Lazard: European effects and China's other issue

From the epicentre of New York, Ron Temple heads up US equities at Lazard Asset Management and serves as the Co-Head of Multi-Asset Strategy.

He recently made headlines for his views around the 'nightmare' not being over for equities, but claims this was taken out of context. In fact, Temple made no such comments to InvestSMART, describing himself as 'optimistic/constructive' going forward based on what he believes is now looking like 'a positive market backdrop'. 

Temple thinks Brexit may create opportunity even (or particularly) for the UK, provided the UK doesn't crash out of the European Union. For a US-based fund manager, it's also interesting to hear Temple's views on the offshore-earning, automotive-driven German market, increasingly seen as competing with the US. Temple thinks it may be turning a corner. Is the Eurozone really as ugly as the individual markets suggest?

Lastly, Temple considers China's conundrum, which has nothing to do with US trade relations, and everything to do with age. This has very real implications for Australian investors, but there may be a silver lining. 

Listen to the podcast or read the full transcript below.

I'm joined by Ron Temple, Managing Director of Lazard Asset Management who is the Co-Head of Multi-Asset and Head of US Equity at the firm.  Ron joined Lazard in 2001, from a background in fixed income derivative trading, risk management, corporate finance and corporate strategy. 

Ron, considering your broad-brushed perspective, I'm curious to hear whether you think the worst is behind us in global share markets or should we brace for more?

I actually think we should expect volatility through 2019, so it's hard to basically forecast whether we'll see more volatility or less, or whether it'll be more unnerving than what we saw in the fourth quarter.  But that said, I think investors might have gotten a bit spoiled in terms of 2017.  If I look back, and I think in 10 years when we look back, we'll say 2017 was a dream year, in terms of basically having strong ‘up’ markets globally and very little volatility.  In fact, if you look at the US market, it was up 21.8 per cent in 2017.  We only had eight days where the S&P [500] moved more than 1 per cent that year and I think we had 62 new all-time highs.  I mean, that's about as good as it gets. 

In 2018, the US had about 64/65 days where the market moved over 1 per cent.  It felt really volatile.  I think, part of the reason is a lot of that happened in the fourth quarter.  But when you look at 2018 versus the 25-year history, it was bang in line with the typical volatility you get in an average year.  And so, I tend to think, going forward, we're likely to see more volatility, lower returns, but I do think it's still a positive market backdrop.  I would say I'm optimistic/constructive on the outlook.

More of a normal market environment?

Yep, exactly. 

We've seen what happened lately: well, lately especially with Brexit, but in the past couple of years that's been brewing.  We have seen a period of fire and fury at the start of a year and now there might be a bit of an in-between period where we've just had the [UK] Prime Minister Theresa May and the European Commission President meet and say they had a ‘constructive dinner’ in Brussels.  Politically though, the fallout could be bad on both sides.  What scenario do you still see as the most likely one with Brexit?

The challenge on Brexit right now is it seems there are two scenarios that are the most likely: one would be the worst one which is a no deal Brexit, and clearly in the UK there are huge incentives to try to avoid that because of the disruption it could have to corporate supply chains, to commerce, and to markets.  I would love to say that one's less probable, but given where we are in the timeline between now and the end of March, that one seems to be increasing in probability.  And again, we can watch the internal skirmishes within the UK in terms of trying to avoid a no deal Brexit. 

The other scenario that’s most likely would seem to be extending negotiations.  But I do think there's a challenge there from the European side in terms of, there's only a point in extending negotiations if there's something new to discuss.  So, perhaps this constructive engagement over dinner is the start of a positive trajectory, but it's very difficult for me to see what Theresa May could offer in terms of a new course of action to discuss with the Europeans.  It's looking, in my view, to be more on the negative side.  I guess, the positive scenario there is you, kind of, kick the can down the road and extend the negotiations.  The negative side is the UK crashes out of the European Union. 

How exactly are you positioned to the downside if that does happen?

Well, when we position it depends on which strategies we're looking at, but generally, in most of our strategies, we're looking at bottom-up security selection, so we're always trying to take into account who would benefit and lose.  For example, there might be an assumption if the UK crashes out of the European Union, you want to avoid the UK.  Well, that's not necessarily the case because you have quite a few companies domiciled in the UK where their operations are primarily outside of the UK, and if the currency weakens you might actually get positive benefits in Sterling terms for their share price.  It really depends strategy by strategy.  And admittedly, by the way, when we're looking at global strategies, Brexit is unlikely to have a material impact on global growth or on global profitability of companies, so it really comes down to that company-specific analysis. 

I guess that's another way to say, I don't think in most of the strategies I'm responsible for, that you really need to be girding yourself for massive volatility or disruption, even if there is a no deal Brexit.  Now, I should say, on the margin, I think it is probably a negative, as it relates to the UK specifically, and then to a lesser degree for the European Union growth.  But again, I don't think this is something where people need to be hiding in the bunker.

And as you said about the UK, it is full of offshore owners, the FTSE.  Another market in that zone that is full of offshore owners, potentially, is the DAX in Germany.  We did see that Germany came off quite sharply last year.  It was for a very long time the Eurozone leader.  Do you think it was all this talk about Brexit that was the hamstring on Germany and the broader European market last year or was it something else as well? Did it overshoot in that way? 

Yeah, it's always tough to disentangle the causality whenever you have market moves.  I think, you know, Brexit definitely is not a positive for the last year, vis-a-vis Germany, because there are some interdependencies there.  I think, a bigger issue for Germany though is probably been the Chinese slowdown.  When we look at high-frequency indicators coming out of China, basically I would say the Chinese authorities engineered a slowdown to some degree in 2018.  Again, sorry to rewind to long ago, but if you go back to 2015, China effectively had an industrial recession, they had nominal GDP growth in the industrial sector below 1 per cent for three quarters in a row.  They turned on credit stimulus and fiscal stimulus to basically try to prop up that industrial economy. 

The reason I focused on nominal GDP, by the way, is the PPI, the Producer Price Index, was running at a negative 4-6 per cent that year.  Effectively you had prices at the factory gate going down, which then makes corporate debt sustainability troublesome.  The Chinese authorities propped up growth, they ramped up credit growth, and by the time we got to 2017 and 2018, they had succeeded in achieving their objective, and they said: “okay, now we have too much credit growth, let's clamp down on the shadow banking system, let's squeeze out some of the excess”.  When they did that, you got a slowdown in economic activity, and fixed asset investment, industrial production, and even retail sales.  I think that Chinese slowdown actually has more of an effect on Germany, even than the UK-Brexit uncertainty. 

Then also, last but not least, in the Eurozone, we had a major change in emissions regulations in 2018 for automobiles, that led to a sharp slowdown in terms of auto production and manufacturing activity in the motor vehicle space and that clearly is a very important part of German economic activity. 

How are we seeing Germany so far this year?

Too early to tell.  We just got the fourth-quarter GDP numbers and the quarter-on-quarter change was 2-basis points.  Now, the reason I'm saying that and smiling at the same time, is literally Germany have barely avoided having a technical recession because they had negative GDP growth in the third-quarter, basically a zero in the fourth-quarter but they, you know, skirted that kind of technical recession.  Not that there's anything terribly meaningful about having said there was a recession.  Italy, unfortunately, was not so fortunate.  I think what we're really waiting to see is the numbers as we get into 2019, in terms of, is the industrial production coming back?

I mentioned the regulatory change related to autos, effectively after September 1st, you were no longer allowed to sell a car in the European Union, unless it had been certified under a kind of, you might consider, a lab test of emissions, and also a real-world experience on the road test.  There were not enough inspectors, we had a massive backlog of testing, a sharp reduction in motor vehicle manufacturing.  We would expect, as we get into 2019, to see that recover as this kind of temporary issue around regulations moves behind us, but it's too early, we don't have the data yet.

You mentioned the big R word – recession – and that's always an ever-topical thing to talk about.  But we've been talking about it quite a bit in an Australian context with China, what's happening there, and it's very hard to rely on the official figures that come out of China.  It's always a question whether China is on the brink of recession or not, or whether it's about to skyrocket.  What are you thinking about, as you were saying, about Chinese growth from 2017 on?  What do you think about China now, and how that could impact maybe the Australian market to bring it back for our investors? 

Well, let's take, first of all, maybe an intermediate term view on China, because I think it's important to always take that perspective first.  When I think about China, in say five years, I think of sustainable real GDP growth of being 3-4 per cent, not 6-7 per cent and in a way, I think about any country's potential GDP growth is a simple equation of, what's you're working age population?  And what's the productivity of the people?  In other words, how many hours do people work and how much they produce per hour?  Well, if you look at the Chinese economy, the working age population has been shrinking for five years, so the first part of your equation has a negative sign.  The second part in terms of productivity is affected by a range of factors, for example, moving off farms into urban areas, working in factories has a big increase in productivity. That’s been driving Chinese growth in large part for last 30 years.  That's running down a bit, there's still more to go there. 

But other factors that can affect productivity growth include moving from industrial and manufacturing economy to a services economy and what you find is productivity growth and services, almost globally, is lower than manufacturing.  And so, you tend to have lower productivity growth in your overall economy as that mix shifts.  China's now 53 per cent services, so that means it will have a lower productivity growth overall.  One other thing I think people don't discuss enough is ageing, because as countries get older, your productivity growth also goes down.  I tend to always say, if I think about myself at 25, when I was 25-years-old, after coming out of university, you basically have a really steep learning curve, as you're taking academic skills, learning how to acclimate them into a business environment, and your value goes up every year, and by 35, you're still increasing your value.  There is some point in your life span where your value actually starts to decrease, because you're not able to learn the new skills as quickly.  Frankly, a range of factors fit in there.  China's ageing really rapidly.  It's actually ageing faster than any other country in the world, except for South Korea.  And so, you've got a move to services, you've got an ageing population, you've got a shrinking workforce, that all leads to lower growth.  That's the intermediate term backdrop.

It's almost like the Japanese affliction.

Exactly, and by the way, Japan, South Korea and China are the three countries that are at the extreme end of how quickly they age.  We do look at South Korea and Japan as almost like a kind of a parallel.  Again, there are limits to that parallel, because they're much smaller economies, they could be driven by exports for much longer than China.  I mean, it's one thing to be in Korea, with 50-60 million people versus China with 1.3 billion.  Now, the near-term view, though, in China, I think the Chinese government has now switched back into stimulus mode after having clamped down just a year-and-a-half ago on shadow banking and so they've recognised that they don't want a slowdown that's too sharp and they're basically injecting stimulus trying to put a floor in their growth.  I do think they'll be successful in the short term.  But I should say, one thing that really worries me about the Chinese economy, is the frequency of these tightening/easing cycles or the duration of them.  In that it seems that we're having them more and more often, and there's a lot of credit involved, and that credit seems to be less effective each time.   

It does make me worry that maybe that old playbook won't work so well in the future and that means the risk of a hard landing, you might say, that people have discussed in the past, does go up over the next several years as relates to China.  By the way, this was all happening irrespective of a trade war with the US.  I think the trade friction actually adds even more to that pressure.

What you said about Chinese growth, it was tipped to around double what you're expecting (GDP over the next few years). Bringing it back to the Australian market, will that affect us quite severely then if growth is halved in China? 

Well, I think, it affects the world and it affects Australia probably more than the rest of the world.  This is, again, it's a very complicated topic, because it depends how the relationship between Australia and China evolves, right?  It's one thing to be exporting iron ore, it's another thing to be exporting education and tourism.  When I think about it, as China moves more and more towards a service economy, that implies there might be less of a growth or less growth in demand for iron ore and other kind of heavy industrial inputs.  I think that could change the relationship or the dynamics of the relationship.  Slower growth in China, probably, is a net negative for most of the world economy because if we look back over the last 10 to 20 years, on average, China has been 25-33 per cent of all of the global growth as measured in US dollars each year.  So, it definitely takes a little bit of wings out of the sails for Australia, but it doesn't necessarily mean that there has to be a recession in Australia.  I would just note, by the way, the big lever that can move in favour of Australia is your currency value, so to the extent you have economic weakness, if the Aussie dollar weakens as well, that can basically mitigate some of the pressure. 

Yeah, that's a fair point.  What areas in Australia are you actually looking at the moment that are piquing your interest?

Well, within Australia and outside of Australia, there's been a long-term obsession with the housing market and trying to understand what could happen in housing prices and it's a tough comparison.  My kind of standard reference is to look back at the US housing bubble, and in 2007/2008, at the peak of the housing bubble in Los Angeles, the median home price was eight times median household income.  My understanding is looking at the data in Melbourne and Sydney, we reached 15 times median income.  It's a different kind of postcode altogether.  But I don't know that that parallel was necessarily as instructive as people might believe.  If we look at the size of Los Angeles itself, you're talking about a metropolitan area that could be upwards of 18 million people, so it's a very different scale.  It also is not the same dynamic in the US in terms of global demand for property, as you have in the capital cities in Australia. 

One topic we're looking at is housing, and how much of a tail risk that might present to the Australian economy more broadly, and to the financial sector in particular.  I do think, by the way, on the good news front on that topic is the banking sector in Australia post the GFC.  As with all the major banks in the world, they had to raise their capital level substantially, so I'm not worried about some kind of banking crisis in Australia.  But just trying to figure out what kind of tail risk that might be there on the negative side and thinking about what that might mean to the rest of the Australian economy.  On the flipside, to the extent there is a housing downturn, which you know, is not a given, this is just a scenario we're considering.  If there is a downturn, and if the currency does weaken, there could be companies in Australia that actually do quite well on the back of that if they have a major export dependency.

We've got quite a few in our [ASX] Top 20, even.

Exactly, so there's definitely some good candidates there and so, you know, I think more broadly within the firm, different people are looking at the tail risk, but also looking at who could benefit in such a situation from different kind of reaction functions you might say to that housing story.

Yeah, all the different scenarios.  Thank you so much, Ron.  That's a lot of food for thought for our listeners and readers. 

Great.  Thank you.