In China, lending growth easily outstrips GDP growth
The rebound in oil prices from USD 26 to USD 40 a barrel, along with a renewed accommodative stance from the main central banks, drove an equity market revival since 11 February, on a similar scale to that seen in October 2015. From the numerous economic statistics published each day, the markets have chosen to focus on those that suggest a brighter economic outlook for both China and the US (never underestimate mankind’s ability to see what it wants to see).
A clear look at the facts, separating the wheat from the chaff, reveals that the new market conditions in place since last summer persist (see Carmignac’s Note for July 2015 “The great transition has started”). Central banks’ dogged pursuit of monetary stimulus allows for significant transitory movements, hence a degree of opportunism.
However, the accumulation of economic, financial, monetary and political imbalances creates asymmetric risks which are unfavourable to current market levels. So, we will not be dancing on the volcano like so many others, even if it is dormant for now.We are paying close attention to risk management and concentrating our exposure on assets whose risk asymmetry still looks favourable (see Carmignac’s Note for March 2016 ("Sleepwalkers").
Faced with very nervous financial markets at the beginning of the year, the main central banks reaffirmed their support. After the Bank of Japan introduced a negative deposit rate for the first time at the end of January, China lowered its banks’ required reserves ratio in February, the ECB announced an increase in, and diversification of, its quantitative easing in March, and then the Fed cut its key interest rate hike guidance announced in December.
Already comforted by oil prices climbing out of the “lower than USD 30 a barrel” panic zone, the markets viewed this flow of “good news” as understandable justification of fresh risk appetite. However, it is just a temporary shift.
First of all, central banks’ positions are a recognition of failure. In the Eurozone and Japan, annual inflation rates, which are still close to 0%, well below the official targets, are forcing central bankers into overkill. And in the United States, it is the economy’s fragility that has prompted the Fed to revise its predictions of gradual monetary policy normalisation downwards, two months after announcing them.
Most importantly, the markets still do not see these failures as being inevitable. The problems facing the global economy – overleveraging and insufficient demand – will not be resolved by monetary policy alone, however unorthodox it may be.
As we described under the medical term “iatrogenic” in last month’s Carmignac's Note, central banks’ squeeze on interest rates is now exacerbating the situation that it was supposed to ease: it encourages governments to continue borrowing, weighs even more heavily on banks’ profit margins, and increases consumers’ savings requirements instead of providing an incentive to spend. In this context, it would be very short-sighted to rejoice in central banks’ latest effort in vain.
Cruelly, the markets would be just as wrong to delight in the prospect of monetary tightening in the United States. As it is, Fed chair Janet Yellen may soon have to admit that the cost of rents and staple products has started to rise in the US, which is all the more unfortunate as it not only fuels inflation, but also erodes purchasing power and therefore darkens the consumer spending horizon.
The US growth issue
The debate on the US economy’s resilience clearly continues. All and sundry extrapolate each new statistic in a kind of chartist analysis of the economy passed off as research. This myopic approach to macroeconomic analysis makes markets even more unstable. It seems more reliable to examine the fundamentals of current economic movements, and from these try to draw lessons and identify trends.
What we see is that US profit margins have dropped from 10.6% at the end of 2011 to 7.6% today. So we are now, logically, seeing a lasting change in the investment cycle, with profit margins the main influencer.
Furthermore, US consumer spending has been enjoying a dual wealth effect for more than five years (through rising property and financial asset prices), which is now fading. So it is natural that consumer spending on goods and services is now starting to slow, and the savings rate is rising (to 5.4% from 4.9% at the end of last year).
We think the risk of US growth dropping well below the 2% mark in 2016 remains high, all the more so that the Fed – which is now in a monetary tightening phase – can’t intervene by easing its policy. The markets are not prepared for this.
The China issue
The path followed by the Chinese economy, which alone accounts for 16% of global GDP and 25% of investment, is obviously decisive for US and European activity, as well as for market risk. This raises a serious issue, as economic rebalancing at a time of serious industrial overcapacity makes a drastic reduction in China’s rate of investment unavoidable.
There are two possibilities that could arise from this. Firstly, the rate of investment could be quickly adjusted. In this scenario, a marked depreciation of the renminbi would be very hard to avoid due to capital outflows and the need to absorb the shock from this blow to the domestic economy. Such a devaluation would also exert much heavier pressure on the competitiveness of the world’s other leading economies. It is the perception of this risk that opened the markets’ eyes a little at the beginning of this year.
The second possibility is for the government to continue financing only a very gradual slowdown in this investment to sustain growth. This seems to be Chinese authorities’ preferred option today. In this case, news on growth will be reassuring in the short term and the market may be happy with this, especially if currency controls manage to limit the loss of foreign exchange reserves in the immediate future. However, in this case, Chinese private sector debt, which has already surged from 140% of GDP in 2008 to 240% today, would continue to worsen. This is due to the credit growth of between 16% and 20% per annum easily outstripping GDP growth, which stands at 4% to 5% at best. Aggravating this situation, non-performing loans in the banking sector equate to nearly a third of Chinese GDP by our estimates. This path is therefore untenable.
The markets may be able to ignore these scenarios temporarily, but we believe they require very careful management given the highly asymmetric risks that they present.
While central banks have no choice but to carry on doing what they can, their ability to take effective action is reaching its limits, as the markets started to realise at the beginning of the year. Meanwhile economic risks have continued to build up. Then there are the new political pitfalls in Europe, which feed off each other: economic impact of the migrant crisis, security and Brexit risk.
This diagnosis is certainly not incompatible with transitional market movements. But for the moment it justifies us keeping our conviction-based investments safe under the shelter of careful risk management.
Like the BoJ, the ECB seems unable to control the performance of its currency. Despite a significant increase in its quantitative easing and interest rates moving ever further into negative territory, Mario Draghi could not stop the euro from rising sharply against the yen and the US dollar in March. The single currency also strengthened against the pound sterling, which was shaken by the risks associated with Brexit.
Our euro-centric currency strategy thus continued to pay off. We seized the opportunity to take profits on our yen positions and rebalance our holdings between the euro and the US dollar. We are still avoiding emerging market currencies, which continue to look vulnerable.
European yields resumed their convergence in March after the ECB announced a new range of unorthodox measures. Our Portuguese and Greek sovereign debt positions reaped the benefits. On the other hand, the Fed’s wait-and-see approach, despite an inflation uptick, generated pressure on the long end of the US yield curve: the markets are now expecting the Fed to be more passive as inflation temporarily exceeds its target. This prompted us to reduce our US government bond exposure in our overall strategy.
At the same time, we further strengthened our corporate bond positions, especially in the commodities sector, while oil prices continue to stabilise. This segment offers an excellent risk/return profile for investors remaining selective in their portfolio holdings.
The sharp decline in Brazilian yields amidst a possible change of government and economic policy in Brazil contributed to our overall performance through our Brazilian sovereign bond position.
The massive and indiscriminate equity market rally in March bore the hallmarks of investors closing out their short positions rather than returning to the asset class. Emerging markets and European cyclical stocks outperformed by some distance, despite the current economic slowdown. We did not really benefit from this development. Analysts’ continued downward revisions to their profit forecasts give us little reason to gain anything other than tactical exposure.
We are therefore remaining conservatively positioned due to the asymmetry between valuations offering limited upside potential, and a significant downside risk relating to central banks’ loss of credibility. Our main equity performance driver will therefore remain stock selection involving companies that either have the potential to grow their earnings independently of the economic cycle (typically the case with healthcare and technology stocks), or show attractive valuations and restructuring potential (such as in the US energy sector).
Carmignac Portfolio Commodities matched only some of its reference indicator’s rebound over the month. This rally was led by the most distressed companies while the fund, positioned in quality companies, is able to outperform over the long term.
We continued to unwind some of our hedging strategies in March to increase the Fund’s level of exposure. We also carried on building positions in companies able to benefit from steadier oil prices. This was notably the case with US oil service provider Helix Energy Solutions Group.
Funds of funds
Our funds of funds’ highly defensive positioning proved detrimental in March after serving us well at the beginning of the year. The Funds’ exposure levels remained cautious at the end of the month, although we did take profits on some safe haven assets including our currency allocation to the yen.