Posted 14 September 2020
Welcome to this week’s Digest, where we consider some of the crucial questions driving investment markets. To read about all of the issues raised here in more depth, take a look at The Tatton Weekly, and if you would like to discuss any of the topics below in more detail, please contact us directly.
Overview: Frictions and contradictions abound
The ‘goldilocks’ summer for investors has officially ended, and political, societal and capital market tensions have returned with a vengeance. However, that stock markets have not simply plunged on bad news, but instead remained surprisingly stable, is a good indication of the unpredictable economic and market dynamics at present. Europe’s second Covid wave has not prompted a sudden return to depression and decline. The reason for this is most likely that there is a general feeling that we have indeed learned to cope with the virus, even if we have to accept that things will not return to our old normal for some time yet. Nevertheless, the slightly contradictory market reaction seems to indicate that markets no longer assume the second wave will hold back the economic recovery, and should not derail expectations of a rebound of longer-term earnings growth.
In the UK, restrictions on social activity have increased once again. This is troubling, as any return of higher levels of activity restriction and fear are going to increase the damage for the economy. It remains to be seen just how willing the UK general public will be to this latest round of restrictions, whether exhortations to flatten the curve will triumph over the desire to return to normal activities. The government may well be faced with escalating frictions between the frustrated and less-affected young and the more vulnerable older generations.
Given these virus-related political pressures, it is unclear why the UK’s government chose this week to further increase political stresses by announcing their planned breach of the European Union Withdrawal Agreement. The decision has only served to undermine the nation’s standing as a contractual counterparty in the international political arena in an unprecedented way. It appears most likely to be a combination of political actors lacking relative experience paired with a certain gung-ho attitude to shake things up for the better of the country. But, as with the previous disconcerting negotiation moves, this one should probably not be taken as seriously as it was by currency markets, which responded with a distinct mark-down of sterling.
It remains in the best interests of both sides to achieve a mutually beneficial trade deal, rather than falling out at the very point that economic headwinds would be most destructive. Just as the government’s 31 July deadline passed without any further mention, we would not be surprised to see the 15 October Council Meeting – where Boris Johnson has issued his ultimatum for European leaders to agree to a trade deal – to pass in the same way. The real deadline to watch out for is the summit scheduled for early December. Our expectation is that the final outline of the future arrangements will only come together then – after a few nights of gruelling debate.
Can the Fed ensure credit goes where it is most needed?
With the global economy in the grip of its deepest-ever recession, the world’s central banks – led by the US Federal Reserve (Fed) – have injected huge amounts of liquidity into the financial system and government coffers to stop the health crisis turning into a financial catastrophe. But recently, the pace of those injections has actually slowed somewhat. The Fed is still regularly pumping out substantial amounts of capital, and still running multiple support initiatives, including its corporate lending facility, municipal liquidity facility and its Main Street Lending Program. But the volumes are at a level closer to the ‘regular’ quantitative easing we saw over the last decade than the emergency levels we saw from March until the summer.
This is, to a certain extent, to be expected. As long as credit markets and the wider financial system are functioning properly, support measures combined with asset purchases should be sufficient backstops. The crucial question, then, is how well are things really functioning? Low bankruptcy rates would suggest the Fed’s timing is well-judged. But for some of its other measures, such as the Main Street Lending Program (MSLP), it is not yet clear whether the system is working properly. So far, the MSLP has made $600 billion in loan facilities available to employers who were in good financial standing pre-pandemic and, while the loans are administered by private banks, the Fed promises to buy 95% of new or existing loans handed out. However, the recorded take-up of these loans from businesses has been very low, with firms either unwilling or unable to access the funds.
This highlights a real problem for the Fed. In any crisis, when credit conditions tighten and the effective money supply gets constricted as businesses tighten their payment terms, a central bank can do its part to increase the supply of credit. But the actual demand for credit is beyond their control. Even at generous rates and lending conditions, businesses will be uneasy about being saddled with more debt when the prospects for finding their feet are still so uncertain. Borrowing to stay afloat, when you have no idea when or if the business will be viable again, is not an attractive idea. The Fed can provide liquidity, but it is the economy that assures solvency.
Now we are in the final quarter of the year, renewed efforts to resolve this credit impasse could prove crucial. Some analysts expect a spike in default rates towards the end of the year. To us, it is hard to say whether the lower take-up of loans recently is a sign of stability or not – given the demand issues mentioned above. However, if we do see a pick-up in loan demand from now until the end of the year, we would view this as a positive, suggesting businesses see the potential to make profits – the sign of a healthy economy. But it is likely that the MSLP and other emergency lending schemes will need to be extended by whoever is in the White House at the time. We have had the necessary emergency intervention from the Fed, now we need to see that liquidity getting into the real economy.
Why international investors are right to be reluctant on China
From the latest economic data, it looks as though China pulled off nearly a complete V-shaped recovery in the third quarter of 2020. Overall, China’s exporters have fared reasonably well through the pandemic – not only sellers of Covid-related goods (protective equipment, medicine, etc.) but producers of intermediate goods too. Barring a second wave of virus cases, domestic demand – supported by fiscal policy – should hold up well, while the external side of the economy benefits from the global rebound. That economic positivity makes a strong investment case for China.
The problem for international investors is – as always with China – politics. Tensions with the US are well-known, ad there is little sign of de-escalation even if Donald Trump loses office in November. The bigger danger for the US-China relationship is that the growing cold war turns hot, and spills over into accidental or intentional conflicts. That would be a problem for the whole world, not just China and the US. Thankfully though, China’s economic and cultural integration with the US and the rest of the developed world make that somewhat less likely.
However, China’s political problems are not just on the international scene. Since becoming paramount leader eight years ago, and removing constitutional term limits in 2018, President Xi Jinping has slowly broken down the system of informal checks and balances constructed by the Chinese state, and is now the ruler for life of the Communist Party, the state council, the military and, most recently, the police. Xi’s increasingly tight grip on power has caused a great deal of domestic friction. Aside from devastating human rights abuses, and multiple crackdowns on perceived political enemies, frequent ‘anti-corruption’ purges have often led to bursts of wild instability for affected private companies – those ‘purged’ from the system must try to quickly get their capital out of the country.
This is the biggest headwind to the otherwise improving investment case in China. Even though the economic fundamentals are clearly present, such purges and crackdowns highlight the inherent instability of China’s centralised regime. For international investors, the greater risk is that political developments could quickly get in the way of the return of capital – without any recourse if they do. Unfortunately, with Xi’s grip on party, state and military institutions only set to tighten, this is looking unlikely to improve and will require ongoing close monitoring for confirmation or disproval.
This material has been written by Tatton Investment Management and is for information purposes only and must not be considered as financial advice. We always recommend that investors seek financial advice before making any financial decisions. The value of investments can go down as well as up, and investors may get back less than originally invested. All calls to and from our landlines and mobiles are recorded to meet regulatory requirements.