The Beginning Of The End?

John Leiper - Head of Portfolio Management - 3rd April 2020
The coronavirus has brought economic activity to a virtual stand-still and transformed a strong global economy, with lots of debt, to a weak economy… with lots of debt. As a result, financial markets have sold-off in dramatic fashion.

Yet despite all that, and as shown in the chart below, the S&P 500 remains in a long-term uptrend. This trend has existed, uninterrupted, for over 70 years having endured the 2007-2008 financial crisis and 1973-1974 oil shock.

 

Source: Bloomberg.
If this upward trend remains in place, then the good news is we are approaching the bottom of the channel.
When looking at charts, scale is important, and whilst the risk remains that markets could fall further still, we are now at levels where the conversation is turning positive (CNBC).

This presents an opportunity to re-position the portfolios.

Large global events inevitably lead to change, and with change there will be winners and losers. The winner from the coronavirus thus far is China.

If the official numbers are to be believed (something questioned by US intelligence officials (Bloomberg), the number of cases and deaths in China remains extremely low. As a result, economic activity is returning to normal and Chinese assets are outperforming the rest of the world.

The chart below shows the Chinese manufacturing and non-manufacturing PMI numbers. PMI stands for purchasing managers index and is a monthly survey of managers in private sector companies to determine the health of the economy. Values above 50 are considered expansionary and below 50 are contractionary. Both indices recently surged back after falling dramatically the prior month. This could point to strong economic recovery in China.
Source: Bloomberg
The chart below shows the performance of the Shanghai Stock Exchange relative to other developed and emerging market equities. Chinese equities have outperformed by a considerable margin since the onset of the coronavirus in early February.
Source: Bloomberg
Since early February Chinese government bonds have outperformed the benchmark (relative performance in white) as well as European (purple) and Japanese (red) government bonds.
 Source: Bloomberg
Meanwhile, the European political response to the crisis has been found wanting and the US is now heading into a “very painful” two-week period in which confirmed cases and deaths are expected to continue to climb. Therefore, relative to European and US assets, we think it makes sense to invest in China and other Asian countries.

Why have Asian countries suffered less from the coronavirus?

This is a difficult question to answer. But three potential reasons stand out:

The first is superior policy implementation. Simply put, Asian countries are better suited to dealing with global pandemics than other regions because they have experienced more of them.  Prior crises brought temperature monitoring devices to airports and governments monitored mobile phone data to reduce the spread of the virus.

The second reason is herd immunity. The Sars outbreak of 2003, to which many Asian populations were exposed, was caused by Sars-CoV. The current outbreak, COVID-19, is caused by Sars-CoV-2 and therefore Asian populations may have some degree of built-in immunity.

Thirdly, certain Asian hospitals appear better funded and more adequately prepared to handle the virus than other healthcare systems.

If Asian economies can ride out the coronavirus better than their western peers, then the fall in economic activity will be less severe and the recovery quicker.

 

What about the longer term?

Dramatic events bring dramatic change. The big question is how long it will take to beat the coronavirus. The longer it lasts, and the greater its impact on western countries relative to Asia, the greater the probability the coronavirus will act as a catalyst for the decline of the US and rise of China as the next hegemonic power.

This battle is already raging. It is why Donald Trump imposed sanctions on China and accused them of intellectual property theft.

The answer to this question comes down to economic power and currency. The US is the strongest economy in the world. As such it enjoys the “exorbitant privilege” of having the global reserve currency, the US dollar. This is a huge advantage to the US economy.

However, nothing lasts forever. The US took the mantle from the British in 1945, following the devastation of the second world war. Before that, it was the French, who dominated Europe from the early 1600s until the Battle of Waterloo in 1815.

China is next in line. The country has contributed the most to global economic growth since 2008 and in 2015 the International Monetary Fund named the Chinese yuan a global reserve currency. Further, a growing number of countries including China, Russia and the European Union are increasingly looking to move away from the US dollar: (CNBC)

The ultimate transition from the US to China probably remains a long way off. Since becoming President, Donald Trump has eschewed the foreign policy of prior Presidents and aggressively asserted a form of US nationalism. The immense monetary and fiscal fire power we saw last month will likely keep the US on top for the foreseeable future.

However, the “exorbitant privilege” the US enjoys from the global reserve currency has now morphed into an “exorbitant burden” as the Fed is forced to do all it can to support the global economy. This is shown in the chart below which shows the level of purchases under QE4, which now matches the financial crisis in 2008.

This chart shows the total assets of Federal Reserve Banks and how this has grown through several rounds of quantitative easing following the financial crisis in 2008.

Source: Bloomberg

Saving the global economy will involve unprecedented levels of monetary and fiscal policy as well as a weaker US dollar. As such, the US dollar may no longer serve as a beacon of financial rectitude, nor as an effective store of value (one of the necessary requirements of a global reserve currency). If the world is forced to look for an alternative reserve currency this would undermine the US and benefit China.

The US dollar is already overvalued. Since the 1960s the US dollar has moved in 17-year cycles, rising and falling in value relative to a basket of developed market peers. We are now at a point in the cycle where the currency is likely to depreciate over the coming years. This cyclical tendency will coincide with the afore-mentioned policy specifically designed to weaken the dollar. Given the correlation to US equities, this would signal an end to US equity outperformance as the rest of the world, led by China, catches-up.

The US dollar index (in white) typically moves in a 17-year cycle as demonstrated by the red arcs. Movements in the US dollar are correlated with the relative performance of US equities (in blue).
Source: Bloomberg
Positioning the portfolios
So to summarise, Asian economies have proven more resilient to the coronavirus and as a result their economies should bounce back quicker.

Over the longer term, the coronavirus catalyst could turbo charge a broader transition in the global economic order from the US to China. This transition is already under way.

As such it makes sense to allocate investments towards Asian assets, and specifically China, relative to other developed market regions.

We first flagged this opportunity in mid-February (in the first of my weekly blogs) and have since gone overweight Asian equities and bonds across the portfolios.

Final Thoughts
The coronavirus is unique in the level of uncertainty it has un-leashed, in such a short space of time, on our personal lives and on the economy.

This uncertainty has caused ruptures across financial markets. What is required, to break the deadlock, is clear visibility that the end is in sight.

With that in mind, the following interview, published Thursday evening, is very positive (skip to 5 minutes): Foxnews.com.

In the interview Stephen Smith, the founder of the Smith Center for Infectious Diseases and Urban Health claims to have made a breakthrough using hydroxychloroquine on infected patients.

In his words, “I think this is the beginning of the end”.

John Leiper – Head of Portfolio Management
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Bloomberg, Tavistock Wealth Limited unless otherwise stated.

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