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Why it’s time to forget the Fed

Why it’s time to forget the Fed

In the past three years, global liquidity has increased 15% to about $125 trillion, yet contrary to what many would assume central banks have only been responsible for 27% of that rise.

Asia’s growing influence on global finance, however, accounts for approximately 67% of that additional liquidity, with China alone accounting for 42%.

Markets have been thinking hard about the reasons behind this surge of Asian influence, as well as pondering whether it’s finally time for the US dollar to slump and the euro to rise, and whether China is a good long-term bet.

These were also hot topics for the attendees at October’s Citywire Asia Taipei retreat, which gathered together more than 50 leading fund selectors, advisers and investment specialists from across the region for an intensive two-day symposium.

To understand how markets are moving, investors should first look at capital flows and what is driving growth in the global economy today.

Michael Howell, CEO of CrossBorder Capital, was our keynote speaker at the event, and he made the point that the People's Bank of China (PBoC) is now 20% bigger than the Federal Reserve, and it has much more power over the financial system.

Given this, why do people spend all their time looking at the Federal Reserve when the PBoC is the most important central bank in the world?

‘My view is don't just look at the Federal Reserve: look at China and look at the People's Bank of China. That is the most important institution in the world and very few investment advisors or managers particularly in America or Europe really understand that point,’ he told delegates at the retreat.

‘Many people a year ago were very downbeat about China and China has actually surprised us with its positive rebound. The second thing is the US dollar. Basically a year ago, most people were very, very upbeat about the US dollar.

‘In our view what you are likely to see is further strength out China and weakness in the US dollar – and that’s going to colour the shape of financial markets. If the US dollar happens to be very weak, and capital leaves the US, that's where there is a risk of a major correction in markets,’ he added.

Three growth engines

Today, there are three major engines influencing world growth: US globalisation, Chinese infrastructure growth and the eurozone.

Howell said the US globalisation model is starting to fade, and the eurozone model is questionable, but the Chinese infrastructure model will be with us for the next 20 years and it will be very successful.

If you look at the US, it supplies safe assets to the world, and investors like US Treasury bonds and the dollar. As capital comes into the US, the Americans can benefit from that by essentially exporting capital or buying productive assets internationally.

‘But to do that they need a strong dollar because it increases their purchasing power. And they focus on interest rates because they are financing safe assets. So that's the recipe for the US success. Strong dollar, low-interest rates. So the question is will the US model derail as interest rates go up and as the dollar weakens,’ he said.

China, on the other hand, has an economic model that’s similar to the former Soviet Union. ‘That may be heresy, but in many ways what's going on in terms of the Chinese model is that it’s creating capital goods driven growth. Very much like Soviet Russia did in the 1950s and 60s.

‘But what you need is high savings and an abundant credit to do that. And that is exactly what China has. It basically has a very high savings ratio and the PBoC has a tremendous control of the financial system,’ he continued.

‘One of the things we say to our clients that are concerned about China is look at the control the PBoC has over credit markets. The central banks in Europe and America do not control their financial systems. They have lost control and a lot of that control is being lost because of international capital flows.’

Turning to Europe, Brexit has left the monetary model in the region looking questionable. Howell said with European globalisation and mercantilism threatened, the Chinese infrastructure model, which the West decries, is the one that's actually  most likely to succeed.

Chinese monetary policy

China is central to the emerging markets (EM) universe, and as China expands, EM liquidity expands too. As such, examining money flows is critical, and China’s monetary policy is key. According to Howell, the PBoC doesn't operate monetary policy through interest rates because China does not have a reserve maintenance period with banks.

‘Every bank in China has to hit a reserve target at the close of business every day. Which means that interest rates at the  interbank market is not the critical thing to look at. The main banking system operates through an allocation of money by the central banks,’ he explained.

The central bank, for instance, has 30 trillion yuan, and China is increasingly using domestic assets to control the monetary system. It's no longer reliant on foreign exchange to the extent it was.

So, the PBoC makes the key decision in terms of the outlook for the Chinese economy, tactically moving monetary policy.

Moreover, many in the West have underestimated the one belt initiative, Howell highlighted. ‘Effectively, this is our future for the next 20 years.

This is what's driving the world economy, and the belt road initiative is going to link 4 billion people worldwide.

‘They basically produce already about 40% of world GDP. They are spending $150 billion a year through this initiative, but will make it in total something like 30 times as big as the Marshall Aid program that lifted Europe out of World War II. This is a phenomenal expansion,’ he added.

2018's top asset class

Poll results from the conference revealed that fund selectors in Asia were looking to increase their EM bond allocation over the next 12 months.

While 56% of the delegates voted to increase their exposure to EM bonds, 27% voted for Asian bonds.

Convertible bonds received only 5% of the vote, followed by 2% interest in US bonds, and no votes for global bonds.

EM continued to be favoured in the equity space as well, garnering 35% of the votes. The equity class, however, lost to thematic equities, which was the top choice for 40% of delegates.

European equities and US equities, which have attracted massive inflows this year, saw less interest at 10% and 6%, respectively.

Private equity, which high net worth investors in the region have been favouring as part of their investment mix, was the most popular alternative asset class at 37% of votes.

Twenty per cent of delegates at the event plan to increase exposure to real assets, and 15% said they will invest in infrastructure particularly.

This article was first published in the November issue of the Citywire Private Wealth magazine.

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