Market Wrap – 20th June, 2020

Market Wrap for 2020.06.20

Markets started Monday weaker on accounts of (i) 2nd wave of Covid-19 cases in the US and (ii) imported cases of Covid-19 to China (based on European food imports) => this pushed US cash & futures equity into red erasing some of last Friday’s recovery. However, at 2pm on Monday, during US trading hours, the Fed announced it would begin buying (directly, instead of indirectly through corporate bond ETFs) corporate bonds with the New York Fed’s Secondary Market Corporate Credit Facility (SMCCF). This spiked new vigor (or fear?) into US equities and pushed transport names 5-10% higher on the day.

The Fed’s SMCCF will begin buying corporate bonds based on its term sheet, which includes (i) 1.5% portfolio exposure to any eligible issuer, (ii) eligible issuer rated BBB-/Baa3 (as of 22 March, 2020) but greater than BB-/Ba3 (as of the SMCCF’s proposed purchase date), (iii) eligible issuer’s business with significant operations in the United States, and (iv) purchasing on leverage at 10:1 for investment grade and 7:1 for (eligible) high yield. While the Fed’s announcement moved US cash and futures higher, this tailed off on Tuesday with geopolitical tensions rising.

However, moving forward to Wednesday, we see higher shutdown risk (insert tailrisk-on) with (i) New Zealand calling in the military to enforce border controls (over managing Covid cases), (ii) Beijing shutting down all of its schools and sealed off particular residential compounds to stem the Covid spread, and (iii) US cases picking up in six states (Arizona, Florida, Oklahoma, Oregon and Texas) with an expectation for hospitalisations to subsequently rise, as a result.

On Thursday, US equity futures began to show weakness after a relatively mixed Wednesday cash trading performance (NQ outperformed RTY & transportation) on the back of rising tail risk of lockdowns => VIX trading 4% higher to ~35 (in risk territory) post US cash close. Concerns over a second lockdown are warranted => China’s official data suggests it quashed the spread of Covid-19 back in February, however with recent lockdown and work-from-home measures being instituted, it’s risk-on for the US where daily infection count is rising in California and Texas, followed by Arizona and Florida <= this could represent the tail-end of ‘outbreak 1’ or the start of ‘outbreak 2’, pending hospitalisation data.

AUDJPY (L/S) was tipped as one of the key trades for 2020 (on the back of rising inflation concerns), however this may be weakened as Australia’s unemployment rate reached 7.1% (in April vs. 6.4% initially disclosed). Additional risks from (i) a BLM protestor in Melbourne has tested positive and (ii) Qantas has cancelled most international flights until October (as Australia’s Gov indicates its borders won’t be open any time soon). Still, focus will be on the commodity-driven nature of Australia’s economic recovery and Japan’s weakness in exports (amidst weaker global demand) and (relative) increased cost of importing energy. We should not discount the risks that Covid presents, especially on the ‘upper echelon’ of decision makers – Honduran President was hospitalised and diagnosed with pneumonia a day after he tested positive for Covid-19.

On Friday, the UK demonstrated a borrowing spree (under Rishi Sunak) of GBP55.2bn (taking the trailing 3 month total to ~GBP125bn) to stem the impact of Covid-19 on the UK’s economy. NA/EU markets closed lower with Apple announcing store closures given the spike in Covid-19 cases, a decision that brought heightened volatility on the day of ‘quadruple-witching’. Healthcare, specifically biotech, was the only positive performing sector.

My perspective on equity markets

Given the current level of risk vs. reward (read: every market commentator saying ‘distorted’), I remain out of any US & UK equity market positioning (sold out 9-10 June 2020) and will remain underweight both markets until we see greater clarity over (i) US political developments, in particular the social unrests, passing of $1 trillion in additional stimulus, control over Covid-19 spread, and (ii) UK developments on Brexit, clarity over BOE’s monetary policy coordination with its fiscal response (e.g. Project Birch, furlough budget)

US equity markets have sustained an impressive rise on account of improved equity risk premium (from a lower cost of capital), which I believe will represent a short-term ‘blip’ on the long-term equity chart. Given talks of the Fed considering yield curve control and its SMCCF (& PMCCF), in addition to broader QE (including corporate bond ETFs), the cost of debt remains artificially suppressed with (i) risk-free rate and (ii) corporate spreads completely distorted and not reflective of their underlying credit risk. Coupled with this is a general view of US dollar weakness => better relative value trades will present in Asia & Europe.

The US market has been driven purely on the ‘Fed Put’, without accounting for the economy’s underlying drivers: jobs, GDP, and inflation. The Fed’s forecast on the US economy’s underlying drivers underwhelms. The imminent systemic issue arising from inflation will wreck havoc on equity markets and monetary policy (to contain runaway inflation), both of which already sit on their ‘upper limit’ as we face record dislocation in valuation vs. fundamentals. The S&P 500’s concentration in F-A-A-M-G has yet to abate from ~22%.

The consequence of monetary and fiscal response creates a systemic concern over whether credit rating agencies will shift their credit rating spectrum on a fundamentals basis. This would see a weakening on financial thresholds for investment grade => high yield credit (e.g. 4.0x Debt/EBITDA => 5.5x Debt/EBITDA), on account of the system wide leveraging UP and suppressed (i) risk-free and (ii) credit spreads. Credit is always priced on a ‘relative’ basis, not on an absolute basis. If credit rating agencies loosen their financial thresholds (at the same time investors accept looser protective covenants), there will be increased pressure on well capitalised companies to increase their debt holdings (while keeping net debt at 0 or negative). This effectively worsens a key theme from 2019: zombie balance sheets (for investment grade) and zombie companies (for high yield).

Key events from the week are highlighted below:

India vs. China

Clashes on the border between India & China has resulted in ~100 fatalities (on both sides) and tension remains high. Confrontation has brewed for a while over India’s building of a new road in Ladakh which runs along the ‘Line of Actual Control’ which divides the two countries. Understandably, this puts into jeopardy the signing by China & India of the Regional Comprehensive Economic Partnership, which also involves Australia, Japan, Korea, and New Zealand. As India has shifted its geopolitical relations towards the US, at a time US-China relations have soured, puts India’s eggs ‘all in one basket’. India’s alliance with the US is expected to pay-off as Trump & Biden are essentially campaigning over how strict the US policy will be on China post November 2020 elections.

On the other side of China’s land mass, North Korea blew up its North-South Korea liaison office and moved its military police into the DMZ. Meanwhile, Beijing has shut its schools and urged people to work from home in order to extinguish the spike in Covid-19 spread. Questions over China’s growth are at the forefront of how a global economic recovery will be achieved, given China represents the second largest GDP in the world. However, with China escalating geopolitical tensions with pretty much every nation in Southeast Asia (Vietnam, Philippines, Malaysia over O&G and fishing resources, and Taiwan over WTO inclusion) and escalated geopolitical tensions with the West (United States, Canada, United Kingdom, Australia).

China’s Economic Outlook

China’s economy, previously driven by (i) external demand for its manufacturing and (ii) internal production debt-fueled often leading to an overproduction of ‘unproductive projects’ (e.g. ghost cities, roads to nowhere). Infrastructure upgrade has fueled asset wealth and introduced the idea of land ownership to the Chinese. However, what resulted from a decade of high growth was lifting a relatively poor population (on a GDP per capita) into ‘new’ wealth, which spurned global travel & foreign asset purchases. Southeast Asian economies and destination regions in Europe shifted their economic model towards serving the Chinese tourist. A global slowdown dampens China’s growth potential – this places further downward pressure on the ability to recover for already weak & tourism-dependent economies.

Looking inwards, China’s high growth has sustained its debt-fueled growth, something which comes into question if high growth slows, even if still double (the growth rate) relative to the global economy. Gross domestic debt is estimated to reach ~300% of GDP by 2022, a figure which puts into question how they will either (i) service the debt or (ii) deleverage its position. Deflation (if sustained) would exacerbate economic issues so we’d expect a stronger fiscal policy to support credit creation and money supply (via monetary policy, lowering bank reserve requirements and interbank rates) => however, skeptics are rightly concerned over China bank NPLs, particularly as China AMC NPLs are not inconsequential.

China 2H2020 Stimulus

Yi Gang (PBOC Governor) indicated on Thursday that China’s credit creation in 2020 will likely rise to RMB20trn from RMB16.81trn in 2019 and TSF to reach RMB30trn, accounting for ~30% of China’s GDP. PBOC measures to cut bank reserve requirement ratios and lower reverse repo rates has helped boost credit creation. However, the excess liquidity in the system (designed to stem issues of solvency problems) will need to be released in coordination with global economic recovery, in order to reduce the likelihood of demand-pull inflation:

The interaction between China’s economic recovery and global economic recovery continues to be mistimed in 2020:

• In January & February: China shut down its economy, this caused a ripple effect on Western economies as the reduced flow of goods & threat of Covid spread created a massive tail-risk on the economic cycle;
• In March, April, and May: China began (almost full) recovery from Covid spread and began opening its economy, however the rest of world was beginning to enter & remained in lockdown mode, slowing China’s ability to kickstart a recovery from exports.
• In May: Western economies have begun to show signs of lockdown easing, mostly partial but a trend toward re-opening their economies shines light on a potential for V-shaped recovery.
• Since mid-June: Covid cases continue to rise in the US, remains elevated in Brazil, and China contained a recent outbreak in Beijing (via partial lockdown measures) reinstitutes tail risk given chance of further lockdown.

China’s ability to institute lockdowns has been (drastically) more effective than the West. I see elevated risk of a second lockdown given Western government’s inability to institute quick measures to contain a potential new spread. A second lockdown would result from a foreseeable, uncontrolled spread. Given the limited knowledge governments (seem to) know about the virus, this overhang remains unpriced into the markets (given their focus on a higher equity risk premium).

China Financial Market Reform

New rules for Shenzhen’s ChiNext (a tech-focused board), whose constituents feature in benchmarks like FTSE China A50 and CSI 300 index, will be allowed to move upto 20% (either direction) in a trading session. This will impact broker risk-control systems regarding margin financing, share pledging, and ETF inclusion (given potential volatility of premium/discount to NAV). The reform by China Securities Regulatory Commission is meant to ‘open’ its financial markets, away from the volatility-reduced policy measures taken in 2015. Enhanced potential for volatility may increase southbound trading to Hong Kong as funds seek greater stability within the Hong Kong exchange mechanism.

Equity risk for China Big4SOE banks remains the upcoming TLAC issuance (and potential Basel reforms) which indicates a 5-20% dilution to CCB, BOC, ICBC, ABC (in order of dilution).

TINA: There Is No Alternative

The USD’s importance and value often ascribed with ‘there is no alternative‘ is still a currency which carries a relative price => this represents the currency nation’s value proposition (economic, financial, social, and political factors) in comparison with another nation. Some observers expect a 20-30% decline in the USD’s value, primarily against its main trading partners. Five countries account for 72% of total trade weights in the broad USD index: China (23%), Euro (17%), Mexico (13%), Canada (12%), and Japan (7%). Therefore, a weaker USD would require a coordinated strength in China and Euro area, given a combined 40% contribution to the index.

For China, structural reform whereby a shift from (i) manufacturing to services, (ii) investment- and export-led to consumer-led growth, and (iii) financial liberalisation of the financial system would underpin a strengthening RMB, especially in the face of increase US-China trade risk. For the Euro area, fiscal policy coordination between Germany, France and Italy has raised confidence in the area’s ability to maintain unity. Therefore, USD weakness hinges on RMB & EUR strength, which would solve China & Europe’s concern over its sustained current account surplus.

Furthermore, USD’s share of official foreign-exchange reserves has declined from 70% to 60% in the last 20 years. If this trend continues, TINA doesn’t hold in the face of sustained devaluation from increasing debt issuance and weakening of the “Dollar Smile” framework, which describes gains in the USD from EM positioning on (i) US growth > RoW and (ii) safe haven currency. In the near-term, regions able to establish a sustained reduction in nationwide coronavirus cases, of which the US has not established, will give it a ‘leg up’ on its peers.

Given the Fed has effectively locked-down the front-end of the UST curve, until 2022, the flattened yield curve has compressed out any premium from the swap rate between USD vs. G10 currencies. In the medium-term, the Treasury’s sustained debt issuance in the face of weak economic & political structure erodes its (comparative) ability to run a large current account deficit while maintaining low borrowing costs.

US-China Trade War 2.0

Trump is set to meet his advisors ahead of this Sunday’s deadline on the next round of US import tariffs on Chinese goods, while Pompeo has met with Yang in Hawaii which resulted in a pledge of cooperation. Trump’s decision will be to implement (a 15% tariff on $160bn of Chinese imports) or delay the proposed measures. While these measures are designed to improve their respective current account imbalances, heightened geopolitical tension remains a cause for concern over potential for escalation.

Myth of Imported Labour

As raised (to his own contradiction), Mark Zandi, head economist at Moody’s, responds to the question of “shutting down immigration”, in an interview with CNBC, that sectors like “agriculture, construction, leisure and hospitality” as needing ‘those workers’ as ‘being necessary’, being immigrants, and then flows the discussion towards “immigrants being key to innovation and ultimately technological change and productivity growth and growth in standard of living. They are, by definition, risk takers.”

Importing low-quality labour into the US has effectively deflated prices, since your input cost (labour) is lowered, however to then branch the discussion into (what I would assume as children of) immigrants being risk takers and promoting innovation and change is somewhat farfetched given the current economic outlook for the US. If unemployment in the US remains ~10% by end-2020, a US citizen should question whether the chance of getting a jobs is being diluted by immigration policies.

Covid vs. Fossil Fuels

The energy sector has (arguably) been the hardest hit from the coronavirus pandemic, as (i) domestic energy consumption (in the form of electricity & fossil fuels), (ii) global trade volumes, and (iii) leisure travel has been wiped out. As demand for electricity plunges in the West, the East will be looking towards ways to improve its cost of goods sold (as manufacturing hubs). Putting downward pressure on wages pushes deflationary outcomes, therefore lowering production hour costs (electricity, hydro) and easing pollution controls will provide a slight tailwind to fossil fuels => coal.

Asia makes up 75% of global coal consumption, obtaining most of its coal from China, Indonesia and Australia. Coal will become an even larger Asia story as weaker consumer demand in the US has forced US coal plans to shut => they may struggle to re-open as coal prices have dropped to 3-year lows. A similar story is playing out in Indonesian where ICI coal prices are at or close to their cash costs (including government royalties). With the US expected to burn just 394mn MT of coal in 2020 (26% lower than initial forecasts in January), a rebound in the US coal sector will be unlikely as utility companies in the US shift away from coal and into cleaner energy inputs.

For China, which burns and mines ~50% of global coal, coal plays an important part in keeping the cost of living low for Chinese residents. In fact, China is expected to add upto 10% of new coal-fired generating capacity by 2024 (to reach 1,200GW), at which point coal will dominate China’s energy mix for household consumption and factory production. For the remaining BRIC, India’s state-owned Coal India is expected to produce 710mn MT in 2019 while keeping its eye on the 1,000mn MT target by 2024 in anticipation of sustained (coal) demand. Thematically, coal will play an increasingly integral energy source for China and India moving forward as their economies seek greater independence from reliance on global trade while looking at ways to stimulate its domestic consumption levels.

This coincides with an IEA report (on Thursday) suggesting that 2019 will represent a peak in global emissions but will cost the global economy a $1 trillion investment from public and private capital, on top of the existing investment allocated to clean energy. Potential job gains from the new investment could help offset a subset of the inevitable job losses in the fossil fuel sectors. 

Indonesia Growth Concerns

Indonesia decided to cut its RRR rate by 25bps (to 4.25%) and lacked the ability to demonstrate strength (to other EM central banks) that remaining steadfast on their monetary policy will play an important role in preserving capital flows. Mizuho expected rates to remain steady at 4.5% in order to provide stability among global uncertainty. Remember, back in 2019, the Bank of Indonesia was doing everything it could to strengthen and keep the Rupiah under 15,000:USD.

The Indonesian rupiah has strengthened from its weakest point at ~16,500:USD back to 14,200:USD area (similar to the intervention levels in 2019, amidst a strong DXY). A stronger IDR boosts importers of raw materials & goods while weakens its exports (crude palm oil, coal, O&G) => given where commodity prices are (weak and at near cash cost levels in US$ terms), a stronger rupiah reduces risk of imported inflation. However, Indonesia’s economic recovery hinges on China’s recovery (given its placement within Asia’s supply chain) and remain a ‘cheap’ production house, an incoming issue given the outlook of a weakening DXY (discussed below).