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The Big Conversation

Episode 85: Is now the time to buy Europe?

This week Garett Lim, Director, Group Strategic Relations, LSEG talks to Steve Brice, the Chief Investment Officer for Standard Chartered Bank, Wealth about the state of the reflation trade, the recent underperformance of Chinese equities and the opportunity that he sees in European equities. The reflation trade may be taking a back seat for now, but growth will pick up into 2022 and weakness in value stocks over the next few months could be an excellent opportunity to ease into a long position. Steve will be watching the UK closely for signs that the Delta variant is under control.

  • Roger [00:00:00] Over recent weeks, we've seen momentum in the reflation trade start to falter. Most of the perspective on this subject have been based around the views of US investors. But China is equally an important part of this narrative. In this episode of The Big Conversation, Refinitiv's Garett Lim speaks to Steve Brice, the Chief Investment Officer of Standard Chartered Bank Wealth, to get the views of an investor within the Asia region about the outlook for global growth and the performance of the Chinese equity market.

    Garett [00:00:33] Steve, thanks very much for your time. We're here today to talk about the reflation trade, a lot of people are asking questions about actually whether the reflation trade has actually started, has it ended, are we in the middle of it? What's your what's your view? And what's more specifically, SCB's house view on this?

    Steve [00:00:46] Yes so we certainly see that the reflation trade is likely to restart maybe as we go through the rest of this year. We are obviously in a very strong growth phase at the moment, people talking about peaking growth a little bit, but overall growth is still pretty strong. And we're seeing that excess capacity that was created during the pandemic slowly being eroded. So our view is that we'll see a bit of a soft patch maybe at the turn of the year, but then growth will still hold up in 2022 and inflation expectations, while they will come lower, they won't go to sub 2 percent next year. So that should keep people very focused, or get people back focused on the reflation trade going forward.

    Garett [00:01:27] I just wanted to touch on the transitory part of this. Transitory can mean a lot of things to a lot of people, three months, six months, what have you. So I think the narrative has been going on for about five months now. What do you, what are you looking at? I mean are you looking at commodity prices coming off right now, and that's going to feed into inflation or prices? You mentioned excess capacity. So do you think it's due to Covid that we're seeing sort of supply- side constraints right now and that's going to even itself out as things progress?

    Steve [00:01:53] Yeah, so, I mean, if you look at the drivers of the rebound in inflation, really there's several things going on right. So there is a very low base effects from last year is obviously a key focus. That's already probably peaked right, so that's going to be a drag on inflation going forward. Other factors are supply disruptions, bottlenecks, and then people actually not going back to work either due to fears of Covid or because they're being paid actually more to stay at home rather than go and get a job. That in the US at least, that will filter out in September. So we really should start seeing people coming back to work and that should lead to this peak inflation for the short term. So obviously very strong inflation now, over the next three, six, twelve months, we should see inflation come lower before it sort of plateaus. And then we start talking about, OK, how much excess capacity is left? Obviously, we've seen the biggest stimulus in the US that we've ever seen in history. And so that output gap is going to close quite quickly, and that's where inflation could become more of a problem, but that's probably two to three years out.

    Garett [00:02:56] So just in terms of stimulus measures, you mentioned it's very, very addictive. We've used that to really reflate the stock markets for sure. But when does the Fed actually start to take that off? I mean, are we do we need to see a stock market correction? Do we need to see economic conditions really, really get heated up before we do that? Without doubt, we're going to see a massive reaction from the markets, especially what they've done in the last 18 months. I know earnings have done very, very well recently. The valuations are quite expensive. So where does the Fed stand on this?

    Steve [00:03:26] They're obviously getting a little bit more balanced, which at this stage of the cycle, I suppose, is more normal. Right. When you enter into a recession than everybody is on the same page, as you come out of the recession and start seeing strong growth and even temporary pickup in inflation then obviously you'll get people getting a little edgier. Our central scenario is assuming that there's no major stock market correction, and economic growth holds up reasonably well, we believe that they're probably going to make an announcement with regards to tapering towards the end of this year and start tapering from the beginning of next year. So that's where it comes. Now, obviously, if the fear of tapering leads to equity market weakness in a significant extent, so to your point, leads to that volatility coming through, then that could actually delay that tightening. That's what we saw in the taper tantrum of course, now markets are much more prepared this time. So actually, I'm not sure we will see a dramatic weakening in markets. But if that did happen, then I think that would probably push it out further.

    Garett [00:04:26] What's interesting recently we've seen actually the yield curve flattening in the last two or three months. It is kind of strange, we're seeing a situation where actually there's more worries about growth for next year especially, and we're in a situation where we're trying to take 120 billion away and there's worries about growth. Does that mean that we are at status quo and the markets continue to to ramp up? What's your view on that?

    Steve [00:04:48] Yeah, so, I mean, we do believe that there's still, the market is going to do well over the next 12 months or so. Right. So we still believe that that relatively strong growth, good earnings growth and still stimulatory monetary policy. I mean, what we're talking about here is not the Fed slamming on the brakes right. We're talking about and taking the foot off the accelerator. So from that perspective, it should be still a pretty conducive environment for investors, despite valuation concerns, et cetera. But obviously, in the short term, it can lead to some sort of short- term volatility. And we haven't really, we're up 90 percent, global equities are up 90 percent since the low of March last year, almost without any major pullbacks. We've seen sort of five percent here or there, two back-to-back five percents, I think September, October last year. But pretty much we've almost gone straight line, so that's abnormal. We would expect some volatility. Now, what could lead to that? That could be OK a policy statement coming out, it could be fiscal cliff concerns, it could be debt ceiling concerns, or it could be the obviously the elephant in the room is the re-lockdown. So going back into lockdown's based on the Delta variant right. So there are lots of things that could cause a pullback. We would certainly be buying the dip. You know, the only thing I would say is, it seems like everybody is waiting for this pullback and probably have been waiting for it since September last year. And it hasn't really happened yet. So maybe until people think, oh, no, it's not going to happen, maybe we can just still grind higher.

    Garett [00:06:21] So if that's the case, we're going to stay in equity markets. I mean, what are sort of the preferred sectors? I mean, you've mentioned a lot about maybe staying in the market and maybe rotating a little bit. Can you give us a view on where SCP stands for your clients? I mean, how do we stay positioned in the market but be relatively defensive, obviously?

    Steve [00:06:36] So I suppose this comes back to the reflation trade, right. So at the beginning of the year, we were saying, OK, we should be rotating from growth towards value. So we'd been overweight technology probably nine out of the last ten years, right. So which has obviously done really, really well for us right. Right I mean, and it was a consensus trade right. It's not like we were necessarily super smart, but it was something that did very well for clients. I think that, you know, what we said was at the turn of the year, we indicated that there was a huge underperformance of value versus growth. Now, that's been a trend for the last ten years, but that accelerated during the Covid crisis right. So obviously, as growth became really scarce, those companies that could grow were seen as very, very attractive, particularly on a relative basis, but also on an absolute basis. So what we saw, I think at the beginning of, what we said at the end of last year was, that at least that gap from the trend line underperformance is likely to close. And that's what we saw in the first three or four months of this year. We certainly saw that gap closing quite considerably. And that was just on based on you know obviously still strong growth, rising inflation expectations and rising bond yields. Clearly in the past couple of months, we've seen that wane a little bit. So we're still, we're still value has still outperformed growth since the end of last year. But we have seen that narrow a little bit. Our sense is that we're going to re-engage at some point into that value trade because we haven't closed that gap. We probably closed about 30, 40 percent of that gap. So we still think there's still upside for value relative to growth. It doesn't necessarily mean that we don't think tech is going to do super badly going forward. Valuations are obviously a little bit of a stretch, but they're generally reporting still very positive earnings. But we just think like, so financials, energy are probably going to outperform going forward based on obviously the drivers that we see higher bond yields resuming at some point in the coming few weeks, and obviously higher oil prices as well.

    Garett [00:08:32] Yeah, I just want to touch on, you mentioned markets overall up 90 percent, but there's been some real outliers recently. Year to date as you know, China has done phenomenally badly. I mean, what are your worries there? I mean, there's lots of regulatory concerns, it's a big economy to reflate, they came out of the Covid lockdown early. I mean, what are you what are you telling clients right now in terms of China?

    Steve [00:08:55] Yes, I think there was the first-in first-out phenomenon right. So that did them very well in 2020, the second half of 2020. Then obviously at the beginning of this year, the focus shifted to the US and we believe in the second half it's going to shift more and more to Europe. But as far as China is concerned, I think there's three issues that we need to be focused on. So one is geopolitics. So there's meetings coming up soon right, so obviously we hope those go well. But it's really, to me it's been quite disconcerting the way there's sort of been almost a public slanging match between the authorities rather than sitting around the table to try and sort things out. So I think that's, that's not good for increasing certainty, making people more comfortable about the long term outlook. Clearly, the regulatory challenges is something that caught people unawares right. So and that on the tech side, more recently, obviously on the education tech side, that has really damaged sentiment quite significantly. And it's caught in the crosshairs, obviously, of this IPO or US listing of Chinese entities. You know, so that's caught in the geopolitical crosshairs as well. So these things can still take some time to play out. I think obviously the conversation at the moment is, OK, so we've had well, three actually, because we had property as well, so you had three sectors or subsectors being targeted. What's next? That's obviously the question investors are asking today, so this is probably going to be a bit of a weigh on the markets. If you want to look at the bright side, I think the main change is that obviously we entered the year with this PBOC very focused on tightening policy, and trying to make sure that, you know, the credit creation didn't get excessively go, excessively strong, creating more debt challenges going forward. I think you know we're now starting to see through the first triple R cut, that they're saying, OK, we've got projected now the credit impulse has turned negative, we know that the economy is going to slow going forward. How quickly and how fast do we want that to slow and how low? And they are starting to sort of say, OK, let's start putting a little bit more liquidity back into the system. It's not enough yet to change the tide, but I think it is an indication that they're not going to let this run too far and too fast.

    Garett [00:11:10] So the building blocks are in for China so, but too early yet so maybe ease into some positions in China? Would that be that a prudent view?

    Steve [00:11:19] So I think yeah if we're looking at China, we should probably be averaging in, but pretty gradually at the moment, so I wouldn't be rushing in too fast. I think we see better opportunities probably in Europe. Clearly, we've seen the lockdown's ease. We do have the experiment going on, and I call it an experiment in the U.K., obviously with higher vaccination rates than in most of the world, but also a re-acceleration in cases and that's feeding into hospitalisations. So now we have seen cases peak a little bit in recent times. If that follows through into hospitalisations, then I think that would be a huge sign of confidence for the Europe region as a whole that actually we can, just we can still continue with that reopening phase and therefore growth is going to be secure. And obviously, we've talked about value being important, well Europe is very important from a value play. So if you're overweight value, generally you prefer Europe as well. So if we did see that growth recovery being more secure, then I think that would be very good for European equities, including the UK,

    Garett [00:12:19] The DXY has been sidelining for, for quite a while. Do you see any potential big moves out there? You're in a situation where there's a lot of question marks about whether the Fed will continue to be accommodative. We're going to see interest rate rises. Not too sure when that will be. Are we going to see the dollar in doldrums for a while, which will mean probably underperformance in Asia from our experience, right?

    Steve [00:12:41] Yes so I think we are bearish on the dollar. I mean, obviously, we've seen some strength in recent times which sort of fits into this US exceptionalism story. And obviously, the Fed bringing forward its proposed rate hike from 2024 to 2023. I mean, obviously these things are extraordinarily uncertain so, projecting that far into the future is really challenging. But just that was enough from very key support levels for the dollar to bounce three or four percent. We would be selling into that rally. So we don't think the dollar is going up much from here. So on dollar index is sort of looking at ninety three fifty ish around that is being peak and we're sitting around ninety three now, so we'd be selling dollars pretty much here against a wide array of currencies. So whether it's the Euro Sterling or some of the commodity currencies such as Australian dollar and Canadian dollar as well. So, you know, we're pretty, we're looking for around seven percent weakness in the dollar over the next 12 months. So it's not dramatic, but it's certainly there. And I think there's three reasons that we have that. So you have, we do think that this peak US exceptionalism is is a real thing. So we're going to hand the baton over to Europe, and then in maybe 2022 will be handing it over to emerging markets, which obviously have been in a much more challenging situation outside of China. So then you've got the Fed's average inflation targeting as well. So that's a key element of the overall story. And then we see the sort of pro-risk environment is generally negative for the dollar as well, especially alongside twin deficits, the budget deficit and the trade deficit for the US. So we think all of these factors are likely to lead to the dollar coming lower over time. As I say, probably a reasonable opportunity now to be averaging into those positions a bit more aggressively.

    Garett [00:14:27] So just really in summary, you're still very accommodative in terms of your positioning for the markets, apart from obviously Covid, you know rearing its head again. I mean, what are the risks that we we're looking at? Is it inflation? I mean, you mentioned that it should pass, but is there a sort of a couple of indicators that maybe might get you to change your mind or SCB's view?

    Steve [00:14:49] Yeah, I suppose so. There's two things that I'd look at, and we've covered both of them in slightly different ways. So the one is inflation. What if what if we're wrong? What if inflation actually, this is here to stay and we're going to see sustained you know two and a half, three, four percent inflation over the course next twenty-four months. Clearly that's a very different environment to what the central banks are planning for today. And that would lead to effectively I would say what we're seeing now is a policy mistake. Right, so we're we're on the same page as the Fed. We don't think this is a policy mistake, we think they're doing the right thing. But we could be wrong. And in an environment where they slam on the brakes, obviously the worst environment for equities is when inflation is going up, policy is tightening and growth is slowing. Right, so that would be a pretty, pretty bad environment for investors in equities in particular. The other one, I think, you know, would be geopolitics. I think we've, we've obviously seen tensions between the US and China for an extended period. I'm almost more worried today than I was, you know, under the previous leadership in the US because it was very transactional. It was very, you know, OK, if I if I say something, China could give the US something and then it would go away for a while and then it would resurface. This is much, this looks much more concerted effort to address things on issues that China will be less, potentially less flexible on. So on economic issues, I think China will be fairly flexible. But on the geopolitical issues themselves, obviously elsewhere in Asia and obviously within its own borders as well, I think there will be a little bit more inflexible. So I think we really would like to see some sitting down around the table and starting to make some progress in agreeing to disagree in different areas and things settling down there. But, you know this, this seems to be two strategic powers and global powers coming head to head, they, you know, obviously it's in everybody's interests that they learn to coexist. But at the moment, they do seem to be on a collision course. Now, you know, if this were to escalate on what timeline does it escalate? Anybody can try and make a forecast, and would almost certainly be wrong. But that's probably the thing that's always at the back of the mind, nagging me, saying we really could do with seeing them calm things down and just work together to resolve issues rather than throwing barbs across, the across the world.

    Garett [00:17:19] So, Steve, thanks very much for that. So just in summary, maybe a few words just to maybe give some advice to the investors going forward?

    Steve [00:17:25] Yes. So, I mean, really, I think look for opportunities, i think a lot of investors have failed to catch this recovery in equity markets right. So we've been talking to clients all the way through the recovery, saying at least put some money in, and there's always been this fear of this five to seven percent. So if you're one of those that hasn't invested, then look for opportunities and maybe even start investing today just to get some skin in the game. Don't do it all in one go. So that would be sort of our number one piece of advice. Obviously, we'd say, always say be diversified, but maybe Europe is a good place to be adding equity exposure today, given the reopenings we're expecting. Watch the U.K. is really important. And then when we get, you know, vaccinations rolling through the emerging markets, dollar weakening in a sustained way. So watch out for dollar index at 89 DXY. If we break through 89, that's a big signal for us that dollar weakness is really happening. Then that's probably an environment where Asia and emerging markets generally will start doing a lot better. So that's sort of where we sit today.

    Garett [00:18:33] Right. Thanks very much for your time.

    Steve [00:18:34] Thank you

    Roger [00:18:36] for Steve timing is key. He believes that the reflation trade is still in play, but we might get a lull over the next few months as some of the recent extreme readings in inflation reach a short-term peak. It may come as a surprise that Europe is on his radar. For many, this has become a forgotten market, but it is a great value play. China, on the other hand, has a wealth of opportunity, but the regulatory uncertainty warrants caution. Steve will be dipping into both Europe and China, but doing so very, very slowly. But if the dollar starts to weaken again, then these value in reflation themes should start to build momentum and Steve's interest will accelerate.

    And if you've got any questions about the themes in this episode or anything else to do with the world's financial markets, please drop your questions into the comments section and we'll try and answer them in future episodes.