Asset Allocation: The big picture
As 2016 opened, the fate of emerging market assets was tied to fears of renminbi devaluation and the collapse in commodity prices. Now market focus has moved, and with a bounce in commodities it is Chinese economic news, as well as the ever-important Fed pronouncements, that determine mood.
The data from China has been showing signs of economic stabilisation, although it is patchy and not overwhelmingly positive. Economic growth – mostly within the industrial sector – has benefited from policy easing over the past year or so, although it remains unclear as to how sustainable this growth may be.
With US data quite disappointing, the Fed remains in wait-and-see mode on how robust the economy is. Recent jobs figures did have hawkish forecasters pushing back the date for their predictions of the Fed’s next hike, moving towards the consensus view of one move this year.
The US economy is perplexing, with so many data series giving ‘unconventional’ signals. Take the housing market, for example. After the huge damage wrought by the financial crisis, this sector has, subsequently, been one of the strongest, prompting the FOMC recently to note how it ‘continues to improve’.
However, the headline housing starts number, is still only at the level last seen in the months after the US economy emerged from its 1990-91 recession, although it has recovered from the historic lows of 2010-11. As with so many other aspects of this atypical recovery, a closer examination of the data actually reveals little wrong with the housing market, so the slow-but-steady growth may be explained by a slow growth in supply rather than by low demand.
Also, it is evident that commercial borrowers have found it easier to access credit than the more risky individual borrowers, which would appear to bode well for mortgage credit quality. Perhaps this steady, unexciting growth will be more sustainable in the long run.
When considering the economies within the CEEMEA investment grouping (Central and Eastern Europe, the Middle East and Africa), it is hard to know where to begin identifying the main influences, and this has never been more true than in 2016.
With many significant oil producers the strongest force currently affecting the macroeconomic numbers is the oil price. The recent bounce has boosted the Russian economy, for example, which contracted painfully in 2015 after oil’s precipitous declines, and now faces upward revisions for 2015 GDP forecasts, from -1.5% to just -0.8%
Geopolitics in CEEMEA are varied, always changing and a dominant influence in investment decisions. Europe’s migration crisis has increased Turkey’s influence, and this looks set to lead headlines for years.
The migration deal brokered between the EU and Turkey is already in jeopardy. While no one believed the deal would not have setbacks, the spat between Turkey’s two top politicians ended with the resignation of the deal’s chief negotiator, the pro-EU prime minster, Ahmet Davutoğlu.
There are now question marks over the independence of Turkey’s central bank, both because the orthodox Davutoğlu has gone, and because there could be moves to widen President Erdoğan’s powers. The president is less keen to befriend the EU than his erstwhile prime minister, and is already suggesting that the the migration deal is intolerable.
Turkey’s position, both geographical and political, is important, and the migration crisis is Europe’s most dangerous problem. However, with the mercurial and aggressive Turkish leadership gaining more powers, the outlook is uncertain for the EU’s politicians. Erdoğan recently stated a blunt and uncomfortable truth: “The EU needs Turkey more than Turkey needs the EU”.
With the softer data from the US, risk-free rates have been trending lower as risk markets become nervous, looking around for something to sustain recent rallies. With political risk high on both sides of the English Channel and the Atlantic, cautious positioning, even within risk-free, is probably advisable.
Although China’s economic data has improved, and thus boosted global risk sentiment, there is scepticism as to both the sustainability of the growth and its ‘cost’ in terms of restructuring and reform, as well as to potential balance sheet damage.
According to the Bank for International Settlements (BIS) China’s combined debt of non-financial companies and households rose from 117% of GDP in 2008 to 201% in 2015, which represents the addition of $15trn (€13trn) of debt. It appears debt is still rising, with total social financing* surging to an all-time high in the first quarter of this year.
While most agree that the speed of this debt creation is ominous, there are differing predictions for its future course. Some argue that China is heading towards its own banking crisis, similar to that triggered when Lehman Brothers went down. Others say China’s situation could instead mimic Japan after 1990.
Emerging market bonds in particular have been benefiting from the rising oil price. However, although the price has risen dramatically, there are no guarantees that these increases are sustainable. Given that tightening supply rather than increased demand from a reflating global economy appears to have boosted oil prices, there are concerns as to the longevity of this trend.
Saudi Arabia, for example, may turn its taps back on to engage in a price war with Iran. If the oil price rises beyond a certain level then there could be little to stop US shale production from coming back on stream. If emerging market bonds have passed the worst they will need more tailwinds than oil’s recovery to keep them sailing.
The dollar index reached its peak early in 2016 and been falling since. The decline has shaken out much of the long-dollar positioning in the market, but may not be convincing everyone that the great dollar bull market has concluded. Many argue that this is just a pause, and that appreciation will recommence soon. This bullish view is predicated on US economic growth forecasts that, although feeble, remain positive and better than much of the world, that ‘normal’ price pressures will emerge, and that the Fed will raise rates.
However, if the dollar does move up, this could be bad for risk, particularly emerging markets. A weakening dollar index has ‘allowed’ the broad Chinese currency index to decline, while the renminbi has risen versus the dollar. Given the positive correlation between the USD/CNY and the VIX, for example, the question is how vulnerable emerging market currencies might look.
Unlike the dollar and the Fed, the yen may appreciate because the Bank of Japan (BoJ) did not announce more QE at the end of April. The ‘wait-and-see’ stance of BoJ Governor Kuroda was not what markets wanted and there is every danger that the USD/JPY rate will move lower as markets push for more action from policymakers to combat the deflationary forces and to boost the economy.
* Total social financing was introduced by the Chinese government in 2011 to measure the debt of non-state entities.