Forget Brexit – China is the key risk: Five key investment themes for 201626 July 2016
Tilney’s Chief Investment Officer Gareth Lewis reviews the themes likely to dominate investment strategy for the remainder of the year
2016 has so far been a rollercoaster ride for investors beginning with a sharp decline in the Chinese stock market, worries about the health of the European banking sector and ending the first half in the UK voting to leave the E.U. What then might the rest of the year have in store?
Speaking at a seminar in London today, Gareth Lewis, Chief Investment Officer at Tilney Investment Management, which oversees £11.4 billion of assets, sets out five themes that he believes will influence investment markets for the remainder of 2016 and are driving Tilney’s investment strategy.
1. Brexit: part of a much wider disaffection with political elites – naïve to assume the current policy orthodoxy will go unchallenged
“Current monetary policy has failed to secure an equitable and sustainable recovery. In fact it has accelerated the pattern of wealth inequality favoring the asset rich over the wider populace. This can be seen in the most extreme form in the US, but it is a pattern that is repeated throughout the developed world.
“The result is a growing frustration with current policy that threatens the credibility of the world’s leading central banks, which is exploitable as the politics of disaffection fuels anti-establishment politics and drives greater policy polarization.
2. Political disaffection – Will it begin to drive policy change? Carney and BoE don’t yet appear to have heeded the key message from the referendum!
“The initial policy response following Brexit has focused on the possibility of further easing of monetary policy: lower rates and more QE, despite scant evidence this will boost genuine economic activity. The irony is the system continues to provide artificial support to asset prices as a default response. This is one of the key causes of the problem – bailing out asset owners perpetuates inequality.
“We still expect the debate to shift towards fiscal measures as politics takes centre stage, not least in the UK when Brexit has opened up the possibility of a “reset” of fiscal policy and the new Government has already dropped the previous Chancellor’s timeline for eliminating the UK deficit. The Eurozone and Japan have already reached the natural limits of monetary policy orthodoxy. Helicopter money in all its many guises is now a real possibility across much of the developed world – but will not be enough to offset the grinding deflation driven by China.
3. Liquidity – the cause of and solution to all of life's problems Excess liquidity provision has driven an indiscriminate bull market across all asset classes
“Banking deregulation and Fed monetary policy have driven a 15 year liquidity glut, with the resulting capital misallocation (TMT, US housing, China) creating increasingly frequent bout of capital market instability. The 08/09 banking solvency crisis drove the global economy close to a synchronized depression, however the “fix” has seen central banks (In the West) and Governments (China) perpetuate the problem by burying the solvency issues under an abundant supply of cheap capital.
“While this policy initially averted a worse crisis it has allowed the excesses to build further - much of the liquidity has remained trapped in the financial system, boosting asset prices and preventing a normalized default cycle. This has encouraged further mal-investment as investors have taken on more risk in search of yield, resulting in reduced productivity as companies eschew capital investment but increase short term/temporary employment or buy financial assets.
4. Forget Brexit – China is the key risk Extreme capital misallocation and a devalued currency are the global economy’s biggest threats
“The Chinese authorities response to the Western banking crisis has been an explosion of debt funded internal investment which has been the fastest case of debt accumulation in history, both the magnitude and speed of this investment suggests misallocation. While a Chinese hard landing is by no means guaranteed, the risks are growing.
“We expect further stimulus measures to put off the day of reckoning – interest rate cuts, extending the local Government debt refinancing, state intervention in both property and stock markets. But the most obvious response will be a further currency devaluation, as regaining manufacturing competitiveness through devaluation buys time while other reforms are initiated. China’s share of world exports is at a record level while world trade is declining there is nowhere for their exports to go, swamping the globe with excess inventory could trigger deflation and fan the flames of protectionism.”
5. Secular Stagnation Easy credit, capital misallocation, excessive debt = weak growth and “lowflation”
“Many of the current conditions of the world economy show signs of secular stagnation. The misallocation of capital created by easy credit conditions both before and after the global financial crises has created a supply/demand imbalance. High levels of Government and consumer debt will constrain consumption for many years, while the absence of a true credit cycle has prevented the needed destruction of excess capacity.
“While QE has increased the wealth of the few, its wider economic benefits are open to doubt. Only the inappropriate and excessive debt fuelled Chinese investment cycle has kept world growth afloat, while weak commodity prices and the collapse in the price of oil are symptoms of the stress this policy has created. The consequence will be lower terminal interest rates (the “new normal”), weak inflation and lower for longer bond yields."
“Thus far in 2016 actions by central banks may have shifted asset prices but has done little to improve economics. Central bank action during Q1 highlights how weak the global economy remains, causing GDP forecasts to have been lowered suggesting the last year’s oil price weakness was an early stage indicator. Stimulus may arrest the decline – but only temporarily.
“China shows the greatest scope for economic traction as its Government resists reform and increases fiscal stimulus and internal investment. However the first half recovery will come at a heavy price further down the line, as we expect the Yuan devaluation to continue driving global deflation. Brexit must be viewed as a short term economic negative of sufficient magnitude to change monetary policy and an opportunity to reset fiscal policy, but it is by no means the primary risk facing investors.”
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