• 'We expect the next five years to be
more turbulent that the cycle just passed'
• 'China will emerge a stable, open global
economy with deeply entrenched trading ties'
• Reforms from Beijing will slow Chinese growth more than markets anticipate
By Kay Van-Petersen
As 2017 ebbs towards a close, the groundwork for a
new era of a different sort is being prepared in China – the National Congress of the Communist Party. Held just once every five years, the NPCC brings together China’s ruling elite to shape a new five-year plan to oversee the vast country’s economy, societal development and policies on the world stage.
The 19th congress kicks off in mid-October and will be more keenly watched than ever before given China’s rising star in the global arena.
When asked to sum up the structural theme and
significance of this upcoming meeting, my colleague at Saxo Bank in Singapore Andrew Bresler points to the expanding influence of party general secretary and president Xi Jinping. “The first five years of Xi Jinping’s tenure can be characterised as building his base to extend his stay. Through a massive anti-corruption drive Xi has stamped out former leadership stalwarts and replaced them with his own key lieutenants to ensure Xi is not just around for another five-year tenure, but more likely for 10. Confirmation of this will come during the Congress.”
The past year in China has been characterised by
stronger than expected economic growth as the overhang of the 2016 credit expansion and a global economic tailwind have seen the old-China model of manufacturing and exports lifted in sync with the ongoing strength in the new-China domestic consumption services-driven economy. This debt-fueled growth tailwind has been a source of concern for investors and regulators alike and the key lesson from the five-yearly financial working conference was that the period of excess leverage is now over as it risks financial stability.
The Chinese authorities have responded by reducing liquidity in money markets thus lifting rates and stemming house price rises. Deleveraging of state-owned enterprises has begun in earnest, a sector of the economy that contributes just 30% of GDP while being responsible for 70% of the nation’s debts.
Extrapolating from this, if the first five years of Xi’s
tenure were characterised by achieving stable economic growth and building his power base, and we assume he will extend his leadership by another 10 years and not five, then we expect the next five years to be more turbulent that the cycle just passed. Xi will press harder on his economic reform agenda and seek to further stamp out the leverage seen as so risky to China investors.
He will do this early and effectively by choosing to take the pain now rather than later. This will slow Chinese growth more than markets anticipate and have significant consequences for the rest of the world.
At the end, China will emerge a stable and open global
economy with deeply entrenched trading ties both in the east and the west.
At the end of the day, Xi’s regime seems set to follow
through on focusing on quality of growth rather than quantity of growth, as well as the continued switch in weaning China off of its historical reliance on exports which are still a sizable chunk of GDP, yet tend to support a much larger employment base (also known as social stability). It also makes sense that Xi needs to solidify and expand his powers like never before because the last big hurdle of reforms lies with the state-owned enterprises which are a series of powerful fiefdoms within the communist party.
Those expecting huge fiscal spending plans, loosening
of monetary policies, and general expansion could be in for disappointment. So does this put us in a potential hard-landing scenario in China?
Everyone who advocates that view needs to bear in
mind that China’s an autocratic state and can turn on the taps at will both from a fiscal and a monetary perspective. While tactical shorts may work here and there, structural long-term shorts need to be structured carefully to withstand an opening up of China’s capital markets – the Ace of Spades that China always holds up its sleeve.
Global macro: thoughts on positioning
The next three to six months will most likely determine
whether things calm down on the Korean peninsula or escalate to levels not seen in recent times. The scenario illustrated below, taken from our weekly cross-asset Macro Monday call, should give some ideas on positioning around the three potential pathways into year-end and
the first quarter of 2018.
My views for the rest are sharply unchanged; an inflationary view in a deflationary-positioned world (which is starting to wake up) still leaves me wanting structural exposure along the following:
- Develop market duration, potentially even looking to
play flatteners on the Canadian curve, short front end of the curve and long the back – US 2-years and 10-years.
- Early days, but our short Jan 2019 Fed Fund futures are looking pretty hot right now and Q3 gave some juicy entry points to build up that structural short line. This is high conviction. Any time we get back to the market pricing solely one hike between today, the balance of 2017 and the entire 2018 that’s an asymmetrical trade I want to put on in size.
- Short volatility on VIX spikes through long options, similar to the likes of the SVXY calls and call spreads that we had on in Q3 that returned +188% and +118% on their respective premium. I would not advocate outright short options or VIX futures. I don’t like unlimited downside, but I just love unlimited upside.
- Equities? Bull market, dude. Yes recessions tend
to bring -20 to -30% drawdowns, but the risk is we could be going up another 30-50-100% before we go into a global recession. The next 12-18 months seem fairly intact and robust from a global growth perspective. No, central banks are not hawkish, they are less accommodative. The delta there is massive. Furthermore, volatility is so low it would be sacrilegious to not have downside protection (see tech put structures from Q3 publication). At the same time, it costs you very little to have exposure to the upside. Would look for value plays in the energy sector, which has still lagged this grind up in oil.
- Emerging-market high-yielding sovereigns and forex,
the mother of all structural longs on India. I think I had this view on from back in 2014 – multi-decade in nature.
- Crypto space, you know the five-to-ten year cryptocurrency
basket. They are here to stay, playing this space on a weekly or even quarterly basis is a roll of the dice in my opinion.
- I like commodities and think we are in the process of
breaking out structurally to multi-year highs. Remember, we are seeing the best growth globally in over a decade in regard to that growth being symmetrical, plus inflation remains very contained, a Goldilocks scenario. I think oil has a floor as long as global growth holds up and the house of Saud needs to list Aramco. I reckon that gold and silver are also breaking up structurally, and, once again, the miners (SIL & GDX) are the way to play this, with silver potentially having a more asymmetrical payoff not to mention under positioning in comparison to gold.
- Forex is tougher to call in a general sense. I favour USDCHF to the upside, as well as long-term 3-5 year horizon sterling longs that have positive carry (vs CHF, EUR, JPY). Everyone who imagines that Brexit will be the equivalent of the UK jumping off The Shard and shooting its brains out on the way down fails to understand physics. Action. Reaction. The UK (read: London) will do whatever it needs to do to reinvent itself. Hard Brexit? OK, new global tax haven, thank you very much. The lows in cable and other major crosses
were in over a year ago, by the time this is published the market will be long sterling. I still like the usual suspects that we’ve mentioned on Macro Monday many times: RUB, MXN, INR, BRL, IDR.
Multi-year GBP longs with carry... is it really that complicated?
The 20-year monthly chart on GBPCHF shows a c. +60%
move to the median level – that’s unlevered, and with carry not taken into account over the 5-year horizon that one needs on a trade like this.
The three main scenarios on the Korean peninsula
Scenario one – nuclear conflict: tail risk:
- In the tail risk event of a nuclear conflict, the
magnitude of the fallout would be massive.
- The escalation of tensions could come in two forms:
Rapid escalation via miscalculation or a slow constant increase in escalation ending in a nuclear conflict.
- Our view is that rapid escalation is more likely than
a gradual increase as the market will desensitise itself to provocations.
- Key strategic hedges that stands out are being long
gold and silver.
- Structural: Precious metals and precious metals
miners (ETFs such as SIL, GDX and GDXJ).
- Tactical: NDF longs such as JPYKRW, long yen and Swiss francs.
- Long VIX futures, long SXVY puts and VXX calls, long
- Knee-jerk reaction:
+10% spike in $KRW, -5% in $JPY, -10-15% in SK and JP equities. US 10-years and bunds tighten by 20-50bps and 15-30bps respectively. Gold and silver rise 10%.
- How long the risk-off would last is debatable, a pathway where the strikes and engagement are over quickly, with minimal collateral damage, could see a selloff reverse quickly. In a drawn-out, damaging pathway, we could see further extensions of the knee-jerk reaction.
Scenario two – peaceful resolution: tail risk:
A peaceful resolution where North Korea agrees to halt
or curb its nuclear ambitions with the caveat of trade and economic concessions. It could also be a change of regime within NK.
Pyongyang agreeing to negotiations could be a possible
start of this scenario, it would be well-telegraphed and slow-moving.
The general move would be a steady risk-on of South
-Korea related assets, bonds, precious metals, the yen and Swiss franc losing some of their NK hedge premium.
Potential for strong SK equities and as strong KRW.
Scenario three – 'muddle-through' status quo: base case:
- The base-case scenario is an amalgamation of "muddle-through" scenarios. Note that this could encompass anything from continual posturing and action from both NK and the US and its allies.
- More sanctions, more missile launches, more nuclear
tests, military drills, etc.
- The potential for non-nuclear military
engagements and skirmishes.
- Structural overlays of hedges (gold, silver, miners, JPY, CHF) while remaining invested elsewhere.
- Market will increasingly become desensitised to minor
provocations. This is the most challenging scenario to navigate, filled
with numerous intervals of risk on/off.
Positioning around scenarios:
Source: Saxo Bank
— Edited by Michael McKenna