reflate the world?
Investors look to China for good reason. Since the financial crisis, China has been the main driver of global growth. Furthermore, investors have been conditioned to expect the authorities in China to stimulate when the economic going gets tough, just as they did in 2009-11, 2012-13 and 2015-17. However, based on the facts available today, the magnitude of the recent easing looks to fall well short of those previous rounds of stimulus.
As such, we worry that it is unlikely to reflate the Chinese economy, let alone the global economy. Should the macro environment deteriorate further in China, a more concerted effort at reflation is likely. However, with the current-account surplus now much diminished, the bloated Chinese financial system is increasingly sensitive to changes in global financial conditions. To this point, the experience of 2015 is perhaps indicative of the increasingly binding constraint on the ability of Chinese policymakers to stimulate the economy.
When the People’s Bank of China began expanding its balance sheet to provide liquidity to Chinese commercial banks to counter the growing non-performing loan issue, it exacerbated capital outflows and currency weakness, leading to a further tightening of domestic financial conditions that undermined efforts to stimulate the economy. It was only when the Fed stopped tightening and the European Central Bank (ECB) ramped up its own asset-purchase programme that global financial conditions eased, giving Beijing a free hand to reflate the Chinese economy.
It has become increasingly clear over the course of the year that the financial conditions have been deteriorating in the offshore dollar financial system. The emerging-market rate-cutting cycle that began in 2016 has come to an end, with a number of emerging-market central banks forced to increase interest rates and intervene in the currency markets to defend against capital outflows. There is little reason to believe that global financial conditions are about to ease any time soon. The Fed, along with other major central banks, continues to tighten monetary policy. September saw the Fed increase interest rates by another 0.25% (to 2.25% – the eighth increase since December 2016), while monthly asset sales will increase to $50bn. The month also saw the ECB announce that its own asset-purchase programme will finish at the end of the year
You can go your own way?
An appraisal of the US economy gives little reason to expect that the Fed will stop tightening monetary policy anytime soon. The US economy and financial markets continue to inflate, fuelled by easy fiscal policy at the expense of the government balance sheet, easy financial conditions, a tax cut which is financing leveraged buyouts in the equity market, and financial capital inflows from the offshore dollar financial system. The performance of the US equity market is thrown into sharp relief when compared to the returns from indices in other major regions.
At the start of the year, the consensus was expecting US equities to underperform after the equity bull market had broadened out and the post-financial crisis laggards continued to take the lead on the back of synchronised global growth. Yet, nine months into the year, the US equity market is once again in pole position, having chalked up solid positive returns year to date, whereas many other markets are in negative territory. This has led to another debate in markets – can the US ‘decouple’ from the rest of the world?
We do not think that such a decoupling is likely. While the US is clearly pursuing a more nationalistic/self-interested foreign policy, for now the US economy and US companies remain deeply embedded in the global economy. In 2017, S&P 500 constituents generated 43% of their revenues outside the US, reflecting the fact that US corporations have been phenomenally successful at taking market share at the global level. Testament to the success of corporate America in creating ‘shareholder value’, the quarter saw Apple become the world’s first trillion dollar company, a market cap which reflects the company’s global reach.
Given the performance of the US economy and markets, loose fiscal policy and monetary policy tightening look set to continue. So too does the tightening of financial conditions in the offshore dollar financial system that this policy mix is exacting. As such, economic growth and financial assets in emerging markets are likely to remain under pressure. However, more so than ever, the health of the world economy depends on emerging markets, which now account for 59% of global GDP, up from 37% in 1980. In due course, we anticipate that the deflation of the offshore dollar economy that US policy is currently precipitating will infect the US economy and markets, but as it stands, they appear unruffled.
Financial crisis 10 years on: more debt and more money
There is no agreed date on which the global financial crisis officially began, reflecting the fact that a financial crisis is better thought of as a process rather than an event. The third quarter marked the 11-year anniversary of when BNP Paribas froze withdrawals from three of its investment funds linked to US sub-prime mortgages, with money markets starting to seize up shortly afterwards. Ten years ago, Lehman Brothers was allowed to fail, a move which is considered by many to have been a mistake and the start of the financial crisis. The escalation of the crisis led to an unprecedented coordinated response from the world’s central banks, which continues to this day. The fact that over 25% of the global economy still operates under negative central-bank policy rates, and that around 15% of all global government bonds trade with a negative yield, is indicative of the shadow that the crisis still casts.
The crisis also led to a regulatory response. A widely held view among investors is that post-crisis improvements in global financial regulation have delivered a more stable financial system and will prevent financial distress from spilling over into the real economy. Regulators, however, are destined to fight yesterday’s war. While structural reforms in the banking system, including steeper capital requirements and stress tests, may give comfort that we are not destined to see a repeat of the financial crisis, it is highly probable that ultra-easy monetary policies have incentivised and enabled precisely the risky financial behaviour that regulations were supposed to limit, only this time in financial pastures new.
As the banking sector retrenched in the wake of the financial crisis, asset-management companies and private-equity firms readily displaced regulation-constrained banks as lenders. The Bank for International Settlements noted that “the increase in international credit since 2010 has been driven primarily by debt securities rather than bank loans. At the same time, the US dollar has become even more dominant as the prime currency of denomination since the global financial crisis). This ‘second phase’ of global liquidity implies that global financing conditions have become more sensitive to developments in the bond market, and even more tightly linked to US monetary policy. Emerging-market borrowers may be particularly vulnerable if they have relied heavily on US dollar-denominated debt securities, as international bond investors tend to retreat quickly when US rates rise”.1 This evolution has only served to increase the opacity of the financial system, making it increasingly difficult to see what is actually going on.
The increase in international credit since 2010 has been driven primarily by debt securities rather than bank loans. At the same time, the US dollar has become even more dominant as the prime currency of denomination since the global financial crisis). This ‘second phase’ of global liquidity implies that global financing conditions have become more sensitive to developments in the bond market, and even more tightly linked to US monetary policy. Emerging-market borrowers may be particularly vulnerable if they have relied heavily on US dollar-denominated debt securities, as international bond investors tend to retreat quickly when US rates riseThe Bank for International Settlements
The most worrisome side effect of recent monetary policies has been a continuous increase in the ratio of non-financial debt to global GDP. The 2008 crisis offered an opportunity for deleveraging, yet the opposite has happened. Debt has continued to pile up worldwide. At the end of Q1 2018, total global debt stood at $247 trillion, which is equivalent to 318% of GDP, up from $178 trillion ten years ago, when debt accounted for 282% of GDP. In solving the crisis, more debt has been added to an already heavily indebted system. Central banks have imposed a decade of extraordinary measures, from most of which they are still struggling to withdraw.
Storing up trouble?
Since the financial crisis, debt has been accumulated more readily in emerging markets. The recovery in emerging economies was lauded as part of the post-crisis solution, being seen as a picking up of the economic growth baton from the crisis-afflicted developed world. A new dawn beckoned. Now, however, emerging economies and the debts they have accumulated are part of the problem.
The fact that so much of this dollar-denominated debt has been issued by non-residents means that another costly currency mismatch crisis could be on the cards.
History may not repeat itself, but today there are some roots in, and rhymes with, those earlier crises. Following Argentina’s acute difficulties earlier in the year, the collapse of the Turkish lira was perhaps the most telling development of recent months, with Turkey palpably vulnerable to the gamut of changes now occurring in the framework of global finance and economics.
The country’s difficulties are to some extent attributable to President Erdoğan’s management of the domestic economy and bellicose handling of foreign relations, which included the allegation of a foreign “operation” to bring down the Turkish economy.2 However, the tightening of US monetary policy, the accompanying resurgence of the US dollar (in which mountains of unhedged Turkish debt are denominated), and the breakdown in the rules of multilateral trade are momentous exogenous changes that have significant ramifications for Turkey and economies like it.
Alongside Ankara’s woes, there were wobbles in other emerging markets whose external financing traits resemble those of Turkey, such as Brazil and South Africa. Sentiment towards emerging markets was not helped by mounting evidence of slowing demand in China, rising oil prices, and sharp falls in the prices of industrial metals such as copper, aluminium and zinc, as well as from escalating trade disputes between the US and China.
The near-term fate of emerging markets which have soaked up abundant and cheap liquidity over the last decade stems from changes which have the potential to cause wider complications. The price of money is rising meaningfully for the first time in a decade, not least for foreign borrowers of US dollars.
Finance – doomed to repeat itself?
Extended periods of loose finance distort market participants’ perceptions and expectations, the structure of economies and the functioning of markets. The decade of easy money orchestrated by the central banks since the financial crisis is no different. Years of quantitative easing-manufactured liquidity backstopping markets have fundamentally changed the way market participants view risk. With the financial system awash with central bank-created liquidity, deleveraging dynamics have not been able to attain momentum. Safe in the knowledge that the central bank ‘put’ (safety net) was firmly in place, a buyer was always there to welcome the dip.
Today there is little concern that trouble at the ‘periphery’ will gravitate to the core. Long forgotten is the traditional dynamic in which risk aversion at the periphery commences a process of de-risking and deleveraging that leads to declining liquidity conditions and financial contagion. A major default in emerging markets, whether in the government or corporate sector, could have consequences for European banks in the same way that the onset of the Asian financial crisis in 1997 affected Japanese banks that had lent heavily into developing Asian economies, owing to a lack of demand for credit from Japanese borrowers following the bursting of the Japan’s bubble economy in 1989.
With the private sector retrenching in their domestic markets, European banks have funnelled liquidity into the emerging world. Spanish banks in particular have loaned heavily to Turkey, Latin America and other developing nations, leaving them exposed to a credit event in these economies, and thus providing the channel for financial contagion. In a similar vein, it should come as no surprise that the German government pledged to support Turkey, given the extent to which European banks have made loans to borrowers based in Turkey.
The mounting financial stress over the course of 2018, particularly in the offshore dollar financial system, show that continuing monetary tightening is taking its toll. With global asset purchases by central banks set to turn into aggregate sales by the end of year for the first time since the financial crisis, asset markets which have been so quenched by the flow of liquidity to date may well become parched. Against this challenging backdrop, we believe it is crucially important that client portfolios remain focused on investments that do not depend upon another rising tide of debt, liquidity or growth. We think that security-specific characteristics will be increasingly important.
Key investment risks
- Past performance is not a guide to future performance.
- Your capital may be at risk. The value of investments and the income from them can fall as well as rise and investors may not get back the original amount invested.
- The performance aim is not a guarantee, may not be achieved and a capital loss may occur. Strategies which have a higher performance aim generally take more risk to achieve this and so have a greater potential for the returns to be significantly different than expected.
- This strategy invests in international markets which means it is exposed to changes in currency rates which could affect the value of the strategy.
- The strategy may use derivatives to generate returns as well as to reduce costs and/or the overall risk of the strategy. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
- Investments in bonds are affected by interest rates and inflation trends which may affect the value of the strategy.
- The strategy holds bonds with a low credit rating that have a greater risk of default. These investments may affect the value of the strategy.
- The strategy may invest in emerging markets. These markets have additional risks due to less developed market practices.
- The strategy may invest in investments that are not traded regularly and are therefore subject to greater fluctuations in price.
This is a financial promotion. This document is for professional investors only. These opinions should not be construed as investment or any other advice and are subject to change. This document is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that portfolio holdings and positioning are subject to change without notice. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority.