Tactical Asset Allocator: a contrarian bull in the China shop

Where could investors find refuge, as fear grows that US interest rates will rise too quickly and that the October sell-off marks the start of the next crisis? Ceri Jones writes

The big news this month has been the climb in US 10-year Treasury bond yields to 3.2%, their highest level since July 2011. Bond yields had been rising gently (and their prices falling), reflecting confidence that the US economy was robust enough to weather trade wars and other setbacks. However, the rise has spooked markets, forcing a reassessment of risk-free assets compared with equities.

It all kicked off when US Federal Reserve chair Jerome Powell declared on 3 October that rates are a long way from neutral, hinting that there will be many rate hikes to come. The main aim of such moves is to control inflation. But while higher rates help restrain spending, they slow the housing market and damage prospects for large-ticket item manufacturers such as carmakers. That all came to a head on 10/11 October when the Dow led the world in a sell-off, tumbling more than 1,300 points in two days.

Stock markets have fallen after each of Powell’s three rate-setting committee news conferences this year. Together, they wiped $1.5 trillion off the market. That all came to a head on 10-11 October when the Dow led the world in a sell-off, tumbling more than 1,300 points in two days.

Investors primarily fear that the Federal Reserve will miscalculate and move too quickly to normalise interest rates, although there is also a perception that should the stock market lurch from bad to worse, the central bank now has limited powers to do much about it.

Until recently, headwinds from higher interest rates were no match for the US market, which continued to storm ahead, powered by robust economic growth, tax cuts, deregulation and share buybacks. However, while the 30-constituent Dow Jones Industrial Average index continued to climb, more than half of the 3,000 stocks in the Nasdaq Composite index were said to be trading below their 200-day moving averages, a bearish sign indicating all is not well in the broader market.

Some commentators predict that the very monetary stimulus measures put in place to stabilise markets in the aftermath of the 2008 financial meltdown will cause the next crisis. Overall, central banks have bought an eye-watering $10 trillion in assets, and no one knows what will happen when this all unwinds.

High levels of global debt mean any pain from a hike in interest rates will be sharper than in the past, especially when an unstoppable dollar is pushing up the cost of dollar-denominated debt outside the US. That’s one reason why there has been so much concern about Argentina’s debt, for example.

Liquidity crisis

JPMorgan already has a name for this scenario – The Great Liquidity Crisis – but it is vague on the timing. It says this depends on the pace of central bank moves, the business cycle and ‘various idiosyncratic events’.

Traditionally, most portfolio modellers have used bonds to offset equity risk, but this tactic is likely to fail during this monetary stimulus inflexion, because of low rates and swollen central bank balance sheets. The truth is, there are few assets at reasonable prices to be found. As inflation rises, the fixed coupon offered by most bonds becomes less valuable, while stock valuations are high across the world.

There’s a chance, though, that investors are still largely overlooking a historic opportunity: China. Its scale and speed of development are stupefying. The Shanghai Stock Exchange boasts more than 200 million retail investors, and though it has made losses this year, it remains the world’s second-largest IPO market. And there’s a lot more where that came from: only one third of China’s GDP is represented in the public equity market.

China also leads the world in building the infrastructure that will count in tomorrow’s world. For example, it has 800 million internet users – compared with 300 million in the US – 98% of whom are mobile net users. The country’s mobile payment market has grown by nearly 30% in a year, to $4.7 trillion (£3.5 trillion), and its two e-payment platforms – Ant Financial’s Alipay and Tencent’s WePay, which are locked in ferocious competition – each have 500 million active users. Tencent seems to be nosing ahead, largely because WeChat, its instant messaging app with one billion monthly users, is such a rich experience that users spend an hour on the platform each day on average.

The Boston Consulting Group’s Global Wealth Report 2018 estimates that China accounts for 15% of the world’s upper-high-net-worth individuals (worth $20-$100 million) and ultra-HNWs (worth $100 million plus), and that these groups are growing by 22% a year. China’s middle class is growing exponentially and now numbers about 400 million people, at a time when the developed world’s middle classes are shrinking. 

Promising territory

This thinking is behind our decision this month to buy a stake in Fidelity China Special Situations investment trust, which has some 48% in information technology, 29% in consumer discretionary and a relatively small exposure to the financial sector.

While markets globally have been rattled, some in particular have disappointed relative to expectations earlier in the year. For example, Japanese equities have fallen, despite their low valuations, positive EPS growth and Japan’s resilient domestic economy. Longer-term, though, Japanese companies have strong operational gearing to global growth.

Trade fears have held back the developed Asia Pacific ex Japan region, although the fundamentals again look quite positive.

Across continental Europe, equities were caught in the rout despite attractive fundamentals and corporate earnings. One perennial issue is the credit quality of key pillars of the region’s banking system, but all eyes are currently on Italy and the budget proposals put forward by the new left-right insurgent government, which has reignited fears of fiscal disaster.

In the UK, Brexit has stifled stock market growth. The median forecast price-to-earnings ratio for all shares with estimates in the UK is about 13, compared with 23.55% for US shares. That’s very low.

Click here for larger version of funds table

A table of funds in the Tactical Asset Allocator portfolio

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