The bulls came back in full force as the Brexit sideshow gave way to dreams of a successful conclusion to the US-Chinese trade war. It was difficult not to make money on Friday as a rising tide lifted all boats and reversed December’s misfortune. Will markets move on as if nothing happened in December or was it merely a trial run for a larger correction?
In October, we advised equity reallocation to “defensive long exposure to non-cyclical components and with portfolio insurance strategies.” When markets broke into panic selling in December, we recommended staying put until credit markets confirm the end of the cycle. On the 7th of January, we joked that bulls are nowhere to be seen as the media coverage turned dire. We wrote:
Credit markets are holding up well during this recent bout of volatility, and US junk bonds have not really reacted in the same way as the equity markets. US economic performance continues to astound. Unemployment figures blew estimates. Services PMI beat expectations. Bank credit continues to expand at a more modest rate than in 2016, and syndicated loan issuance set a record in 2018, exceeding $2.5 trillion in volume.
We now have a rally on our hands that most people missed, and the fear of loss has turned into a fear of missing out on further gains. A focus on risk management works, and it keeps you from making emotional decisions that hurt your long-term performance.
Britain’s Trump Card
A hard Brexit does not have the support of Parliament, and the current deal is dead. Labour lost its bid to topple Theresa May’s government. So what options does the UK have?
There is no way out of the Brexit indecision except for a delay. EU governments are reportedly discussing how long of an extension they should offer Britain to negotiate a deal palatable to the British Parliament. Some EU governments are vocally against an extension. Despite this political posturing, EU courts have already stated that it is up to the UK to delay Article 50 unilaterally.
Delaying Article 50 gives Britain time to shape the next elections in the European Parliament. Although we do not believe that the change in EU personnel in July will make any difference, the illusion that Britain has any control will give politicians the justification to do what they do best: tell a good story. A new narrative is needed to delay Brexit until Britain has a better hand to play. The best card that Britain has in this game is the option to delay, and that is better than nothing.
Betting Against the Matador
China’s GDP expanded at 6.4% in Q4 year-on-year, making GDP growth 6.6% in 2018. While retail sales and industrial output were growing at a stronger pace, it was the fixed-asset investment that came in a notch lower at 5.9% vs estimates of 6%. This is no surprise as the Chinese economy responded to the trade war by devaluing the currency to stimulate industrial output and exports during the period.
The good news is that the Chinese government is succeeding at making consumption a larger component of GDP. Economically, Consumption in GDP is more stable over time, and Investment is the most volatile component of GDP. With the world’s largest population and its rapid adoption of technology, the Chinese consumer is what the world should be watching. This is a country that had its online retail sales grow by 23.9% in 2018. A decade from now, we will see the Chinese consumer as the more dominant engine of global economic growth.
Is the weaker Investment a sign that the trade war is having a negative impact? We do not believe the impact of the trade war on Q4 GDP was significant. Weaker investment is the result of policy tightening in the real estate sector. It is the one area where the Chinese authorities have not done much easing. Restrictions on property development and real estate lending are still in place and continue to be part of the government’s deleveraging program.
China’s inflation came in below target. The trade war did not impact prices negatively because China lowered tariffs on non-US imports to compensate. This is good news for Chinese bond investors as yields move lower in response to lower inflation levels. It also means that the powder is still dry for the rally in Chinese equities that is about to ensue.
Trading the Trade Deal
US and Chinese equities rallied on news of China’s offer to ramp up imports from the US over six years to the tune of a $1 trillion increase. China further stated its aim over the same period to reduce the trade surplus between the two nations to zero from the current $232 billion. For their part, the American negotiators continued to play hardball and ask for the imbalances to clear within two years, but markets took these latest developments as positive.
While an important factor, the trade balance on its own is not the hardest part to resolve. We are yet to see concrete evidence of an agreement on intellectual property rights and the opening of China’s financial sector to foreign competition.
What is clear is that a trade deal is dollar-friendly, and it will bring the Fed rate hikes back into play. As the odds moved in favor of a successful conclusion to the US-Chinese trade negotiations, the US dollar and equities rallied. This removes one obstacle facing the Fed as it tries to sneak a rate hike in before financial conditions tighten in a material way.
The Week Ahead
The ECB will decide on its policy rates, and we expect no change from the previous period. South Korea releases GDP figures today. Japan, South Africa, New Zealand, Hong Kong, and Singapore are releasing CPI figures. With the recent layoffs in the auto industry, an uptick is expected in US Initial Jobless Claims and UK Claimant Count Rate. Also look for January PMI figures out of Europe and US. In the background of trade negotiations, the US monthly Trade Balance is expected to come in at -$54 billion.
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