.
.
.
.

Weekly investment: almost time to be contrarian?

Willing to ‘think the unthinkable’ in our investment views will lead to investment success in 2016

Claude-Henri Chavanon

Published: Updated:

Renewed sizeable falls in Chinese equity markets late last week were almost entirely shrugged aside in developed markets. This may have been partly due to Wall Street’s half-day session and reduced volumes on Friday, at the end of which the S&P 500 index closed up 0.1% on the day, although there does seem to be less follow-through between the West and the East these days. On Friday the main Chinese equity markets closed almost 6% lower, demonstrating the most volatility for three months, after reports that some leading brokers had been placed under regulatory investigation.

Emerging and developed markets will probably only be affected by Chinese events from this point if Chinese growth stumbles afresh, and commodity prices fall even further. In the meantime, however, we would note that last week’s falls happened to occur at a significant technical resistance point (i.e. focused close to 3,650 on the Shanghai Composite, and 2,350 on the Shenzhen Composite). The very badly-received policy moves designed to calm the market this summer in the wake of the Chinese stock crash appeared to be (incredibly!) fading from investors’ memories, only for this rude awakening to occur. The botched interventions reflected a lack of experience in the regulation of markets, rather than evidence that the Chinese authorities are failing to manage the transition in its economy. Such a judgment appears premature, especially as some very significant macro-level policy adjustments (e.g. in effect slashing rates a few weeks ago) have been made. Lastly, although the majority of market commentators don’t trust the Chinese GDP statistics, let’s not forget that the services side of the economy (judging by both official and private PMI readings) appears to be doing well, and that this could now be about half of that number - even if the number itself remains rather fuzzy.

In contrast to expectations for monetary tightening in the U.S. in a few weeks, most in the markets see the ECB easing monetary policy further when it meets this week. However, as with the Japanese a few weeks ago - if the ECB do disappoint, it could actually be perceived as a sign of strength (i.e. that eurozone growth is thought to be sufficient to ensure economic health at an acceptable level), even if it’s not shooting the lights out. Some commentators still have doubts about whether the ECB is really serious about its commitment to QE, though; the influence of the Bundesbank is surely substantial, and the latter has always been about ‘hard money’, and being a bastion of economic prudence. We are still asking ourselves why a reputable central bank would want to engage in such an experimental policy in the absence of another Great Recession? Nonetheless, the market expects another 20 basis point deposit rate cut (to minus 0.4%), and a €20bn increase in monthly asset purchases, says the FT, which also noted Danske Bank’s comment that the ECB is considering the introduction of a two-tier deposit rate system (which appears to have helped in Denmark and Switzerland). With yields for quality sovereign paper in the eurozone already negative, buying more quality bonds deepens the experiment further, and forces the ECB further out along the risk curve, into lower-quality paper, and we doubt this is something they are comfortable doing.

In addition, let’s once again consider how unusual it is to have negative rates at all, which have been turning established economic and banking mechanisms on their head. John Maynard Keynes would surely be horrified. As we have said in months past, an optimum allocation of resources is far less likely to be achieved if rates are artificially low - and this is already difficult enough to do with positive rates. Not only do banks have difficulty passing on negative deposit rates to customers, but think of the way all this affects the pensions industry in an era of aging populations. Pensioners used to be able to emphasize yield and income the closer they got to retirement; nowadays they and their advisors have to take more risk to achieve capital appreciation, out of which income must be drawn. And as income fund managers will tell you, ‘dividend-stripping’ doesn’t work! It only reduces capital.

OPEC meets on 4th December in Vienna for one of its regular meetings. Part of the background is that non-OPEC oil and gas capital investment has been cut since the oil price tanked. Will Saudi Arabia, as the prime-mover, begin to reduce its (over-) production, and encourage other OPEC members to do so? We think that would be premature, and that they anticipate taking more pain themselves before such a significant change of policy. There are solid fundamental reasons why oil prices are likely to remain in a trading range of about $35-50 on WTI (vs. $41.83 as we go to print) for the next few years (add a spread of about $4 for Brent; the OPEC reference price is about half way between the two). At the lower end of the envisaged range, demand will be stimulated and U.S. shale oil and Canadian oil sands producers will be hit – while at the upper end of the range, producer forward selling will materialize, as would more U.S. shale-derived production. The IEA is currently projecting an average WTI oil price of $51.0 (for WTI) for 2016, and $56.24 (for Brent), compared to $44.77 currently. Depending on the exact grade, the 2019 forward price for oil is quoted in a range of $60-62. For planning purposes, it is safer to be on the conservative side; accordingly, for 2016 we are assuming an average of $46 for WTI and $50 for Brent, but with significant volatility around these numbers. Looking to the downside, the existing physical inventory levels are truly substantial. On the upside, the political ‘premium’ could increase if, for instance, Saudi Arabia experienced growing political instability, and/or if the shorts decided to run for cover.

To guarantee sound overall fundamentals in the oil market, China must get through its current difficult transitionary period, and India must continue to make progress, resulting in sustainable economic growth. Clearly, both the above would lead to increases in oil and oil products’ demand. Other factors that could improve the oil price outlook include a more substantial reduction in U.S. production. With a U.S. interest rate increase pending there are signs that the availability of capital to U.S. oil producers is drying up quicker than thought. Also, the strength of the dollar in recent months and years must have impacted the global demand for oil - so what if the dollar reversed course, or even just meaningfully corrected?

Picking-up on India, there may be hope for some progress on structural reform in India, with signs of a move on GST (general sales tax). With the apparent prompting of former Prime Minister Manmohan Singh, Congress President Sonia Gandhi met with Prime Minister Narendra Modi to discuss the issues at hand. Modi is understood to have agreed to consider two of the three adjustments proposed by the Congress Party regarding the implementation of the GST. The Congress Party has gone away to consider their response to the bi-partisan talks, and the two sides are expected to meet again soon. A resolution of the GST issues would give much needed impetus to the reform programme. The implementation of a country-wide GST and the Land Acquisition Bill are two crucial pieces of legislation that the government is keen to make progress on. The setback for the BJP party in the recent Bihar elections showed that the government was going to have to be more open to negotiation to achieve reforms, and hopefully Mr Modi has received that message loud-and-clear. The markets will be hoping this is the start of renewed progress on reform in India, beginning to make all the hopes of the past eighteen months reality.

In summary, we feel that being willing to ‘think the unthinkable’ in our investment views will lead to investment success in 2016. As the U.S. heads slowly (but we think surely) towards a cyclical recession - ahead of the eurozone, for instance - the U.S. administration will need to get the dollar down to a more competitive level against a range of currencies, to boost exports and maximize the value of overseas earnings upon translation (about 48% of typical S&P500 earnings). Apart from pure safe-haven demand, it is increasingly difficult to see what will lead to further dollar strength from this point, especially as the perceived size of the ‘dollar bullish’ crowd is now so huge. We are now more mindful that euro/dollar parity may not be seen after all. In recent months we have been focusing on the likelihood that the IMF bringing the Chinese renminbi into the SDR fold (as is now happening) could be instrumental in turning the dollar, via central banks having to buy renminbi (and selling dollars to do so).

Emerging markets look almost low enough to buy - perhaps once a U.S. recession or growth recession becomes apparent, and we are crunching the numbers for such a contrarian call. Commodity markets - so important to emerging markets - already look really dire. Also bear in mind that most of these currencies have been hammered as capital has flowed out of these countries.