Strategy & economics
Exploring the new horizons for the known-unknowns
After a nine-year, five billion-kilometre journey from Earth, NASA’s New Horizons spacecraft reached Pluto, the most distant domain ever visited in the history of space exploration. As we celebrate this milestone in civilisation, a few unprecedented events in financial markets have also unfolded through the month. July 2015 marked the nine year anniversary since the last interest rate increase by the Federal Reserve (Fed) – the longest in the history of US monetary policy. Nine years after the build-up of the biggest equity market bubble in China’s history, China cut benchmark interest rates to a record-low and intervened aggressively in an attempt to halt the free-fall in domestic equities. Last but not least, Greece narrowly avoided an exit from the eurozone – an uncharted territory for the currency union, after the country had lost around a quarter of its gross domestic output (GDP) over the last nine years. As much as we like to reminisce, let us explore the new horizons for these three key known-unknowns for the global market – the US Fed rate hike, the Chinese equity tantrum and Greek financial turmoil.
The Fed – centre of the universe of central banks
With a notable rebound in US activity during the second quarter, the Fed is under increasing pressure to start the process of policy normalisation. Economic data suggest the recovery is broadening: the unemployment rate dipped to 5.3% in June which is the lowest since April 2008. Housing starts and building permits are both currently hovering around a seven-year high, and while headline Consumer Price Index (CPI) remains depressed due to energy (whose negative effect on CPI will wane by year-end), rents are rising at the fastest pace since October 2006 leading to concerns over inflation.
As we have long argued, these robust domestic economic data do not warrant interest rates being at the current crisis level. While financial market participants have had varying macro views, and markets overall were relatively dovish on the expected path of interest rates, they can no longer turn a blind eye to the increasingly hawkish stance from the Fed. In the latest Congressional testimony, Janet Yellen delivered her most blatant message yet: the Fed is on track for a rate increase in 2015. While there are concerns surrounding the dollar strength and international macro developments, it is clear that the Fed does not view them as impediments to US policy normalisation. The wavelength of the market has subsequently become more attuned to that of the Federal Open Market Committee (FOMC), as is evident from the narrowing divergence in short-term interest rate expectations.
We believe positive momentum in US data will provide the FOMC with enough confidence to initiate its first interest rate increase for nine years in September 2015. As the Fed is the centre of the monetary universe, policy reactions of many other central banks will gravitate around it. As the UK currently shares a similar growth trajectory as the US, continuing interest rates at crisis levels risks destabilising the economy in the longer-term. Resonating Janet Yellen’s speech, Mark Carney also warmed to the notion that an increase in the Bank rate may happen sooner than markets anticipate. While we expect the Bank of England to raise interest rates in the first quarter of 2016, the probability of a policy response by the end of 2015 increases with the momentum in wage growth.
Chinese equities – a supernova in the making
A supernova is a stellar explosion that briefly outshines an entire galaxy before fading from view over several weeks or months – which is analogous to the developments in the Chinese equity market. Since reaching a seven-year high on 12 June, the Shanghai Composite Index was in freefall and slumped 32% within a month. The explosive nature of the Chinese stockmarket, a significant detachment from the direction of economic fundamentals, was led by leverage-fueled speculation, and increasing distrust of government policies.
The slowdown in growth in China is not news, and we see limited growth catalysts from domestic or external sources. Despite four cuts in the benchmark lending rate to historical lows, real interest rates remained at the higher end of the scale due to disinflation. While activity may improve modestly in the near-term due to some pick up in housing activity and the lagged effect of monetary easing, the secular trend of structural deceleration remains in full force. The colossal run-up in Chinese equities was fuelled by margin financing, which has peaked at 12% of the free float of marginable stocks and 3.5% of GDP. Margin-financing is a double edged sword and is likely to cause more lasting-damage as the leverage unwinds.
The government’s attempt to support the market is highly intrusive, confusing and desperate. We are particularly disappointed by the voluntary trading suspension by 43% of listed companies. Such an interventionist approach is highly inappropriate at a time when China is taking tentative steps to open up its capital markets. The inability for investors to sell in distressed market conditions will dent confidence for international investors and renders China’s efforts for financial reform back to square one. In our view, the invasive approach of the Chinese authorities on the stockmarket is a huge step backwards. It puts a huge question mark on the genuine interest for all sorts of reform promised by the new leadership, especially those in relation to State-Owned Enterprises (SOEs) and the financial markets. While the slump in the stockmarket may not lead to a negative spill-over effect on the wider economy due to limited wealth effect and a huge liquidity buffer provided by the State, the potential stall in reforms will put further downside risk to long-term growth.
Greece – a financial black-hole
Greece has made a round trip to the edge of an unknown abyss and back to the safety net provided by its creditors. While the likely three-year bailout deal of up to €86bn will settle the dust temporarily, there is really no big-bang for Greece’s financial sustainability or structural landscape. The Greek banking system was on the verge of collapse and it will require ongoing life-support from the European Central Bank. Deeper austerity attached as conditionality of the bailout programme poses a huge restraint to growth, as well as having significant implementation risks. As mentioned, the Greek economy has already contracted by more than a quarter since its peak and will be contracting further in the aftermath of this crisis. In or out of the euro, the outlook for the Greek economy is bleak.
In the International Monetary Fund’s latest debt sustainability analysis, Greek debt is forecast to peak at close to 200% of GDP in the next two years, contrasting with earlier projections that the peak in debt would be 177% of GDP in 2014. Without a haircut to Greek debt and the ability to devalue its currency (infeasible as long as Greece stays in the eurozone), Greece will be perpetually trapped in a financial black-hole with limited growth potential for the foreseeable future. Therefore, we think the distinct possibility of a Greek exit from the eurozone remains on the horizon.
This article is issued by Cazenove Capital Management which is a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Issued in the Channel Islands by Cazenove Capital Management which is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission.
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