Market Report: July – August 2019
Economic uncertainty related to American trade, immigration policy and deficit, slowdown the world and American economy.
It seems that economic uncertainty has now become an instrument of DT administration policy that can be used in conjunction with regulatory, fiscal and monetary policies, to achieve policy goals.
The escalation of the trade war with China, the threat of customs duties on imports from Mexico and additional tariff threats on European cars, even French wine, have created uncertainty in the entire manufacturing sector. The negative effects caused by the uncertainty related to the trade war have been compounded by media debate on reversing the FED’s interest rate policy with the possibility of another government shutdown and the accompanying congressional debate on raising the country’s debt limit.
At the end of July this year, doubts around the FED and uncertainty about the debt limit were resolved, when at the July meeting, the FED reduced interest rates by 25 basis points, and Congress passed a two-year draft budget that eliminated the risk of government shutdown. Uncertainties related to the trade war and the slowdown of the global economy remain valid.
The effects of these uncertainties are evident in the slowdown in industrial production growth, where the annual growth rate peaked in September 2018 and since then has fallen each month.
We see a similar pattern in the total employment chart, where annual growth peaked in January 2019 and has shown a downward trend since then. A similar trend has been observed since February 2019 in the case of commercial and industrial loans granted by all American banks.
Indicator drops also appeared in transport activities. The annual increase in the Cass Freight Index, which records activity in all forms of transport, began to decline in May 2018. It entered the territory with negative growth in December 2018. We are talking about growth rates, not activity levels.
Is the Chinese banking sector safe?
In May this year, due to serious credit risk, the Chinese financial regulators took over control of the regional lender Baoshang Bank. While personal and small business accounts were protected, some corporate and interbank clients suffered losses. This shocked investors, who believed that the government had effectively guaranteed all Chinese financial institutions. The acquisition briefly raised concerns about a domino effect in other small banks.
At the end of July, the country’s largest bank, the Industrial and Commercial Bank of China (ICBC) and two other state-owned banks, rescued another regional lender, Bank Jinzhou.
In August, a subsidiary of the Chinese sovereign wealth fund took over the third distressed regional lender, Hengfeng Bank, which is owned by the same parent company as Baoshang Bank.
In a diverse banking system in China, risky lenders are in banks of the third and fourth tier. They represent about 20% of all banking assets in China:
We detected early risk indicators for 20 low-level banks. These signals include: the lack of data publication, deterioration of financial indicators and indicators that mean higher risk and / or lower transparency. For example, a clear sign of hidden unprofitable loans (NPL) is when overdue loans appear to grow faster than published non-performing loans. This discrepancy meant problems at Baoshang Bank.
These 20 low-level banks with 3 trillion ¥ assets (USD 426 billion) represent only 1.2% of the entire Chinese banking system. But apart from these 20 banks, many very small lenders are unlisted and do not disclose financial statements. They constitute 10% of the Chinese banking system and are unknown. If we accept the conservative assumption, that half of these unlisted banks are in trouble, it would mean that the percentage of troubled banks against China’s total bank assets is around 5-7 percent. This is not a sign of the structurally difficult situation of the banking sector.
First, the restructuring is underway.
To minimize market impact, several vulnerable small banks in China have already been restructured and recapitalized. In fact, this process has been going on for five years, as the number of NPLs in China has grown gradually. It seems that at present, China is controlling the situation of regional stability of the banking sector.
Secondly, the funding risk is limited to small banks.
Large financial entities, which are the lion’s share of the Chinese banking system, are exposed to very little funding risk. First, these banks have little reliance on external financing, which minimizes susceptibility to foreign flows. The assets for borrowers from Chinese banks are financed by either state-owned enterprises (SOEs) or self-financing entities (LGFVs), which the government still effectively guarantees. Otherwise, banks have some exposure to households, which are only moderately leveraged. An extensive asset quality shock is unlikely.
Third, the system can absorb bad debts.
The NPL rate reported by China is only 1.8%. But even if – as we believe – the true NPL ratio in China is around 8% and even if all these loans become an immediate loss, the banking system has internal resources available to fully absorb hidden bad debts and still has a capital surplus. This means that the reported capital ratio is higher than the minimum requirement of the Basel III criterion.
Financial markets focus on the ongoing trade war between the US and China – the goods and services that are in play are being watched, and what measures are being taken or threatened in each case. A trading conflict however, can spread to currency markets – and this is a risk to monitor.
Until now, currency intervention has been rare
Capital flows in currency markets determine the value of global currencies, but from time to time decision-makers step in to buy or sell their domestic currencies to influence their value – in fact, trying to take control of the market. Intervention was widespread, but it has been very rare in developed markets since the mid-1990s. The US did not intervene in the value of the dollar exchange.
Currency intervention is rare because it is usually not effective. Currency markets are huge and it is unclear whether intervention can permanently change the value of a currency. In addition, global coordination between decision makers has led to widespread recognition, that monetary intervention is a beggar thy neighbour policy. If one currency becomes stronger, the other must weaken, which may cause retaliation. If everyone intervenes, no one gets anywhere – while the financial markets are more satisfied.
However, in our opinion, US currency intervention is currently at the table. The president’s advisers publicly indicated that this was a point of discussion at the White House.
How would currency intervention work? The president may order an intervention without any control. The US Treasury Department would order the Federal Reserve to sell dollars on the market, using the sales department at the Federal Reserve Bank in New York. Historically, the FED has also participated in interventions, using its own funds in equal amounts to emphasize that policy is being coordinated. The FED is not legally obliged to do so, but we expect that it is unlikely to risk openly disagreeing with the executive body – the legal arbitrator of monetary policy.
If there is any intervention, we expect the US Treasury Department and the FED to try to be as transparent and public as possible. Scientific literature and evidence from previous interventions explain that movements must be signaled to be optimally effective. In this case, the Federal Reserve Bank’s sales office in New York would sell dollars to major dealers, and the US Treasury Department would also announce its intervention in the currency markets.
Does the FED still manage the market?
The Fed’s independence is under threat because the President’s tweets and recent institutional reforms, increasing accountability to public authorities and civil society, as well as greater public pressure, have significantly increased the number of restrictions affecting his decisions. The approach to text mining, based on an analysis of sentiment in social media, confirms that the years 2017-2018 were a turning point in the perception of FED policy.
FED is too "market dependent".
The policy response function with parameters that change over time shows that the FED is increasingly attaching greater importance to market stabilization, to the detriment of its growth and inflation goals.
The FED is increasingly less credible in fulfilling its double mandate.
Our indicators reflect the higher risk of persistently exceeding the inflation target of 2% in the medium term, the changed ability to maintain full employment – in the event of a further deterioration in the economic cycle – and a higher risk of political error.
The FED’s status-quo as a market guide is being questioned.
Assets correlated to high levels in 2019. This is equivalent to losing market direction. This suggests that the current FED status quo may be questioned and that in a market stress situation everything will have to be shown “at the table”.
FED may soon lose control over monetary policy.
Despite the ease in the US monetary policy, the Trade-weighted USD Index reached record highs in the summer of 2019. This reflects primarily the loss of influence on currency issues due to the actions of the US Treasury and the People’s Bank of China (PBOC).
History says, that weaker central banks are associated with a higher risk of recession. Political errors include premature tightening of monetary policy, bubble care or lack of authority in circumstances requiring rapid and bold stabilization moves. Separately, the lack of direction perceived by the market favors the existence of many balances and self-fulfilling prophecies. This combination of factors tends to increase the likelihood of recession, as we see today.
What happens at the level of small, medium and large enterprises?
At the global level, the working capital requirement (WCR – The Working Capital Requirement calculated in the formula: WCR = DSO Days Sales Outstanding + DIO Days Inventory Outstanding -DPD Days Payable Outstanding) for large companies (EUR 50 million of turnover and more) – a measure of financial resources, used by companies to cover operating costs and other expenses related to conducting business in an efficient manner – decreased by +1 to 70 days in 2018, to the highest (worst) level since 2012. In terms of value, this represents an increase of 12%, i.e. +820 billion USD of additional financial resources was used for working capital in 2018 – instead of supporting the development of new products, modernization, geography expansion, acquisitions or debt reduction. In 2019, we expect stock adjustments and stronger wage discipline, in response to lower global growth and higher global uncertainty: this would help reduce the WCR of large companies (from -2 to 68 days).
Most WCR increases of large companies were recorded in emerging markets, in particular in Brazil (+9 days), South Africa (+8) and Russia (+2) with China as an exception and an increase in inventory as a key reason for growth. This was accompanied by a strong increase in debt at the end of 2018: + 1 pp of GDP in emerging markets in the fourth quarter of 2018 compared to the previous quarter. However, advanced economies were not resilient, especially in the US (+1) and Europe (on average +4 days for Nordic countries, +3 in Germany and Spain). Several other developed economies have stabilized or diminished the WCR of their large companies by decreasing days of overdue sales (Japan, UK) or an increase in days of overdue payments (Italy, France, Portugal). At the global level, WCR’s growth was concentrated in six sectors: agri-food, automotive, household appliances, paper, utilities and business services.
Observing Western Europe, small and medium-sized enterprises recorded better results in terms of WCR changes than large companies in 2018. In Italy, SMEs reduced WCR by -14 days (compared to -4 days for large companies). In Spain, SMEs recorded a 7-day decrease in WCR, and large companies recorded a 3-day bounce. WCR slightly improved for French SMEs (-1 day), although it remained stable for large companies. In Germany, the WCR for SMEs increased by 2 days and by 3 days for large companies. The highest increases in WCR were recorded mainly in sectors dependent on external trade (in Germany: electronics, transport equipment, machinery and equipment, paper and agri-food products; in France: electronics, textiles, pharmacy and automotive suppliers).
The overall WRC for SMEs remains a month longer compared to large companies. This is particularly evident in southern European countries, with the spread being 37 and 22 days in Italy and Spain, respectively, compared with 23 in Germany and 15 in France. In these four countries, six sectors have experienced more than the average WCR for their small and medium-sized enterprises (105 days in Italy, 89 in Germany, 81 in France and Spain): textiles, transport equipment, machinery, metals, to a lesser extent chemicals and electronics.
Chart: Large enterprises WCR calculated in days and USD bln:
Chart: Large enterprises WCR year / year percentage change:
Chart: Large enterprises WCR – Map Heat by country and sector:
Reading notes: Darker green means a lower average WCR for a country or sector; Conversely, a darker red color indicates a country or sector WCR extension.
Methodology: Our calculations were performed on a sample of 25,000 listed companies in 20 non-financial sectors and 36 countries downloaded from the Bloomberg database. All numbers are simple and unweighted.
Current market narrative
Global markets are looking for optimism in the face of trade unions and signs of even greater stimulation of monetary policy. Easy money can give short-term increases in asset prices, but long-term prospects seem more difficult, especially for Europe.
We see two obstacles related to the latest market narrative:
First, the truce in the trade war is at most restless. If, we believe, the trade war is just the beginning of a broader, long-term conflict between the US and China, it probably won’t be long before the situation worsens again. In addition, there is a possibility that the trade war will spread to other countries.
Secondly, although central banks are ready to provide more incentives, we are concerned about the effectiveness of this policy. Certainly, the answer to what worries the global economy, will not be even lower interest rates and greater quantitative easing. Even if more incentives help stabilize growth, it’s likely to do so by encouraging individuals and companies to incur even more debt, raising interest rate sensitivity and an even lower interest rate balance. In our view, the Bank for International Settlements (BIS) rightly called it a debt trap.
Lower global growth is a particular challenge for Europe. Not only because the eurozone countries are more dependent on international trade than the US and China, but also because they have much less political flexibility. These double sensitivities are shown in the picture below: if the risk of a deterioration in the global economy really starts to crystallize, the last place you would like to be is in the upper left corner of the chart (see the chart below), with high sensitivity to international trade and low flexibility of the applied policy.
Chart: Flexibility of implemented policy and openness to trade:
Source: December 2018, Haver Analytics, estimates for the flexibility of fiscal and monetary policy.
The euro zone’s lack of flexibility applies to both monetary and fiscal policies. The European Central Bank (ECB) has signaled its intention to introduce a new stimulus, but with negative interest rates and a strained balance it is not clear what lies in the monetary policy toolbox; Draghi’s recent appeals for further help in fiscal policy suggest that the ECB may share these fears. Meanwhile, fiscal policy is still hampered by eurozone budget rules, a weak starting position in many countries, and Germany’s reluctance to use its own significant fiscal space.
This is a difficult situation that Christine Lagarde will inherit in November when she will replace Draghi as President of the ECB. We think Lagarde is a good choice: has the rank and communication skills to do the job, and can also appreciate the broader political context in which the ECB operates. But she will take on a new role at a crucial moment.
We expect a significant easing of the ECB’s monetary policy in September. This should be enough to stabilize the economy and calm markets if the global slowdown remains shallow. But it is unlikely to be enough for growth and inflation in the region. It is also not enough when the slowdown becomes something less mild. In the latter case, markets will probably re-estimate the risk.
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.