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David Coombs: China sneezes with Europe confined to bed

Is it back to the drawing board for the continent?

Well, it’s certainly all eyes to the East at the moment. As China’s economic growth has slowed, its lower demand has flowed through to weaken two of its large suppliers: Japan and Europe. Both make their way in the world by producing things, much of which they sell to China, so they are more sensitive to less demand from the Asian powerhouse.

We are happy with the long-term outlook for China, although we expect a few wobbles along the way as it moves from being a giant factory nation to a more services- and tech-led economy, and one driven increasingly by household spending; essentially, as it transforms from an industrial to a developed market economy in the space of only a few decades.

However, for us, the real weaknesses are the second links on the chain. Europe and Japan both flirted with recession at the turn of 2019 as China’s economy hiccupped, but it’s only Europe that makes us nervous. Japan should be able to shrug off the recent drop in trade, we believe. It’s closer to China than Europe is, and therefore sends a larger proportion of its exports to the Middle Kingdom. However, we think its politicians – while not perfect – are doing the right things to try to improve the country, its labour market and its economy.

Important reforms to Japanese businesses over the past few years have made them leaner, more profitable and generally better able to roll with the punches. Also, we think the nation will keep benefiting from the growing Chinese middle classes, who are increasingly travelling to the island on holidays.

Different story in Europe
Europe, on the other hand, looks exceptionally fragile to us. And not just short-term fragile, but fundamentally broken in a back-to- the-drawing-board kind of way.

If Europe goes down for a moderate-to-deep recession at the same time as China slows noticeably and the US Federal Reserve plods on with tightening monetary policy, would that be enough to tip the whole world into recession?

Is that why the Fed conducted such a screeching U-turn this year, slashing its rate hikes to a standstill and all but calling time on running down the trillions of dollars’ worth of bonds and mortgage-backed securities racked up during quantitative easing?

Historically, the Fed has had scant regard for the rest of the world when setting monetary policy.

In the 1970s, president Nixon’s envoy to Europe said the dollar was “our currency and your problem” after severing the currency’s gold standard.

In the 90s, with inflation running at a fairly muted 2.75 per cent, the Fed hiked rates so aggressively it sent emerging market currencies into a tailspin, contributing to the Asian financial crisis.

But the scales may have shifted; if America is more susceptible to recessions overseas, perhaps the Fed is taking account of what is happening beyond US borders.

Whether this is the case or not, the Fed has unequivocally put the brakes on its rate-tightening agenda.

This is good for capital markets, as lower-than-expected interest rates mean upcoming cashflows are worth more today. It should also release some of the upward pressure that was brought to bear on US sovereign bond yields last year. This reversal in the fortunes of bond markets led us to buy both gilts and US treasuries, at roughly eight- to 10-year maturities.

We’re cautiously optimistic for the year ahead but are aware volatility has picked up noticeably as well. We expected this and feel market prices are likely to continue jerking around violently. Having a few more safe-haven bonds in our portfolios should help to offset some of these movements. A bit more of the iShares Physical Gold ETC should hopefully offer similar protection.

People get carried away
Don’t let these safe-haven purchases get you thinking that we’re expecting the worst. In fact, when markets took a tumble late last year and in early January, we were steadily rebalancing our equity positions. We sold our put contracts, which had protected us from some of the falls, and we spread the lump of cash between equities and cash.

To us, investors are sliding between absolute panic and eager optimism too quickly and on too little information. We don’t mind a jot though, as it gives us lots of opportunities to trim positions at higher prices and buy things we like at lower prices. We’ve been sticking assiduously to companies with strong balance sheets, high returns on assets and a true edge on their competitors. These businesses are in no way immune to a recession, if one comes (they are nigh on impossible to predict), but we believe they should fare best.

David Coombs is Rathbone multi-asset portfolio funds manager


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