Recent quarters, months and weeks have played out as a remarkable clash between the goals of the US Federal Reserve and Chinese Communist Party: the one trying to expand credit into their "supercharged, super fair recovery", the other trying to rein in what they see as excessive capitalism in general and, particularly, what they see as market excesses. This is not a war between opposing enemies or even a battle in a traditional sense. But it is nevertheless a clash of significance for both the global political narrative and for economic development in the coming years. And in the short-term, global market stability is at stake.
Supported by low interest rates and strong earnings, US equities made further progress since the last edition of our Global Market View publication, and we had another decent month across mandates and funds. The situation was very different in emerging markets, which got caught between a strong US dollar and Chinese politics. We hold little exposure in this sub-asset class and don’t see the sell-off as a reason to add. To assess whether to remain fully invested in equities, or risk on, as we call it, in a tense environment like this, we rely on our algorithms and their daily assessment of the risk to global financial stability. Since 2011, these algorithms have been set up as a traditional investment committee, with human analysts and portfolio managers organised in "teams" covering Macro, Fixed income, Credit market, Equities, and market risk, etc. Compared to a traditional investment committee, the algorithms have the advantage of being more concise and consistent in their communication and conclusions, which they provide every morning around 4 a.m. CET. Just like markets, the Fed, the Communist party, and their regulators, the algorithms also work every day winter and summer.
We have often discussed the Fed's and the US Administration's perspective. In this edition we will focus on the action in China. During the year, what initially looked like a campaign focused on Tech tycoons has developed into something more akin to a massacre of Chinese equities, well expressed by the decline in the Nasdaq Golden
Figure 1: Price development of Chinese stocks vs S&P 500 Hong Kong and US equity markets risk
Dragon China Index, (HXC), the Hong Kong index, CSI 300 and in DIDI, seen in Figure 1. This campaign has a primary goal, but also produces collateral damage. It is clear that the Chinese Communist Party is happy to encounter less rivalry from billionaires for the attention of society, which runs across the board from public prestige to cash and data control. The same holds true for crypto currencies. On the one hand, bitcoins collide with the environmental goals of the Chinese government - and the governments of most other developed countries. On the other hand, decentralised finance and crypto currencies collide, in general, with government control of markets and movements of capital, which obviously are not in the interest of a country like China with controls on movements of capital. We therefore caution anyone from excessively celebrating the recent bounce in crypto prices. A more interesting development will be the digital currencies from the Swiss and the Chinese central banks and if they can be used to ease global transactions without upsetting the US Department of Justice.
The fact that the clampdown started more than half a year ago and included Ant Financial, the politically sensitive "Education" sector and the Didi listing, makes it clear that even though Chinese market regulators have talked to local and western banks and tried to cool down the situation, the aims are backed by the real powers in the communist party. It would be foolish to assume that some of the most well educated and well-informed people in the world would not have foreseen that the blows that they delivered to these growth companies would have devastating consequences. It is therefore likely that even the latest game of chicken, and the fact that the Chinese "blinked first", was part of the original strategy. We will return below to this important topic of China's influence on markets. We will also offer our opinion on why it has not until now had a larger effect on global markets. Meanwhile, as our market risk algorithms on the last page show, it continues to be warranted to stay positively positioned, because the recovery is ongoing, markets are well supported, and the outlook favours equities and credit risk over high-grade bonds and duration. We therefore remain fully invested in these types of assets, together with our long held US equity and USD overweight, across our USD, Euro and CHF mandates and funds:
We maintain a 100% equity allocation in our Systematic Equity Allocation Strategy, significantly above the long-term balanced level of 60%. The year on year return is a respectable 30%. The year-to-date return is 15%. The associated ACCI SA fund is comfortably in the top 10% of its peer group.
In our multi-asset mandates and funds, we retain the full allocation to equities and the enhanced 30% allocation to high yield bonds with duration of around 3 years. These portfolios are up 9%-14% year to date and 19%-23% year on year, all dependent on risk level and currency.
In our Global Fixed Income Opportunities strategies and funds, we maintain our high yield bond positions. These portfolios are up 2% year to date and 8% year on year. It is worth noting here that the current short duration positioning has not helped much in recent months but should find support if the Fed's renewed optimism regarding the US recovery turns out to be justified.
Why the Chinese Market Massacre did not take down global markets
As our regular readers will know, we have a long record of participating in and chairing investment committees and for a number of years we were simultaneously running both a traditional committee and a virtual committee of algorithms. In recent years we have shifted fully to the virtual version, where the actual "Global Investment Committee" is a group of virtual "analysts" represented by separate algorithms which are then combined to form an aggregate reading. One of the many advantages of this setup, compared to a traditional investment committee, is that they work every day, just like markets and Chinese politicians and regulators. Another advantage is that they always have a consistent and updated conclusion (much easier to understand than policy language of economists, etc…). At the moment, that conclusion advises us to stay invested in equities. In this context, unless there is more noise out of China, global investors are probably best advised to ignore it. This is not always the case, obviously, but as opposed to the situation in the second half of 2015 and early 2016, the rest of the world is running full steam ahead. At least according to our analysis data for the last 30+ covering equities, fixed income, macro, monetary policy, etc. Looking at market momentum and the vulnerability of market sentiments, the correction in Asian markets is clearly visible at the segregated data level, but when we combine these data to obtain an overall reading, we get a rather solid signal of 0.4 much like early 2017.
Figure 2: Market momentum algorithms for risk management and portfolio positioning
In Figure 2, we show the readings of these algorithms in 2015 and 2016 where the collapses during that period can clearly be seen. As seen in Figure 3 below, the situation on the macro side of the economy and therefore also in our macro algorithms was even more dramatic back in 2015. After a very severe setback in the commodity sector, both investment demand and commodity prices took a severe blow, credit spreads widened, and financial conditions tightened in a classical reflexive move of self-reinforcing deteriorations across macro and markets. Now the situation is very different because the Fed, with its fixed income market operations, together with the strong cyclical position of the US economy, supports the economy, credit formation and markets. So does the extreme profit recovery, much stronger than expected by a chorus of equity analysts and macro strategists. The reading of our profit algorithms remains at 1.0, the maximum capped out reading and well above where they went even in the period January 2015 to July 2017, as shown in Figure 3 below.
Figure 3: US corporate earnings momentum (data for the rest of the world are too poor in quality)
Our profit algorithms are based on a simple data structure, but they are nevertheless very helpful because they have helped us to remain fully invested and to enter the market in early 2016 and stay invested in 2017, which proved to be beneficial. And while we maintain that earnings is a lagging indicator, we also know that selling early feels great for the portfolio manager who executes the sale or for the analyst who recommends, but it is not necessarily quite as beneficial as it sounds for the actual investor. As outlined last month, other important factors are technology trends, optimism, exuberance and nervousness and the panic probabilities of markets themselves. The aggregate result of our algorithms is shown on the last page of this publication. Their signals have not changed much. For the time being, we remain fully invested. If the algorithms change across their respective thresholds, we will change our positions accordingly and decisively.
The Federal Reserve vs. the Communist Party
The clash between the goals of the US Federal Reserve and Chinese Communist Party is neither a hot or a cold war, or even a battle in a traditional sense. As far as we know, the main goal of the two contestants is not to defeat or even hurt each other. It is nevertheless a very significant battle, with both the global narrative and global markets at stake. It would be exceedingly optimistic to expect the result to be a stable equilibrium. And it was probably judicious for the Communist Party to blink first.
In our experience, the Chinese authorities know what they want to achieve on a 1–5-year horizon. They will then move back and forth as they feel their way. The overall target is to re-establish respect for and the undisputed authority of the Chinese Communist Party. The immediate effect has been the largest slaughtering of potential and prospective unicorns in Asian history and a severe correction in Chinese and Hong Kong equity markets and their US sister listings. As of the morning of the 28th of July, the Nasdaq Golden Dragon Index was down 50% from its peak and as of the morning of the 30th of July it was down 20% for the month of July.
In this context it is worth remembering that a core lesson learned the hard way is that the Chinese cannot control the value of their own currency, since any significant movement has too large and uncertain consequences for their exports, imports and growth. The US is a large economy with limited dependence on trade and strong and well-tested institutions. The Chinese economy is driven by domestic demand for investment and consumption, but China is a large economy with a large dependence on foreign trade and new institutions. No one is more aware than Xi, for example, that the re-election of the Chinese President is locked in a fixed framework and can be changed. Returning to the currency and markets, England, Germany, and France learned long ago that they cannot control their currencies, interest rate levels and financial markets, independently of the US or the Fed. So even if they talk as though they have power over these matters, in fact they don’t. We therefore also expect the Chinese to maintain the nationalistic façade while in practise the issue will remain hidden under a capital account that remains closed for the masses and for the publicly known billionaires as well. It is now clear that to be rich in China is a lot less glorious than it used to be.
It is well documented in numerous speeches and statements from President Xi that the Chinese Communist Party should be and will be in control, so it can be assumed that in his view this is right and just. And herein lies the real change over recent years. For the current leadership in China, the number one institution is the Chinese Communist Party. And in the view of the leadership, in recent decades the Party has lost too much control in both relative and absolute terms. Xi has therefore made it a top priority to turn this development around and re-gain control. As is well known from centuries of Chinese and global history, such a development is not easy to control or stop once it has started, and it should therefore be assumed that the trend will continue, but it is unlikely to bring down global finance. The Chinese depend on global trade and will keep it open. They don’t depend as much on their currency reserve as they used to, so maybe they could sell their holdings of US treasury. This question has been with us for a decade or so with much talk back and forth. A simple calculation might solve the issue. If the Chinese hold USD 1,200 billion, this will equal 10 months of current QE. So, now that we know that the Fed can gulp up huge sums, the Fed could just buy them. If the Chinese had 3,600 billion, it would require something like 3 years’ worth QE at the current run rate. So, in both cases it could be an extension to the QE. If this were to happen overnight, it would be very disruptive. In some ways the situation would be comparable to when world realised that Covid was not only a Chinese problem, but a global problem. It would therefore require a pandemic-like response from the Fed and the Treasury. And it could take weeks to get the situation under complete control because markets would be very volatile. It is unlikely, however, that two trillion in fiscal support would not be required. Also, BOE, BOJ, SNB and even the ECB would probably help; in this latter case, hopefully without the President feeling the need to say anything as unhelpful and unwise as she did about government bond spreads during the Covid calamity.
Mads N. S. Pedersen, Managing Partner and CIO