In an article last year, we discussed possible portfolio strategies in order to navigate the potentially tempestuous waters of rising populism and related to that the evolving trade war between China and the U.S. Although earlier in the year it appeared that both sides were willing to compromise and reach a mutually beneficial deal, in the age of "ego" and nationalism (nationalism is really just a reflection of ego at the national or societal level), this now appears to be an optimistic assessment.
Perhaps more ominously it appears the Chinese are seeking to use the trade war as an opportunity to showcase the superiority of their anti-democratic, repressive and authoritarian political system. The Chinese believe that with the Trump administration just over a year away from the next election, the administration will capitulate and eventually offer the Chinese better terms. In this manner the Chinese will essentially 'kill two birds with one stone,' obtaining a better trade deal than initially envisaged and also highlighting the inherent weaknesses (revolving door leadership) of a free and democratic system (or at least as Beijing sees it).
Put bluntly, unless the economic pain becomes unbearable, China may be willing to remain obstinate far longer than many may have originally anticipated. Furthermore, China's declining dependence on the US as an export market, reflected in the chart below, suggests that the immediate impact of the tariffs will not be that meaningful. The slowdown in the Chinese economy during 2018, was probably - if not more so - a function of the slowdown in credit and particularly shadow bank lending as opposed to intensifying trade frictions.
Source: Alpine Macro Research
Nevertheless, a protracted trade war will still create negative headwinds, especially for the Chinese economy over the medium-term. It will more than likely accelerate the shift in lower-tier manufacturing to regional competitors with cheaper labor such as Vietnam. This shift is largely inevitable, a function of rising Chinese wages and income growth, but there is little doubt a protracted trade war would exacerbate and accelerate this dynamic, creating a persistent headwind for the country's export sector. As such, if or when Chinese stimulus and elevated investment spending in the infrastructure and real estate sectors ebb, the risk of a hard landing (even if it only materializes in 2020 or 2021) has probably increased in light of recent developments.
If this analysis proves correct, then what can investors do to protect their portfolios, especially when traditional hedging mechanisms such as index shorts are often inefficient in this type of situation? Why do we say inefficient? Well, we are dealing with an inherently chaotic and random process where much depends not on fundamentals but political dynamics. This makes timing in terms of placing and removing portfolio hedges extremely challenging.
As such, in the aforementioned article last year we suggested that allocating some capital towards gold (NYSE:GLD) could serve as a decent portfolio hedge in the event that trade frictions intensified. Gold would benefit from an easing in interest rate expectations in the event that global growth slows due to the imposition of higher trade tariffs. More specifically, gold tends to perform very well during periods of rising risk aversion, particularly when the increase in risk aversion is reflected in a widening in credit spreads.
Although the imposition of tariffs will lead to a transitory pick-up in inflation, the eventual outcome is likely to impact growth negatively and this could force the Federal Reserve to consider cutting rates or at a minimum resist raising rates in response to the transitory acceleration in inflation. This effectively implies a reduction in real rates, again a scenario which should prove to be supportive for gold prices.
More significantly perhaps, there are also sound fundamental reasons for an investor to consider having at least some exposure to gold and gold equities. As the chart below indicates, gold exploration expenditure remains well below the 2008-2011 cycle high, while the number of new gold discoveries has also declined steadily over the past two decades. This suggests that markedly higher prices may be required in order to stimulate sufficient supply growth in the next decade. Therefore, as a portfolio hedge, owning gold does not come with the burden of having to know when to increase or decrease the size of the hedge, since it is a position that can simply be held as an investment in its own right.
However, we also cautioned that an escalation in the trade war should not automatically be regarded as a negative development for the U.S. Dollar. Specifically, we wrote, "The reflex in financial markets to the announcement of proposed trade tariffs by the Trump administration has also been to sell the U.S. Dollar. However, it remains open to debate whether the currencies of surplus or deficit countries should fare worse. Although both surplus and deficit economies are likely to be negatively impacted in terms of growth expectations, higher tariffs would arguably reduce the trade deficit of deficit countries (the reason for the imposition of the tariff in the first place), and one can therefore make a sound argument that the currencies of deficit economies should fare better comparatively in a global trade war relative to the currencies of surplus economies"
Secondly, the Chinese authorities could choose to weaken the Yuan in order to offset the negative effects of the trade tariffs on their exports. However, a marked devaluation in the Yuan would create a ripple effect throughout the Asian region, placing similar downward pressure on the currencies of other regional exporters. Invariably, this would likely lead to a tightening in global U.S. Dollar liquidity, resulting in a broad and possibly significant appreciation in the US Dollar against most currencies. Specifically, emerging-market currencies - most exposed to global trade or with inherent structural vulnerabilities - would bear the brunt of the painful adjustment in global portfolio flows.
As such, we recommended shorting selectively the equities and currencies of the more vulnerable emerging-market (NYSE:EEM) countries as a hedge against a rapid appreciation in the U.S. Dollar. Obviously in an environment where the US Dollar does appreciate significantly on a broad trade-weighted basis, gold prices as well as gold equities would perform poorly, or at least temporarily. In this kind of scenario, US policymakers including the Federal Reserve would likely react eventually to any marked US Dollar appreciation with various interventions including reducing interest rates.
Apart from the currencies of smaller Asian exporters, currencies such as the Turkish Lira and South African Rand (NYSE:EZA) also come to mind as attractive short hedges, given the structural vulnerabilities in both countries. Some of these structural vulnerabilities are political or "micro" in nature but largely reflected in macro indicators such as a large current deficit or low levels of foreign exchange reserves.
As reflected below, Turkey and South Africa are the only two EM countries where their gross external financing requirements exceed their foreign exchange reserves levels.
Given last year's devaluation in the Turkish Lira including the increase in short-term interest rates, a short position in the South African Rand is probably more attractive at this juncture (cheaper carrying cost). The current Turkish refinancing rate stands at 24%, while the comparable South African refinancing rate stands at 6.75%.
However, although Turkey and South Africa have equally onerous external financing obligations, we should note that much of Turkey's obligations are denominated in foreign currency, while South Africa's external debt is denominated mostly in local currencies. More specifically, Turkey's short-term foreign currency debt in 2018 exceeded the value of the country's central bank reserves, while South Africa's short-term foreign currency denominated debt stands at roughly half of the value of its respective central bank's reserves.
This fact, along with the view that South Africa is likely to see improved governance and reforms following the rise to power of Cyril Ramaphosa as opposed to Erdogan's Turkey, explains most of the relative outperformance of the South African Rand. While we acknowledge that Turkey is relatively more vulnerable given its large stock of external foreign currency debt, we are nevertheless not convinced that the difference in quality of political leadership is all that relevant.
Many of the structural vulnerabilities and imbalances South Africa exhibits is rooted in the ruling party's political mind-set and policy ideology. The net result of this "mind-set" is a set of contradictory policies or what we would term a "policy disconnect". As we have written in past articles, this policy disconnect largely reflects harmful or interventionist micro policies but "institutional-friendly" macro policies.
The net result is a real and nominal growth outcome that is actually worse than if both populist micro and macro policies were being pursued. To be sure, in this case, the likely outcome would lead to elevated nominal inflation. However, ultimately it would also end up eroding real debt burdens, improving the relative competitiveness of the export sector and lowering real interest rates. These dynamics take together would ironically lead to a higher real growth outcome (although not optimal), compared to the current situation.
Unfortunately, there is little to indicate that South Africa's policy disconnect will be resolved anytime soon. Just this week, President Ramaphosa reiterated his commitment to continuing the active involvement of state-owned companies including Eskom in the economy (an example of harmful micro policy). At the same time the administration has chosen to raise electricity tariffs at a rate well above inflation in order to limit the drain on the country's fiscal resources. The higher electricity tariffs will feed into higher inflation, which in turn will see the central bank resist cutting rates given its single objective (inflation-targeting) mandate - despite the poor growth backdrop (this would be an example of institutional-friendly macro policy).
This is a perfect example of South Africa's harmful policy disconnect at work. If the government opted to inject far more money into Eskom, limiting the increase in electricity tariffs to below inflation, while lobbying the central bank to reduce rates (or adopting an export-friendly as opposed to institutional-friendly exchange rate regime) it would ironically produce a superior nominal and real growth outcome compared that being produced by the current set of policy choices.
The largely institutional-friendly macro policies South Africa has pursued has also in our view created another key vulnerability. South Africa exhibits the largest overhang of non-resident portfolio investment in the country's equity and bond markets, as reflected in the chart below. This reflects the country's persistent current account deficit but also higher relative yields (supported by the aforementioned institutional-friendly framework) in a global economy with low or negative real rates.
Data compiled by the Institute of International Finance suggest that the increase in non-resident portfolio investment as a % of GDP since 2010 in South Africa amounts to over 40%, the highest in the emerging-market universe. Unfortunately, unless the country's policy disconnect is resolved positively with the administration opting for investor-friendly micro policy AND institutional-friendly macro policy, a persistently poor growth outcome will ensure that the policy disconnect is eventually resolved negatively (populist pressure will eventually force a shift away from institutional-friendly macro policy). At this juncture, the large overhang of non-resident portfolio investment and large twin deficits will result in seismic re-rating in the country's financial assets and currency.
Turkey and South Africa, a way to hedge oil tail -risks?
A short position in the Turkish Lira and South African Rand would also potentially cover another evolving tail risk, the risk of a significant disruption in global oil supply as tensions between the Trump administration and Iran intensify. Both countries apart from being small open economies significantly exposed to global growth dynamics are also large oil importers.
Once again, the timing of any conflict or supply disruption, should it materialize, is impossible to ascertain with any degree of certainty. Nevertheless, particularly in the case of the South African Rand, the currency remains inherently overvalued relative to the existing fundamental structural reality on the ground. We would further highlight recent high frequency data pointing to a contraction in first quarter 2019 GDP. Unemployment data for the first quarter of 2019 showed another large jump from 27.1% to 27.6%, marginally below the recent cycle high of 27.7% recorded in 2017.
The poor growth backdrop is likely to persist for most of this year and perhaps well into 2020 as a significant increase in electricity tariffs this year takes its toll on household disposable incomes. The large increase in electricity tariffs (13% this year) is as a result of the financial and operational problems faced by the country's state-owned power company, Eskom. Recent revelations further suggest that there is simply no quick or easy fix to the problems facing the embattled utility parastatal.
Ultimately Eskom will require significantly larger sums of public money or even higher electricity tariffs. The former would likely see more immediate pressure on the currency than the latter option. However, the latter option would be far more debilitating on the country's growth and exports, leading to a larger devaluation in the currency down the road. Paradoxically, if policymakers were to accept and embrace a devaluation in the currency sooner rather than later, it would probably end up being beneficial to the economy, providing needed "space" (lowering real electricity costs and debt burdens) for the administration to rectify and resolve the policy disconnect constraint.
As such, the short position in the South African Rand can probably be maintained as an outright directional position in its own right, without any real concern with regard to timing. In summary therefore, investors should probably consider maintaining both a long position in gold and gold equities, while simultaneously a short position in several emerging-market currencies, particularly the Turkish Lira and the South African Rand.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.