Adapting to regime change, single or multiple
As investors, we must always be aware of the regime we are operating in and especially aware of regime change that could cause big asset reallocation flows.
We are probably at the end of a 15-year pro-US regime, the end of a decade of zero interest rates, and now entering a more volatile geopolitical regime after the peak of globalisation. The resulting asset reallocation flows could be profound.
During the pro-US regime, the share of the global equity market value of US equities rose to 60%, despite that country contributing only 25% of global GDP, while S&P 500 companies earned 62% of their revenue inside the US. This demand for US equities and US Treasuries also drove US dollar strength. How much more relative upside could there be for US assets?
GEOPOLITICAL VOLATILITY
As a result of steep US rate hikes, US money market funds are becoming a legitimate asset class for the first time in a decade, with yields approaching 5%. Money market funds are competition for US bank deposits and will compete with US equities and Treasuries soon enough.
Geopolitical volatility arose with unexpected votes for Brexit in the UK and Trump in the US. Neither of these compares with the invasion by Russia of Ukraine in February 2022.
Financial markets struggled to anticipate such extraordinary events, and were caught off guard every time. They failed to anticipate Brexit, Trump, Covid19, the Ukraine invasion, and even made record highs after the Federal Reserve announced the end of a decade of loose monetary policy.
Why is that? Fewer (US) managers try to anticipate such events, which slow the discounting process of news into share prices. Passive funds forecast absolutely nothing, while active managers who do anticipate, are a shrinking percentage of total global assets under management. This results in a longer lag for markets to react to global events, after which markets tend to respond violently.
It is clear that the US and China are attempting to decouple. While the figures do not show the effects of deglobalisation yet, companies are diversifying their production bases out of China. This is a clear inflationary trend.
Morris Chang, founder of Taiwan Semiconductor (TSMC), said recently that chips in its new Arizona factory were expected initially to cost 50% more than those produced in Taiwan, but now he believes they are more likely to be 100% more expensive.
The greatest beneficiary of the past era of globalisation has been Apple, the largest stock in the US and the world.
While more passive markets are slow to anticipate events, banking crises happen much faster today, due to quicker dissemination of panic news on social media, and the ease of phone banking apps.
A bank run is only hours away as Silicon Valley Bank learnt in March, when a quarter of its deposits left in a day.
Shorter term, markets will need to deal with a few variables not widely discussed yet.
The US debt ceiling is likely to be contentious, and there is a high probability of the process running beyond the X-date when the US Treasury runs out of funds. Treasury secretary Janet Yellen estimated the date to be in early June, while some forecasters believe it to be by August. A US sovereign debt downgrade seems highly probable too. It is a US-centric event with potential ripples to the rest of the world, as we question the global risk-free rate.
On a positive note, the probability of a diplomatic solution in Russia-Ukraine is rising off a low base.
Presidents Xi Jinping of China, Emmanuel Macron of France and Luiz Lula da Silva of Brazil would like to have seats at the diplomacy table. Ukraine is least likely to want to negotiate, but the debt ceiling could limit future US payments, without which Ukraine cannot win the war.
Should the various parties succeed in pulling off the unthinkable, then equities and currencies in the EU, UK, emerging markets and Japan should outperform. Chinese equities should outperform most if it lost the Russian taint due to their “unlimited friendship”. Expectations are low, and early signposts are positive.
PASSIVE MARKETS
The Bank of Japan (BOJ) could cause ructions if it changed policy abruptly.
Japanese investors own $3.9-trillion in mostly global bonds, and a retreat to Japan would be bullish yen and Japanese equities, while bearish carry trades such as the rand & New Zealand dollar. The new governor said on Wednesday that the BOJ will take its time, so this risk seems less imminent than expected by the market but remains a risk for 2023.
The single greatest tail risk would be a Chinese invasion of Taiwan. The greatest victims would include emerging market and Nasdaq equities. Apple has 76% revenue exposure to China, unbeknown to its shareholders, who value it on 26 times earnings. The Taiwan risk seems low until the Taiwanese elections in January 2024.
Markets will end up responding to (not anticipating) one event after another. Those of us who search for signposts of events to come, must adapt our timing to the slower pulse of the more passive markets. Being early is functionally indistinguishable from being wrong.
Those who want to win, have to adapt to the effects of passive markets and be prepared for regime change, especially multiple regimes changing at the same time.