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March 2017 | Macro Insights

Global Roundup: Recalibration


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Beyond the US we see a more nuanced regulatory landscape, shaped by the divergent domestic priorities of the largest developed- and developing markets. We compare the investment takeaways in Europe, where cross-border standards are being reset, and in China as the focus returns to reform.

European re-regulation

Negotiations surrounding Brexit will soon dominate headlines, though for the near-term Europe is still focused on post-crisis financial regulations. In both cases, we see a reversal in the decades-long trend of harmonization, with investment implications but without loosening standards. 

Three things to watch:

1. Past peak tightening. In the financial sector, the pendulum is swinging back from regulatory tightening, to address potential areas of overlap and unintended consequences. The review is not related to US developments so much as to a recognition that rules were getting onerous, particularly in an environment of weak growth and lending. The reform process since the crisis has been slower than in the US and more complex, with 41 pieces of legislation compared with one. Regulatory tightening probably peaked early last year with the Basel III proposals, and regulators have since worked with market participants to scale back. Standards will still get tougher, as new measures will be implemented in the next few years, but they are less aggressive than originally drafted, and the industry has more certainty.

Investment takeaway: Clarity on regulations is important for banks to switch their focus from building up capital to ramping up lending, which is beneficial for consumers and business. Lending in the US has been more robust and two-way in terms of supply and demand, and we would expect Europe to start catching up, particularly against a backdrop of improved economic growth.

2. De-harmonization. The second issue is increased fragmentation of financial regulation after an attempt to enforce global standards. Since the early 1990s regulators have worked toward global harmonization. Standards for capital requirements were intended to help build trust in foreign banking systems, and promote globalization of banking products and services. That trust broke down after the financial crisis, as officials cared more about the safety of their own banking system. Re-regulation has come about as each jurisdiction has revised its own standards in isolation. And more barriers are being erected on the basis that it is easier to supervise smaller banks with compartmentalized capital and funding.

Investment takeaway: Our fundamental equity team sees dispersion as banks adjust their business. Those that have gone down the path of globalization may struggle, because a large single-jurisdiction bank may fare better than a small one operating in various jurisdictions. Some banks have retrenched on the view that economies of scale are possible only in local jurisdictions. Our investment strategy is focused primarily on banks with simple business models that are big in their own markets, and these banks tend to be retail. 

Ease of doing business scores—can the UK climb further?

Source: World Bank as of January 2017, 1=most business-friendly

3. Single Again? If the UK is to retain access to the single market, roughly equivalent standards in some capacity will be required to enable business to continue with the EU, its biggest trading partner. While the Brexit campaign dreamt of escape from regulatory overreach, the reality of disentangling the UK from EU rules is likely to prove undesirable on some levels, especially given much regulation had common cause and was supported by the UK. Meanwhile, the Prime Minister’s end- March deadline to trigger Article 50 which starts the two-year formal separation process is approaching. The Office for Budget Responsibility upgraded its 2017 growth forecast from 1.4% to 2% on the back of strong recent data, but cut estimates for the next three years. We see no immediate let up in uncertainty hanging over the UK an continued volatility driven by headlines around the Brexit process.

Investment takeaway: The most significant implication of Brexit in markets so far has been the pound’s decline, which has been positive for exporters and some specific sectors, such as tourism. However, the currency’s decline also brings cost pressures and inflation, with risks to consumer goods companies and retailers. In the UK, our fundamental equity team favors consumer goods companies with a global reach.

China’s re-balancing act

Regulation in China today is a feat of engineering. Policymakers are managing a globally significant slowdown as the world’s second-largest economy transitions from investment-led to consumption-driven growth. They must pursue competing priorities of promoting reform, preserving stability and supporting growth. Because these priorities are often incongruent with each other, we would characterize the regulatory regime in China as a constant re-balancing act.

Over the past couple of years as growth threatened to undershoot the official target, authorities de-escalated some regulatory objectives. The recent stabilization in growth has allowed the focus to return to reform, with an eye to the 19th Party Congress in the fall. This month’s plenary meetings stressed a renewed commitment to measures to tackle excess capacity and leverage, pollution and corruption.

We think this environment is fertile ground for active managers. Opportunities are emerging in sectors catering to the needs and appetites of an expanding middle class. This ‘new China’ growth engine includes companies in the healthcare, consumer discretionary and technology sectors. Many of these are outperforming ‘old China’ industrial names (see Exhibit x) and are under-represented in benchmark equities indexes.

That said, in this re-balancing we are also alert to the risk of policy missteps leading to volatility in global markets.

Consumer-focused industries are outperforming

Source: Bloomberg, Wind, Goldman Sachs Global Investment Research, as of September 2016

Four things to watch:

1. Weaning the system off credit. China’s rapid credit growth and non-performing loans are among the biggest risks to the financial system’s stability. Implicit government guarantees on debt led to a euphoric extension of credit in 2013-2014 to local government financing vehicles (LGFV). LGFVs were viewed as low-risk, high-return borrowers, and considered as government risk despite being commercial entities. Given the risk of market instability, the government is reluctant to force a realignment of risk expectations by allowing defaults. Meanwhile to help safeguard the financial system the People’s Bank of China (PBoC)  is working on proposals to significantly reduce the leverage and increase transparency in China’s C¥100 trillion asset management market.

Investment takeaway: Our fixed income team holds credit protection on China. Our Fundamental Equity team is focused on identifying sound businesses that are trading at a discount to intrinsic value, and particularly on companies with robust organic demand growth, credible long-term business strategies and competent management.

2. Stemming the outflows. China’s actions to address capital outflows have raised concerns about heavy-handed regulation. China’s extensive interventions to stabilize the renminbi have drained roughly a quarter of its foreign reserves, raising pressure on policymakers to protect the remaining $3 trillion (see chart). Authorities have taken steps to curb cross-border M&A and offshore investments by companies and households. While the policies are effective in the short term, Chinese companies may miss opportunities to gain market share by acquiring brands and technology to spur their longer-term expansion.

Investment takeaway: Our fixed income and currency strategies are cautious on the renminbi and positioned for local rates to decline as we don’t think the PBoC will tighten policy further in the near term. Our Fundamental Equity team is constructive on companies with strong brand franchises and product upgrades that could support pricing power.

Net outflows have continued since 2014

Source: PBoC, Haver Analytics, as of December 2016

3. Hot and cold in the property sector. Given the size and complexity of China’s economy and political institutions, proactive macro policies to achieve longer-term structural goals often need to be adjusted at the micro level, in response to internal and external catalysts. One example of fluctuating policy is in the real estate sector, as overzealous construction and an economic slowdown drove housing inventory as high as 30 months of sales. The overhang prompted the government to ease financing policy and purchase restrictions. These steps led to a new spike in house prices, particularly in Tier 1 cities, forcing the government to tighten policy again.

4. Overhang cure. The RMB4tn program to stimulate China’s economy in the 2008/2009 global financial crisis left excess capacity across industries—parts of which remain inefficient and uneconomical. The government has tried to eliminate this excess in recent years via mergers of state-owned enterprises (SOE), production curbs and plant closures. However these efforts have been hampered for the most  part by the stickiness of costs, especially among the SOEs, given an unwillingness to tolerate large-scale job cuts.

Investment takeaway: Our limited exposure to SOEs is based on their susceptibility to unpredictable government intervention, along with a tendency for uneconomical decisions on capital allocation. 

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