Monday digest

Posted 21 June 2021

Overview: Investors try to make sense of the Fed’s ‘dot-plot’
The biggest event of the week took place last Wednesday, as the US Federal Reserve (Fed) concluded its two-day Federal Open Markets Committee (FOMC) meeting, where it discussed economic policy and its latest projections on inflation and interest rates. In his post-meeting press conference, Fed Chair Jerome Powell acknowledged that its so-called ‘dot-plot’ showed that there could be two rate hikes in 2023, with only a small likelihood of any rate rise next year. He said the Fed expected solid employment improvement in the second half of 2021, and that inflation projections showed inflation back down to 2% by 2023. Powell also gave the gentlest of indications bond purchases will slow at some point. Yet the markets moved as though the Fed had announced an immediate turn towards tighter policy. The Dollar rose sharply, by about 2% against most currencies. In bonds, the five-year yield rose to 0.88% from 0.75% and stayed there. The 30-year maturity bond rose to 2.22% but then reversed down to 2.10%. Meanwhile, equity prices edged higher with growth and yield sensitive tech shares in the NASDAQ getting the biggest boost, returning to all-time highs again.

The Fed’s credibility is always a contentious topic, and this has been especially so after such a huge episode of monetary stimulation intervention. So, the sharp flattening is interesting, and continues the move lower in the “term premium” we mentioned last week. Real yields, as priced by inflation-linked bonds have stayed stable, which has resulted in market estimates of inflation going down. When you add in the rise in risk-asset prices, it all says that the Fed’s credibility remains huge. The market is pricing the outcome that the Fed wants: higher near term inflation that proves transitory and is followed by stable inflation around the target.

Of course, the Fed might yet make a policy mistake, but it may be more the markets’ problem if inflation data is challenging. Having sent some signals at this point, the Fed will probably not do anything further as we head through the summer. Markets may get very quiet. However, headline inflation will almost certainly look like it is rising, while an improving global economy may involve money being taken out of savings. By the time we get to the end of August’s big central bank get-together at Jackson Hole, there could be considerable market tension building up. For now, we think the Fed is credible. Of course, we reserve the right to change our minds in the future.

Plenty to celebrate for China’s Communist Party
Celebrations and patriotic fervour are in store for the world’s most populous nation on 1 July, marking a century for the party which has ruled mainland China from 1949. The Chinese Communist Party began in a small house in Shanghai, a house which now flanks the entrance to one of the swankiest shopping areas in the city. We can expect all the frills that usually come with China’s important anniversaries: nationalistic broadcasts, emotive speeches from officials and – crucially – a tightening of the state’s grip on daily life.

China has been cracking down again on risks in its financial system since the start of the year, which is a clear manifestation of the Party’s priorities. Having built its reputation on strength, stability and prosperity, it seemed more interested in strengthening the financial system than trying to boost short-term growth – as shown in its recent relaxing of growth targets. Given the world was in its sharpest recession on record, this was a bold choice. But in fact, the Chinese economy was given a helping hand in this regard, as its exporters saw surprisingly strong demand throughout last year.

That strong external demand for Chinese goods has given officials a lot of security in dealing with the pandemic fallout, focusing instead on fixing internal issues while the global economy is rescued by others. At the end of last year, we suggested the government would be happy to let China be a passenger in the global recovery, only stepping on the accelerator if things elsewhere deteriorated. However, recent developments may force them to adjust that position. China’s trade surplus has been shrinking, for the third consecutive month, as growth in imports outpaced exports. This is not a consequence of weakening global demand though – perhaps the opposite. Commodity and shipping prices have been rallying this year, on the back of the strong global recovery and a number of significant supply bottlenecks.

Another notable development is that Chinese corporates have currently strong pricing power, which historically was not the case. The difference now is that most of the other major producers in the region – Vietnam, Malaysia, Indonesia – are still in the mire of COVID restrictions, unable to vaccinate their populations fast enough and resorting to increased restrictions. This could leave China as the only game in town as far as production goes, giving it the power to up its prices in the coming months. There is indeed already evidence of rising Chinese export prices. In terms of international implications, for at least as long as COVID dominates our lives, China may keep some of its superior pricing power. Further out, as we noted some months ago, after decades of putting downward pressure on global prices, China could well become an exporter of inflation, as it moves away from exports driven by cheap labour supply. This is the latest phase of the country’s modernisation – one the hundred-year old party will no doubt be proud of – and it seems to be happening already.

Japan’s latest corporate scandal bears traditional hallmarks
Toshiba – the technology conglomerate that has long been seen as a symbol of post-war Japan – hit a new low last week. An independent investigation found its management colluded with the Japanese government to suppress the rights of its international investors. The full report – which found that five million AGM votes from Singapore-based 3D, one of Toshiba’s biggest shareholders, had not even been counted – spared almost no one, from the company’s former chief executive to the head of Japan’s $1.6 trillion pension fund, and even Prime Minister Yoshihide Suga. The episode paints a familiar troubling picture for Japan’s international investors. Not only did the old guard pull in political favours to quash investor demands, they did so specifically against foreign shareholders trying to change the company. It shows an insular attitude where activist investors – particularly those from overseas – are seen as a foe to be guarded against.

There was a time when Japan was a major component of the global economy, providing high-tech manufacturing to the world and intricately tying its booming economy into the global fabric. But stagnation has gripped corporate Japan to an alarming extent. These days exports account for only around 17% of Japan’s GDP, only slightly above its 1985 level. Germany – a competitor in terms of the profile of its exports – has an export ratio of 46%. Even the UK, which has seen a drop-off in its exports following Brexit and the pandemic, has a higher share of its economy externally focused, at 25%. In fact, among the developed nations, only the US – the largest domestic economy in the world by some distance – has a lower export component in the developed world.

This greatly affects the outlook for Japan’s equity markets. On the face of it, there is a great deal of value that international investors can find in Japan. With the impressive stock market returns of the last year in the US, we have seen valuations (in terms of earnings per share) become extremely stretched there. But there is very little sign of such overvaluation in Japanese stocks. And indeed, Japan’s equity market looks cheap compared to the rest of the developed world on all major metrics. However, valuations are just one consideration among many. Arguably more important is the behaviours and strategies of companies – whether they seize opportunities by investing in development or acquiring different revenue streams.

To be sure, there have been some improvements recently. Corporate Japan’s return on equity has been increasing, and Japanese companies have started giving more back to shareholders in the form of dividends or share buybacks. What’s more, the fact that Japanese companies are so cash rich tells us the potential is certainly there. But as the Toshiba report shows, cultural issues repeatedly get in the way. The positive, one would hope, is that this episode provides the impetus to do what corporate Japan has long promised. Without that change, Toshiba will continue to symbolise Japan, for all the wrong reasons.

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