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Chinese economic data broadly disappointed in July, spurring fears the government’s stimulus efforts are failing to halt this year’s slowdown. In our view, however, they more likely reflect the predictable after-effects of an early-2018 crackdown on shadow banking and don’t mean the Chinese economy is losing steam.
For your viewing convenience, here are the most noteworthy economic statistics released in July.
Exhibit 1: Chinese July Economic Data
Source: National Bureau of Statistics of China, as of 8/16/2018.
In this week’s surely-not-weekly roundup of random market news, a survey shows Americans are really politicized (duh), Kiwi avocado theft shows the perils of market restrictions, the BoJ swallows Japan, the UK’s real wages may or may not be falling, Karl Marx’s 200th birthday party in Germany proves capitalism’s superiority, and we bid sad farewell to a Queen.
Survey Says Americans Are Too Political
As folks who spend a considerable amount of our workweek reading and analyzing financial media, we are often asked, “Who can you trust? What sources are reliable???” An Ipsos survey published August 7 answered that resoundingly with, “The Weather Channel.”[i] The poll showed the home of reporters getting battered by gale-force winds scored the highest favorability rating and trustworthiness rating of 33 news outlets (including, oddly, Barack Obama and Donald Trump). It was the only outlet 80% of respondents in all three categories—Republicans, Independents and Democrats—held a favorable view of. TWC was also the only media outlet over 90% of respondents in all three categories said they find trustworthy.[ii] Maybe folks just love to Wake Up With Al [Roker]. Or maybe it is something else. Like, we don’t know, the fact the Weather Channel doesn’t do politics?
Turkey’s meltdown remained center-stage Tuesday as financial media remained stuck on the possibility of a negative global economic impact. With volatility striking most major indexes globally (to varying degrees), Turkey is clearly hitting investor sentiment. Yet for a country representing just 1% of global GDP to cause a material global economic issue, there must be a “transition mechanism”—a logical reason its problems could disrupt other, larger nations’ economies and financial systems.[i] In Turkey’s case, the probability of actual spillover is quite tiny.
One oft-cited area of potential contagion is European banks. The ECB stated some concerns about eurozone banks’ exposure to Turkish loans last week, sparking a two-day selloff in European Financials. This seems overblown. Total Turkish debt as a percentage of EU bank assets is exceptionally small at 0.43%.[ii] Breaking down exposure at the country level, Spain’s banks have approximately $80 billion of Turkish assets on the books, French banks own $35 billion, Italian banks have $18 billion and—for those concerned about US exposure—US banks have about $18 billion of Turkish assets.[iii] These figures represent approximately 5.3%, 1.2% and 0.8% of Spanish, French and Italian GDP, respectively.[iv] As for individual banks’ credit risks, the market doesn’t appear terribly concerned. Credit default swap (CDS) spreads have increased marginally but are well below concerning levels, with most remaining far below levels seen in 2012, near the depths of the euro crisis.
While foreign currency denominated debt is a risk for banks when the local currency weakens, the amount of foreign currency debt isn’t the only determinant of banks’ potential vulnerability, as they can hedge foreign currency risks. Turkish banks happen to be very well hedged. About half of Turkish bank deposits—51%—are in local currency, while 49% are in euros or US dollars.[v] On the other side of the ledger, 66% of Turkish bank loans are in lira, while just 33% are in euros or dollars.[vi] As a result, only 22.6% of Turkish banks’ total loans are foreign exchange loans not matched by foreign exchange deposits, which is equivalent to current estimates of the FX currency reserves. (Exhibit 1) Meanwhile, European banks with exposure to Turkey have been hedging currency risk for years. If Turkish fundamentals were to significantly deteriorate, select European banks may have to raise capital, but this seems unlikely to result in the spillover effect the late-1990s’ Asian Currency Crisis had on Japanese banks (which amounted to 12% of Japanese GDP).[vii]
Turkey’s currency crisis has taken some fresh turns in recent days, finding new ways to spook investors globally. First President Trump doubled steel and aluminum tariffs against Turkey—a move that was probably more political than economic, despite its official purpose of compensating for the lira’s decline. In response, the lira plunged about 13% on Friday, sparking fears European banks with Turkish exposure were at risk.[i] Eurozone Financials thus took it on the chin Friday and Monday, dropping -4.9% across those two trading days.[ii] But by Tuesday, the focus shifted to India, as the rupee plunged to a record-low of about 70 per dollar, sparking fears of a contagion rippling throughout Emerging Markets (EM).[iii] Our viewpoint on this saga hasn’t changed. Turkey’s problems are still uniquely Turkish, and there is little fundamental reason for other EM nations to follow its downward spiral. Turkey might keep knocking sentiment, which can spark short-term volatility, but over time, we expect markets to weigh fundamentals.
While investors’ laser focus on Turkey is somewhat new, its problems aren’t. As we explained in more detail back in May, it has steadily slipped into authoritarianism since President Recep Tayyip Erdoğan first became Prime Minister in 2003. Lately, he has taken to arguing high interest rates cause inflation and heaping political pressure on the (still nominally independent) central bank to avoid hiking interest rates—even as the lira plunged this year. After winning June’s election, which made him Turkey’s first President with real power, he transferred most powers from parliament to the presidency and installed his son-in-law as Finance Minister, raising fears of more intervention and haphazard economic policy. This, combined with the specter of diminishing central bank independence, has caused foreign investors to rapidly lose confidence and pull their money out. That tanked the lira, creating a thorny situation for Turkish companies that borrowed in dollars or euros in recent years. Stepped-up US sanctions and tariffs have added fuel to the fire in the short term, but the lira’s woes have much more to do with Erdogan’s warped economic viewpoints.
Other EM nations have their fair share of political risk, but none are backsliding into authoritarianism or meddling with monetary policy to the degree Turkey is—not even close. Overall and on average, most are trending toward stronger political institutions and more independent central banks. There are a couple notable exceptions, such as South Africa, where uncompensated land expropriation and public ownership of the central bank are both on the government’s docket. Thailand still has a military junta following a 2014 coup. But these cases are the exception, not the rule.
Q2 earnings season is winding down, with 459 S&P 500 companies so far reporting pretty good quarterly results and likely more to come. Many pooh-pooh these reports, citing various yah-buts, but[i] this mostly shows sentiment continues weighing on expectations—bullish, in our view, because it provides a low hurdle for reality to clear.
Despite a solid quarter, with most companies exceeding analysts’ consensus forecasts, many—including corporate executives—continue talking earnings down. Q2 earnings for the S&P 500 rose 24.6% y/y, just a shade lower than Q1’s 24.8%.[ii] Moreover, this is well up from forecasts for 19% y/y growth before reporting started—which tends to happen when 79% of company announcements beat analyst expectations—a decade high.[iii] On a sector basis, all 11 sectors reported growth (and all beat expectations, except for Energy), demonstrating Corporate America’s earnings power is not only broad-based, but also underappreciated.[iv]
Earnings coverage was tinged with tariff talk as analysts attempted to quantify their effects and executives tried to set (low) expectations. But for all the hoopla, quarterly results suggest little impact to date—which isn’t surprising! Tariffs are tiny and relatively easy to work around. In our view, tariffs are a convenient scapegoat—for both analysts and corporate executives. Analysts can blame them in case (or, maybe more cynically, when) their estimates prove off target. Executives can use them to massage those expectations for future quarters lower—making them easier to clear. Tariffs just happen to be the get-out-of-jail-free card [v] du jour, considering the weather, currency swings, labor disputes and such may not be as convincing presently.
Central bank watchers have been stuck in quite the conundrum since the Bank of Japan’s (BoJ) July 31 meeting—no one can seem to tell if the bank is “easing” or “tightening.” At first, easing seemed to be winning, since the bank kept all its asset purchasing (aka quantitative easing, or QE) targets unchanged. But as time passed, more observers seemed to realize the decision to let 10-year government bond (JGB) yields rise as high as 0.2% would probably mean fewer JGB purchases, which to most sounds like tightening. But when yields hit an 18-month high at 0.145% on August 2, the bank intervened with a “special buying operation,” driving yields back to 0.115% as one policymaker said they wouldn’t hesitate to stem a rapid rise. Which … sort of seems like easing? Meanwhile, JGB yields have kept on swinging. Overall, we think the saga is emblematic of why trying to divine central bankers’ next move is fruitless—sometimes they say one thing and do another. But we would also suggest investors not read too much into one or two days’ worth of special operations and instead take a longer view. The last time the BoJ widened the JGB trading band, it amounted to a “stealth tapering” of QE. Once all the fuss dies down, this latest tweak could very well do the same. If it did, we suspect it would be an incremental positive for Japan’s markets and economy.
To see why, it is important to understand how we got here. Japan’s QE program is the world’s largest relative to GDP. The BoJ targets purchasing ¥80 trillion (roughly $720 billion) in JGBs annually—nearly 15% of 2017 GDP![i] At its peak, US QE was only 6.1% of GDP.[ii] The BoJ has been so active, it owns nearly 40% of total outstanding JGBs.[iii] But despite this Godzilla-sized “stimulus,” Japan’s economic growth has been tepid. The BoJ began the current QE program near the end of 2010, yet average annual GDP growth from 2009 through 2017 was only 0.7%.[iv] Meanwhile, average annual US GDP growth was 1.7% over that period, without its much smaller “stimulus/QE” for the last three years.[v] This doesn’t shock us. While most believe QE supported the economy and markets—and fear its end—we have long argued QE is a drag. When the BoJ bought long-term bonds, it reduced long-term rates and flattened the yield curve. Banks borrow short-term to fund long-term loans, so a flattish yield curve—with just a teensy gap between short- and long-term interest rates—crimps banks' loan profits. This discourages banks from lending to all but the most creditworthy borrowers, starving most firms of capital and the economy of fuel. It also stifles broad money supply growth, working against the BoJ’s mandate to get inflation back up to 2%. This is why we have long believed Japan would benefit from ending QE as soon as possible.
Japanese banks have long seemed frustrated with BoJ policy as well. Not only because they can scarcely make any money from lending, but because negative short-term interest rates further whacked their profits. The BoJ seemed to get the message in September 2016, when they introduced a program called Yield Curve Control (YCC), which targeted a 0% 10-year JGB yield but allowed fluctuation within a tight bandwidth, widely assumed to be +/-0.1%. At the time, long rates were negative, so targeting a 0% yield actually meant steepening the yield curve. It also meant the BoJ was buying fewer 10-year JGBs, allowing long rates to inch up. BoJ asset purchases fell to ¥50 trillion in the 12 months through May 2018, far below that ¥80 trillion full-year “target.”[vi] Tapering! But that sure isn’t what they called it, so they are tapering on the down-low.
Musers’ Note: As always, our political commentary is intentionally non-partisan. We prefer no political party or candidate and assess political developments solely for their market impact or investing lessons inherent in media coverage. Additionally, MarketMinder does not recommend individual securities. The below merely represent broader themes we wish to highlight.
In this week’s edition of our we-swear-it-isn’t-weekly column, the media learns how to scale tariffs and shatters FAANG stereotypes, the potential Tesla buyout raises some philosophical questions, Brits prepare for a “no-deal” Brexit, craft beer gets accused of being a leading economic indicator, and creative capitalists tackle a certain public safety problem.
Media Finally Realizes New Tariffs Are Tiny
As we trudge through the dog days of summer, the heat seems to be making the financial media even grumpier than usual. For all the speculation tariffs and increased protectionism would knock growth, most available data don’t show any major repercussions yet. The latest business surveys out of major economies show businesses, while wary of tariffs, are still expanding overall. Yet headlines harped on the slowdowns hitting manufacturing[i] and services sectors[ii] globally. The dour reaction to solid economic data is further evidence of the disconnect between sentiment and a better-than-appreciated reality—reason to be bullish, in our view.
These growthy economic data are purchasing managers’ indexes (PMI)—monthly surveys measuring business activity. Responding firms confirm whether activity rose or fell that month. PMI readings above 50 mean a majority of those surveyed reported higher activity; under 50 means more saw activity fall. Though PMIs register only growth’s breadth, not magnitude, they are useful snapshots of how businesses are doing. July PMIs of major economies all exceeded 50—a sign firms across manufacturing and services industries are growing overall, which is consistent with other data pointing to a broad global expansion. Yet many media took the glass-half-empty approach.
In the US, the Institute for Supply Management’s (ISM) July manufacturing PMI hit 58.1 while its nonmanufacturing PMI was 55.7. Headlines fretted US manufacturers were encountering “roadblocks”[iii] and services industries were losing momentum.[iv] This theme persisted overseas, too. IHS Markit’s eurozone July services PMI recorded 54.2 while its manufacturing PMI registered 55.1. Experts responded with comments about eurozone growth “ebbing”[v] and trade uncertainty hampering manufacturers.[vi] The UK’s IHS Markit/CIPS July services and manufacturing PMIs were 53.5 and 54.0, respectively. Folks worried services—about 80% of UK GDP—were now moving into the “slow lane”[vii] and weakening domestic demand was hurting manufacturing businesses.[viii] Even in China, where the Caixin PMIs for services and manufacturing remained above 50 with July readings of 52.8 and 50.8, respectively, analysts argued the twin issues of the US trade spat and softening domestic demand were hurting growth.[ix]
If you happen to know any telephone wire thieves, you may have noticed them looking a little sad lately. One possible reason (aside from the fact living life on the lam can be stressful): Copper prices have plunged -16.5% from June 8 – August 2.[i] Aside from larcenists, this drop spooked many who view the metal as a barometer of global economic health. Copper (the logic goes) is a key ingredient in manufacturing and construction projects—and since it trades globally, falling prices could signal heavy industry is flagging around the world, potentially threatening growth and markets. Thanks to copper’s alleged forecasting powers, financial wags long ago conferred upon it an honorary economics doctorate.[ii] But there are two problems with this thinking, in our view: First, as a mere metal,[iii] its price movements don’t have special significance. Second, we think copper’s recent travails appear sentiment-driven—linked to ill-founded trade war fears—and unlikely to last.
Among the explanations media toss out for falling copper prices, most pertain to perceived problems in China, which consumes about 40% of the world’s copper output. The most commonly cited: An escalating US/China trade war choking off global commodity demand and economic growth. As evidence, pundits point to recent “disappointing” Chinese data—like GDP’s slight downshift (to 6.7% y/y in Q2 from 6.8% in Q1)[iv] or recently decelerating Fixed Asset Investment (which grew 6.0% in 2018’s first half, the slowest on record).[v] Business activity surveys also ticked down in July from June.[vi] To many, this is evidence of China withering under US tariffs’ onslaught—and thus using far less copper. Lastly, some fret a recently weaker yuan relative to the dollar makes copper more expensive for Chinese importers, crimping profits and investment. But in our view, all these explanations fall short, as they ignore sentiment’s role in setting short-term commodity prices. Like stocks, commodities are subject to near-term volatility but move cyclically on supply and demand in the longer term. Trade war chatter can ding sentiment—as can growth jitters. Chinese stocks—which entered a bear market earlier this year based on similar worries—are another exhibit in the case for sentiment’s short-term influence.
But in the longer term, fundamentals win out—and in our view, copper market fundamentals favor higher prices. First, as Exhibit 1 shows, copper supply growth is slowing today and should continue easing over the next few years.