Chinese Policy Uncertainty = Global Equity Risk

Growing uncertainty about China’s economic and financial trajectories is raising the risk premium on global stocks and on China-related plays in particular. This, along with weakening growth/contracting corporate profits in many parts of the world, will continue to weigh on global equities in general and especially EM risk assets.

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China is enduring enormous deflationary pressures. Producer prices for final products in general and export prices in particular are deflating, and volume growth is either weak or contracting. In turn, Chinese companies’ debt-to-GDP ratio has skyrocketed since 2009. As such, Chinese companies’ debt burdens in real (inflation-adjusted) terms are rising as an increasing amount of sales volume is required to service the same amount of nominal debt.

China can partially export debt deflation to the rest of the world via depreciating its currency; depreciation helps the pricing power of exporters and companies that can engage in import substitution. But there is much uncertainty about China’s willingness/ability to use its currency to mitigate deflation. And in any case, it will not insulate China from the pain entirely because depreciation will not help the most leveraged parts of China’s corporate sector, namely, property developers, industrials and materials companies.

Nonetheless, the critical question for investors is whether Chinese policymakers can achieve gradual currency depreciation in a way that domestic interest rates do not rise. This is possible, but not guaranteed.

Rising uncertainty about the path of China’s exchange rate, interest rates and capital flows, as well as the widening range of potential outcomes for mainland growth warrant a higher risk premium on global assets, particularly Chinese growth-related assets.

A Renewed Geopolitical Risk Premium For Oil?

Iran and Saudi relations have hit a low point in an already tumultuous relationship, with potential repercussions for the energy markets.

Saudi Arabia’s recent decision to execute a prominent Shia cleric Nimr al-Nimr, who was originally imprisoned in 2012, caused Shiites across the Middle East to protest. In Tehran, the Saudi Embassy was sacked by an angry mob of protesters, leading Saudi Arabia to break off diplomatic relations with Iran.

Recap of Recent History Between Iran And Saudi Arabia: The Saudi-Iranian relationship began to seriously sour at the end of 2011, when the U.S. withdrawal from Iraq gave the Iran-backed Shia-dominated Baghdad government control of the country. Almost immediately, the then-PM Nouri al-Maliki began persecuting prominent Sunnis, including the Vice-President of the country. In early 2012, the Sunnis in southern and western Iraq restarted their insurgency, prompting al-Maliki to respond with force. This crackdown contributed to the revival of Sunni militancy, and eventually to the rise of ISIS.

Saudi Arabia considers Iraq a vital geographical buffer between itself and Iran. It therefore interpreted the U.S. withdrawal and Baghdad crackdown against Sunnis as a matter of national security. In addition, subsequent negotiations between Washington and Tehran convinced Saudi Arabia that the U.S. was interested in downsizing its presence in the Middle East, pivoting to Asia, and pursuing a strategy of détente with Iran.

Why It Matters: The greatest concern to investors today is that the Iran-Saudi tensions spill over to areas of the Middle East that are relevant to oil production and transportation. Iraq is the main such area of concern. BCA’s Geopolitical Strategy team believes that the defeat of ISIS in Al Anbar Governorate could in fact invite a Saudi military intervention in southwestern Iraq, as the means to carve out a Sunni buffer between itself and Iran-backed Iraq. Second, tensions between Saudi government and its own Shia minority in the Eastern Province could flare up, creating conditions for an insurgency in the region where almost all of Saudi oil production and transportation infrastructure lie. Third, investors should watch Bahrain. While the tiny Kingdom produces negligible amount of oil, it has a Shia majority ruled by a Sunni monarchy. Saudi Arabia intervened militarily in 2011 to prevent an Arab Spring-inspired revolt against the Sunni Al Khalifa monarchy. Another such intervention could further deteriorate relations between Saudi Arabia and Iran.

Bottom Line: The media focus on ISIS has thrown much of the investment world off course. The Sunni militant group has run parts of Syria and Iraq since 2014 and yet it has been completely incapable of affecting the region’s production of oil. However, tensions between Saudi Arabia and Iran are relevant, especially if they spill over into Iraq, the Persian Gulf, or Saudi Arabia’s Eastern Province. Any evidence that Saudi Arabia is taking matters into its own hands in Iraq or that Shias in Bahrain and Eastern Province are ready for another Arab Spring-style uprising, would increase the geopolitical risk premium to oil prices.

[1] Please see BCA Geopolitical Strategy Special Report, “Middle East: A Tale Of Red Herrings And Black Swans”, October 14, 2015.

Global Fixed Income Strategy: Where To Hide

We have recommended a long duration stance for some time because we believe that the Fed will not be able to tighten as quickly as the dot-plot suggests. Global deflationary pressures, and quantitative easing in Europe and Japan, will anchor the long-end of the curve across the major countries. Nonetheless, we have emphasized the near-term risk of a convergence of the OIS curve toward the Fed’s ‘dots’, leading to a temporary U.S. Treasury selloff.

In each of the past U.S. rate hike cycles, there is a period of rapid upward adjustment in market expectations for the pace of Fed rate hikes that occurs near the time of policy lift-off. It is an “ah-ha” moment, when investors are shaken from their complacency about the outlook for short-term interest rates. This is the phase of maximum pain in terms of total return losses in the bond market.

The mid-2000s “conundrum years” provide a roadmap for how things could play out. Treasury investors suffered losses during the period of rapid increase in the 12-month Fed Funds Discounter, which occurred just prior to the start of the rate hike cycle. However, once this phase was complete, the Treasury index provided a positive return over the course of the tightening cycle. The yield curve flattened massively.

Markets discount some upward movement in the fed funds rate over the next year, but we have not yet seen the same violent upward adjustment that has occurred in rate hike cycles since the 1980s. This raises the question of where absolute-return focused, long-only bond investors can hide during the rapid adjustment phase. Please see the next Insight, “Hawkish Fed” Yield Curve Scenario.

U.S. Equities: Deflation Still Prevails

The most widely telegraphed Fed interest rate hike in history ushered in a brief sigh of equity market relief. However, we doubt the sustainability of any rally attempts, because deflation remains the dominant stock market threat.

Domestic goods prices continue to plunge. China’s slow but persistent exchange rate devaluation will continue to export deflation to the rest of the world. China’s export prices are contracting in both local currency and U.S. dollar terms. Sinking emerging market currencies are unleashing a similar dynamic. Rising domestic bond yields constitute rising financial stress.

To help gauge corporate sector health, our U.S. equity strategists updated their industry group pricing power gauges, which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. Please see the next Insight, (Part II) U.S. Equities: Deflation Is Still The Prevailing Wind.

Taylor Rule And The Fed

Plenty of reasons have been offered for why the Fed was correct in raising rates, including the Taylor Rule.

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It is true that conventional Taylor rules – rules that specify what the interest rate should be today based on the level of the output gap and the deviation of inflation from target – suggest that short-term rates should currently be between 1.5% and 2%. This is true for both John Taylor’s original rule as well as Janet Yellen’s preferred specification. In fact, one could even argue that these rules understate the appropriate level of rates today since they do not take into account the fact that the Fed’s QE program has loosened financial conditions by depressing the term premium.

That said, conventional Taylor rules assume that the neutral short-term real interest rate – the rate consistent with full employment and stable inflation – does not change over time. This may be a faulty assumption.

Much of the post-war era was characterized by a period of rising debt. This increase in debt generated a lot of demand – demand that will not return unless we are on the cusp of a new releveraging cycle. In addition, potential GDP growth has come down over the past decade, partly on account of smaller productivity gains, but mainly due to slower labor force growth. Slower potential growth reduces the demand for everything from new houses to shopping malls, office towers, and factories.

A strong dollar also represents a permanent withdrawal of demand for U.S.-made goods and services. This requires an offset in the form of lower interest rates. According to the Fed’s own model, the 17% appreciation in the real-trade weighted dollar since July 2014 is likely to shave 1.1% off of the level of real GDP, while reducing inflation by 0.3%. This is equivalent to 135 basis points in rate hikes based on Janet Yellen’s preferred specification of the Taylor Rule.

Bottom Line: We remain concerned that the Fed pulled the trigger too early.