Market Thinking - A view from the equity market

• Currencies are driving everything at the moment – the S&P is either rolling over, or hitting new highs, depending on whether you are a domestic or an international investor. The US markets are flat year to date, but in Euro terms are up 16- 18%, more than the Stoxx.
   
• March is also a big options expiry month and historically we have seen significant repositioning around this time. We are also coming to the end of the Japanese financial year which may also be having an impact.
   
• Quantitative Easing (QE) in Europe has been the trigger for the collapse in the currency but note it is much more like Japanese than US QE. It will not stimulate a cyclical economic recovery and needs to be matched with structural change. Equally while Japan is encouraging buying of equity, Europe is discouraging it.
   

Two Friday the 13th's  in a row, and the "ides" of March thrown in for good measure, not a good few  weeks for the superstitious perhaps, and equities generally have certainly seen a pickup in volatility, while US equities have sold off.  According to the ‘noise markets' this is all about concerns over when the Fed will tighten. More likely it is a combination of market mechanics, as it usually is. Firstly, there is a currency effect; if we remember when the Swiss Franc rose sharply when the Swiss National Bank dropped the ‘peg' to the Euro, the local price of the equities fell shortly afterwards. The stronger dollar will be having the same impact on US equities. Secondly, March is a big month for options expiry and there is a lot of positioning that takes place, either to roll hedges or drop them. The Japanese fiscal year has quite an effect here as well.

The dramatic moves in currencies make the picture rather confusing. For example, the US equity markets are now flat year to date but in Euro terms the Nasdaq is up 18%, more than the Stoxx. Indeed, we now see that the Japanese market is the best performing major market year to date in dollar terms. The last three words are crucial here of course, because while in local currency Europe is the biggest game in town at the moment, it is only working in hedged currency terms. In the same way that a Japanese investor in US equities didn't see a positive return in Yen for two years after the Fed began QE and a US investor in the Nikkei has barely made a profit in US dollar terms in the last two years, so the international investors in European assets needs to be very sensitive to the market taking away what it gives with one hand in asset price inflation, with the currency loss on the other hand. This is a point I have been making at a number of meetings with private banks in Hong Kong in recent weeks. They are understandably interested in European equities in general and European listed real estate in particular, but we are highlighting that the very conditions that might make them attracted to the asset are also the reasons they might want to hedge the currency.

There is also a broader point about following a simplistic QE "playbook", that is, that the QE being pursued by the Europeans is much more like that done in Japan than the original policy in the US. If we remember back to 2008/9, the original policy intervention by the Fed was because of a liquidity crisis. Starting with buying commercial paper and paying interest on overnight loans back in October 2008, the Fed then bought  significant amounts of mortgage backed securities from financial institutions who were basically no longer allowed to hold them for ‘risk management' purposes. Essentially the new regulations were creating distressed sellers without allowing any buyers. The Fed was the solution. The money thus released was recycled back into other financial assets, primarily corporate bonds and US treasuries, which as we pointed out last week at the time were yielding 8% and 4% respectively. This was a restructuring story, not cyclical demand management via monetary policy, and the performance of the US economy has been about liquidity being allowed to flow as opposed to an artificial demand stimulus. The current proposals in Europe look more like QE3 (a history of Fed quantitative easing can be found here) where the Fed was simply buying in the longer dated securities and it is perhaps worth noting that when that when QE3 began in September 2012, the following 12- 24 months saw US Bond yields rise, not fall. Chart 1 shows the I Shares ETF of the US long bond in the 18 months after the Fed began QE3.

Chart 1. Don't forget that QE3 made US Treasuries sell off sharply.

The monetary stimulus under Abenomics has been similar but different. The Bank of Japan have been buying longer dated bonds from banks and insurance companies, but at the same time the government has been putting in place incentives to invest in real assets, particularly equities. Moreover, in the opposite of financial repression, long term investors in Japan are being actively encouraged to buy equities, notably the giant state pension system, GPIF, which is managed via asset allocation guidelines to reduce bond holdings and increase equity holdings. The first part is similar to the new European QE project, but the second part is definitely not. In Europe, regulators continue to prevent cash from being recycled into the real economy through their obsession with ‘risk'. Insurance companies wishing to buy equity have to provide huge amounts of capital to do so, as do banks wishing  to lend to small and medium sized enterprises (SME's). I would thus be cautious about the ability of QE in Europe to generate much economic growth and would regard its likely impacts as to favour large corporates, who can access ultra-cheap capital, either to buy market share or, in increasing numbers, their own stock back.

The other question is whether in fact we should regard this as a bank recapitalisation? After all, part of the original focus of the US QE was to allow US banks to recapitalise. If so, the markets have yet to recognise it, since although the European Banks index has moved to a new four year high, against the broader Eurostoxx index it is close to the lows seen at the trough of the Euro crisis in 2012.

As noted previously, the Euro weakness that is driving the US dollar strength presents a clear and present danger to those running a US dollar funding strategy, something happening a lot in Emerging Markets. The Brazilian Real has just broken the 2004 highs (weakness) against the US dollar making it the worst performing  of the Emerging Markets currencies over the last six months and there are street protests mounting – a common theme here is anti-corruption, but the bursting of a growth illusion is a key part of the disquiet and stagflation is threatening. Brazil, like Russia benefits from US dollar  earnings from its oil industry, but the failure of oil to break higher is a problem and there is also a second  problem, as much of those earnings are offset with US dollar debt. Generally over $4 trillion has been raised by non-bank foreign entities since the US began QE in 2009. The interest on this needs paying, but more importantly the loans need to be rolled and the risk is that the liquidity is not there.

Meanwhile in Asia, China is not really easing (either). This was the conclusion of an interesting presentation last week from Societe Generale Economist Wei Yao. Wei has a reputation for being ‘bearish on China' mainly because her GDP forecasts are consistently at the lower end of consensus, but in fact her arguments are far broader and basically focus on the fact that the reform that is leading to the lower GDP targets is much more important than the level of the target, a view I very much share. She makes the interesting point that with bank deposits rising by over 10% as foreign exchange  reserve accumulation declines, even cutting the Reserve Requirement Ratio (RRR) is not enough to loosen monetary policy, suggesting they may need to cut the RRR four times this year to have any impact. But as with the various announcements this week on interest rates, this is more about reform of the system rather than short term monetary stimulus.

Other announcements on local government deficits, financing vehicles etc. are also part of the ongoing ‘big bang' in Chinese financial markets .Wei also pointed out that the anti-corruption campaign is here to stay as, in effect, it is the vehicle driving economic and political reform in China. Here in Hong Kong it continues to have a big impact on consumption. While the ongoing impact of Occupy and anti-Mainland protests are being blamed for falling retail sales (something we noted over Chinese New Year (CNY)) it is also clear that the previous big spenders are disappearing.  In Macau, the likes of Galaxy (27 HK)continue to unwind all of their stunning 2013 performance as the high rollers disappear, while Chow Tai Fook (1929 HK) is also getting hit hard. Selling high end watches and gold jewellery to mainland tourists in Hong Kong and Macau (mainland tourists were 60% of jewellery sales in Hong Kong in 2013) always struck me as an accident waiting to happen. The chart shows Chow Tai Fook (top panel) and Galaxy entertainment (lower panel) indexed to June 2013 = 100. As the high rollers have rolled away, so too have the share prices.

Chart 2: High Rollers have rolled away.

As with much of China, this is a structural change not just a cyclical one and (to me at least) look unlikely to come back as the nature of Chinese tourism is changing. Moreover,  it is also clear that the weak Euro and Yen are producing some serious competition for Hong Kong in terms of attracting Chinese tourists. Some members of our management board were here in Hong Kong last week and reported that London, Paris and Rome had been flooded with Chinese tourists over CNY and as I noted last week, the shops in Ginza in Tokyo seem to be picking up the luxury sales previously coming to Hong Kong and Macau.

Briefly on Sterling: it was interesting to see a clear move below the psychological and technical level of 1.50 as not only did the US dollar  strengthen across the board, but traders started to focus on the upcoming uncertainty around the UK Election. A ‘good' Budget this week may lead to some bounce, but this too would be noise. The Election remains too close to call. It should be noted however that 1.40 looks an extremely resilient level for sterling dollar.

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