Market Viewpoints

Summary:

At a time when American prestige in the world is fading and China’s status is rising, and as the US and China work to find a mutually acceptable trade deal, it is difficult to imagine how unequal the two nations were in 1979 – the year of the big reforms in China – let alone in 1949 when then Chinese Communist Party leader Mao Zedong established the People’s Republic of China (PRC). In 1979 China’s GDP stood at $178bn and was 6% of US GDP. Today, China’s GDP is 63% of US GDP. For 22 years after the establishment of the PRC, there were no diplomatic relations between the US and China. It was not until April 1971, at the height of the Cold War, that there was the first public sign of warming of relations between Washington and Beijing in what came to be known as “Ping-Pong” diplomacy. When full diplomatic relations were eventually established in 1972, US-China trade stood at paltry $4.7 million, a rounding error when compared to today, and it now stands at $604 billion. The history of US-China relations is a fascinating read and China has gone from being a pariah state to the US in 1949 to its most important trading partner. So much so, that we are heading into a G-2 world where China and the US will make rules for the rest of the world to follow.

The New Year’s rally in equities continues after the US Federal Reserve (Fed) decided to pause its steady campaign of raising interest rates and shrinking its balance sheet. The S&P 500 Index is up over +18% since its December lows and is up +11.1% for the year. The Eurozone’s flagship Index, the EuroStoxx 50, is up +8.6% this year and is set to get a further boost as the European Central Bank (ECB), alarmed by slowdown in growth across the Eurozone, is about to embark on another round of ultra-cheap long-term loans to the banking system. While this new round of monetary policy is not a panacea for the Eurozone, it will boost European equities, particularly European bank stocks, which have floundered since May last year

Chimerica: A G-2 world beckons

The Chinese economy of today is a far cry from the days of Chairman Mao Zedong and the “Great Leap Forward” – his second Five Year Plan which lasted from 1958 to 1963 – and proved a complete disaster for China. It left millions of people dead and many more miserable for decades to come. Frank Dikötter a Dutch historian in his excellent book – “The Cultural Revolution: A People’s History, 1962–1976” – has painstakingly gone through the Chinese Communist Party’s own record and declassified letters of complaint, secret police reports, statistics, surveys and other archived papers, to draw the picture of misery that China was in the 1960s. By Dikötter’s count, the Cultural Revolution – formally the Great Proletarian Cultural Revolution from 1966 until 1976 – left 45 million dead as Mao forced peasants off their land on to co-operative farms and mindless industrial projects. Mao wanted to lift Chinese steel production by putting the whole nation to work at over 600,000 backyard blast furnaces. Instead, he got famine and tens of millions dead. Mao had been warned by then Soviet Union leader, Nikita Khrushchev, that China’s course to industrialisation risked a famine. Khrushchev knew it from his own knowledge of Josef Stalin’s reckless ambition for industrial power that unleashed a famine in Russia in 1932-33 and killed up to five million in Ukraine, a country land rich and fertile for agriculture. Today however, China is the world’s second-largest economy using its wealth to build “colonies” around the world and the only real challenger to US hegemony. This miraculous turnaround achieved in just over 40 years – beginning with the “reform and opening up” of China in 1979 – has led to multiple years of double-digit growth (see chart below).

China GDP Growth Rate (1979-2017)

At a time when American prestige is fading and China’s status is rising and as the US and China work to find a mutually acceptable trade deal and negotiate as equals, it is difficult to imagine how unequal the two nations were in 1979 – the year of the big reforms in China – let alone in 1949 when Mao established the People’s Republic of China (PRC). In 1979 China’s GDP stood at $178bn and was 6% of US GDP. Today, China’s GDP is 63% of US GDP. The history of US-China relations is a fascinating read and China has gone from being a pariah state to the US in 1949 to its most important trade relationship in the world. So much so that we are heading into a G-2 world where China and the US will make rules for the rest of the world to follow. Europe is the big loser in all this and only has itself to blame – no structural reforms, low growth, high unemployment and an over-reliance on exports and not domestic demand.

Europe is the big loser in all this and only has itself to blame – no structural reforms, low growth, high unemployment and an over-reliance on exports and not domestic demand.

Chimerica is a neologism coined by historians Niall Ferguson and Moritz Schularick describing the symbiotic relationship between China and the United States. Yet for 22 years after the establishment of the PRC in 1949, there were no diplomatic relations between the US and China. It was hard and often impossible to get a visa to China, much like for North Korea today. Businessmen were granted access once a year for the Canton Trade Fair. In neighbouring Hong Kong, camera-toting Americans and Japanese tourists would take the bus to go to the border to catch a glimpse of “Red China” on the other side. The relations between the US and China deteriorated to such an extent, that in the spring of 1955, the US threatened a nuclear attack on China in support of its ally – Taiwan. It was not until April 1971, at the height of the Cold War, that there was the first public sign of warming of relations between Washington and Beijing in what came to be known as “Ping-Pong” diplomacy – the US national table tennis visiting China to play their world champion team. Seeing this as an opportunity to open up political relations with China, US President Richard Nixon secretly sent his Secretary of State Henry Kissinger to Peking to arrange a meeting between himself and Chinese Premier Zhou Enlai. The meetings between Kissinger and Chinese officials were successful and the ensuing trip by Nixon to China in February 1972 would become one of the most important events in the world and US post-war history. Nixon called his visit as “the week that changed the world.” Shortly thereafter, the United Nations recognized the People’s Republic of China and granted it a permanent seat on the US Security Council, which had been held by Taiwan since 1945. With this, the inclusion of China in the world order was complete. However, it still took more than a decade before US-China trade relations began to thrive. When full diplomatic relations were eventually established in 1972 US-China trade stood at paltry $4.7 million, a rounding error as compared to today. Between 1980 and 2004, US-China trade rose from $5 billion to $231 billion and it now stands at $604 billion as reported by the United States Census Bureau. The accession of China into the World Trade Organisation (WTO) in 2001 was the defining moment for China and world trade and you can see the seismic shift in China’s GDP since then (see chart below).

World Bank GDP for China and US (in Current USD)

Source: Bloomberg

US-China trade negotiations are at a crucial stage and, in recent days, US President Donald Trump and US Treasury Secretary Steven Mnuchin have both made positive remarks on the prospects of striking a deal. On Sunday Trump tweeted – “Important meetings and calls on China Trade Deal, and more, today with my staff. Big progress being made on soooo many different fronts”. Talks indicate that both China and the US are focussed on thrashing out a mutually beneficial deal. For instance, Beijing has proposed to increase US semiconductor sales to China to a total of $200 billion – five times the current level. This will help the US narrow its record $384 billion trade deficit with China. Very interestingly, the proposal also indicates moving assembly operations of US semiconductors from countries like Mexico and Malaysia to China. This would allow those products to be counted as US exports rather than those of other countries. What it means is – US and China are reforming the world into a “G-2 world” where their mutual interests will be prime consideration – Trump’s “America First” and President Xi’s “Made in China 2025” (which aims to make China the world leader in cutting-edge technology in ten key industries). The US and China by virtue of their strengths – Technology and innovation for the US, and the size of Chinese domestic market plus the capacity to purchase US Treasury debt for China – put both countries in a position to conclude trade deals which benefit them mutually.

The US and China by virtue of their strengths put both countries in a position to conclude trade deals which benefit them mutually.

As I wrote in the February 2018 Market Viewpoints – “ The world’s two largest economies – US and China have their fates inextricably linked. In a way, they complement and need each other. The US cannot compete with China when it comes to manufacturing and China cannot compete (yet) with the US when it comes to product design or research and development capabilities.” All signs indicate a trade deal will be struck. The March 1 deadline or risk the tariffs on $200 billion of Chinese goods to jump to 25% from the current 10% looks less of a concern. In a statement, the White House press secretary said both sides “have agreed that any commitments will be stated in a Memorandum of Understanding between the two countries.” Recall, in July 2018, the EU and the US agreed to a 392-word statement saying the two sides would work to eliminate tariffs and other barriers and that led to Trump not imposing tariffs on auto exports from the EU. So the memorandum will give room for the US to extend the March 1 deadline to conclude a deal at Trump-Xi summit later in Q2 this year.

Markets and Economy:

The New Year’s rally in equities continues after the US Federal Reserve (Fed) decided to pause its steady campaign of raising interest rates and shrinking its balance sheet. The S&P 500 Index (SPX) is up over +18% since it’s December lows and is up +11.1% for the year (see table below). The Eurozone’s flagship Index, the EuroStoxx 50 (SX5E), is up +8.6% this year and is set to get a further boost as the European Central Bank (ECB), alarmed by slowdown in growth across the Eurozone, is about to embark on another round of ultra-cheap long-term loans to the banking system otherwise known as Targeted Long Term Refinancing Operation (TLTRO). Last week, Peter Praet, the ECB’s Chief Economist, gave the strongest signal yet that more funding could be on the way. He said – “The discussion will come very soon in the Governing Council”. Benoît Cœuré, also a member of the ECB’s decision-making council further boosted the expectation of TLTRO with his comments in New York – “I can see that there is a big discussion in the market of having a new, as we call it, TLTRO. It is possible. We are discussing it, but we want to be sure that it serves a monetary purpose.”

Equity Market Performance (YTD)

Regular readers of this newsletter will know my concerns about the Eurozone – politicians paying lip service to structural reforms, as the economy deteriorates and the ECB runs out of tools to help sustain economic growth using monetary policy tools alone. In March 2015, the ECB launched its bond purchases program known as Quantitative Easing (QE). The program was envisaged to run for a year and a half. However, after multiple extensions the program ran for two years longer and only came to an end in December 2018. During this time the Eurozone had its best growth at over +2%. Now that QE has come to an end, Eurozone growth is sputtering again. This has led the European Commission to slash its growth forecast for the Euro area. The EU forecasts GDP in the 19-member Eurozone to grow by +1.3% in 2019 instead of the +1.9% forecast in November. The forecast also indicates that Italy’s economy which slipped into recession at the end of 2018, will grow at the slowest pace at just +0.2% this year. Germany managed to escape recession by the skin of its teeth. The ECB’s balance sheet at over €2.5 trillion is 40% of the Eurozone’s GDP. By comparison the Fed’s balance sheet peaked at $4.5 trillion and now stands at $4 trillion, or 22% of US GDP. While a new round of TLTRO is not a panacea for the Euro area, it will boost European equities, particularly European bank stocks, which have floundered since May last year.

Meanwhile, in the US we got the minutes of the Federal Open Market Committee (FOMC) meeting held on January 29–30, 2019. The minutes indicate most Federal Reserve officials last month were in favour of keeping the Fed’s $4 trillion balance sheet from shrinking further. Fed officials are in favour of releasing an action plan to underscore this point. They believe “such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve’s balance sheet.” This is a confirmation of the about-turn by the Fed officials who, at the December meeting, raised the benchmark rate by +0.25% and pencilled in two rate rises this year, only to change course at the January meeting as the economic outlook turned grey. Many now believe that the Fed is unlikely to raise rates this year. I am of the view however that the Fed will be able to raise rates this year and that raise will come in Q3/Q4 and not sooner. It may seem that the Fed is hostage to the markets and there’s a lot of supporting evidence for this theory. However, I see it more as a communication problem. Fed Chairman Jerome Powell’s communication in December was hawkish in tone but dovish in intent. The market chose to focus on the tone in the press conference and sold-off. This put the Fed on the backfoot to change course soon thereafter.

A weak retail sales number further highlighted softer economic outlook for the US. As the charts below indicate, the -1.2% (month-on-month) decline in December, was the biggest decline since September 2009. Excluding Autos and Gas, the drop was even more dramatic. However, one swallow doesn’t make a summer. If this decline were to continue for a couple more months, then the Fed would be quite concerned and rate hikes would be off the table for the year. I do not however anticipate such a dramatic outcome. The resolution of US-China trade deal, the ongoing stimulus in China, lowered rate rise expectations in the US all combined with +3% p.a. wage growth, point to an economy which is not close to a recession.

Source: Bespoke Invest

The UK meanwhile, despite the Brexit overhang, is faring well and the recent rally in GBP/USD is indicative of this. Chaining the Quarter-on-Quarter (QoQ) GDP growth for 2018 indicate that UK GDP grew by +1.3% in 2018 (compared to France +1%, Germany +0.7% and the US +3.1%). The International Monetary Fund’s (IMF) GDP growth forecast for the UK for 2019 remains unchanged at +1.5%, while growth in 2020 was revised up by +0.1% to +1.6%. Data released this week indicates that the UK has delivered a record budget surplus in January – £14.9 billion, the largest since records began in 1993. A bumper round of tax receipts helped the surplus climb compared to last January. Borrowing in the current financial year-to-date has nearly halved compared to last year and is 40% lower than the Office of Budget Responsibility’s (OBR) forecast. All very welcome help for a government in case of a No-Deal Brexit. As I have pointed out in last month’s newsletter, I do not expect the UK to leave the EU without a deal.

So, in light of all of the above, my allocation still remains overweight to US equities. I also feel very positive about Emerging Markets (EEM US) and particularly the Chinese tech stocks (Alibaba, Baidu, Tencent, JD.com) and semiconductor stocks (Micron Technology, Qualcomm, Nvidia). As for US sectors, I stay overweight US Financials (XLF), US Communication Services (XLC) and US Healthcare (XLV)

US Equity Sector Performance (YTD)

Other stocks I like: In terms of stocks I like: VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US), Lam Research (LRCX US), VINCI (DG FP).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital