At Linchpin we have had a positive view on markets since March 2023 and the collapse of Silicon Valley Bank. Our thinking was crude: the Federal Reserve reacted to that ‘crisis’ by a further bout of Quantitative Easing, much as they have to every market wobble since 1997. They hid their actions a bit better this time because they kept interest rates high, but behind the scenes they and other central banks used their balance sheets to ensure money was plentiful. No surprise that some of it found its way into financial assets and especially equities.
We are changing our view. This is not because the Federal Reserve has hugely changed its stance. They are not (yet) trying to contract their balance sheets, albeit the main driver now is the parlous state of government finances rather than a financial markets crisis. Central banks are relying more on short term bills than coupon-paying longer duration bonds to finance government debt. The reason is that excessive bond supply would put pressure on bond yields and through that government debt service costs and ultimately fiscal programmes. The outcome is expanding central bank balance sheets, much as under QE before.
There are two reasons why we are becoming more wary about markets. The first and more important is what is happening in China, which seems to be on the verge of a policy mistake similar to Japan in the 1990s. The symptoms are disappointing growth and disinflation on the verge of deflation. The most recent GDP data was below expectations because consumption disappointed. Nowcast surveys are pointing to Asia’s growth being sluggish at best.
A major problem is that the yuan is over-valued, much as the yen was in the 1990s. The PBOC shows no signs of wishing to devalue it, so the pressure is coming through a domestic deflationary squeeze. This is most obvious in the real estate markets where property investment is down 10% year on year, residential sales are down 26%, and prices have been falling for nearly two years. Consumer inflation has been hovering around zero for a year, and producer prices have fallen about 7% over the past two years.
The usual consequence of an overvalued currency is that capital tries to leave and this is exactly what data from our friends at CrossBorder Capital tell us is happening. Cross-border capital flows out of Emerging Markets are running at about average levels relative to the last five years, but have fallen sharply in the past 12 months.
If the yuan is not devalued, and there is no sign that the PBOC is thinking of that, then the deflationary squeeze in China will continue. So far the impact has been hidden by some strength in exports (e.g., shipping rates are high). Given that the West is also suffering from low growth, this looks like an inventory rebuild i.e., temporary. Further out lies the threat that a Trump administration (and/or perhaps security concerns over key shipping lanes) would accelerate ‘re-shoring’ and reduce Chinese exports to the West.
If China does fall into a deflationary slump, there will be an impact on the rest of the world’s markets. Japan is probably the most directly affected because China is one of its top two trading partners (top for imports, second for exports). On a broader scale, because China is the world’s largest manufacturer, our concern is that deflation will be exported to other countries. That may help western central banks keep control of inflation, but it will not help the growth governments need to make their budgets add up.
The second reason for our wariness on markets is to do with the extraordinary rise in tech stocks. The sharp falls in the large tech stocks this week following Tesla’s disappointing earnings results, shows how vulnerable share prices are in the short term. Our starting point is that companies cannot compound their earnings for ever. Constraints, whether total potential market size, competition, or anti-trust regulation, will at some point force a reduction in the earnings growth rate, even of a company such as Nvidia.
Whether this is simply a correction or something longer term is the key question for investors. Tech is going to continue to alter our lives, albeit not everything (AI, for example?) will live up to its current hype. Much like the large drug companies, the large tech companies can simply buy up promising tech inventions and keep their earnings going at lower rates.
Prices today are probably too high, based on excessive expectations from AI and the like, and perhaps also because the relatively liberal monetary stance of the West has, as it always does, led to excess money (i.e., not needed in the real economy) going into financial markets. In global (and very high level) terms the P of the market PER is being driven by the U.S. and the E being driven by China. Both are likely to fall, but our best guess at the moment is that the P will fall more than the E.
That leads us to think of recent market movements as the beginning of a correction, at least until something larger happens to turn it into a longer bear market. The two candidates here are Chinese deflation being exported, or something much bigger happening to damage the prospects of the Magnificent Seven. The obvious one is anti-trust legislation.
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