The Opium Wars - Banca March · The Opium Wars PLand and sea trade flows between China and the West have been a central issue in global geopolitics for centuries. Different segments

Monthly Strategy Report July2017

Alejandro Vidal CrespoDirector of Market Strategies

The Opium Wars

Monthly Strategy Report. July 2017

The Opium Wars

PLand and sea trade flows between China and the West have been a central issue in global geopolitics for centuries. Different segments and flows on the Silk Road were known of since the 1st century B.C., but the first to fully describe and document the route was the Venetian merchant Marco Polo. In the period before Spanish and Portuguese colonial expansion, it was an overland trade flow to Damascus and Tyre, with sea routes around India and Arabia to Constantinople and Alexandria. These three cities handled most of European trade with the Far East for centuries.

The arrival of the Spanish and the Portuguese to the Pacific in the 16th century was going to radically transform this trade flow, with Manilla, Goa, and Macao emerging as dominant powers in the beginning to later be reinforced with Dutch possessions in Indonesia. Trade was open with Europe and also with America. In the case of Spain, this trade flow was based on the Manila galleon. The route to Asia from Acapulco was discovered in 1521 thanks to Magellan and Elcano’s trip, stopping off at the island of Guam. An efficient return route was not discovered, however, until 1565. Spaniards Andrés de Urdaneta and Miguel López de Legazpi found the return current and winds sailing north from Manila to Nagasaki and from there east until they spotted American lands near Cabo San Lucas and then along the coast back to Acapulco, where the prevailing westerly winds would drive them back to Manila with their holds brimming with silver. In Acapulco, Asian goods crossed over land to Veracruz, where they joined the Atlantic trade route with the Indies. The original goal that propelled Columbus to sail was finally reached 70 years later leaving Palos.

The Portuguese followed the Indian Ocean route, going from Macao to Goa, Mozambique, Salvador de Bahia, and Lisbon. In both cases, the route was frankly loss-making in terms of trade deficit. The Chinese exported a wide variety of goods while they hardly imported anything. They were paid in precious metals, not especially burdensome especially if the ones paying were the Spanish. In the 16th century, the continuous entry of precious metals had triggered hyperinflation and economic crisis in Castile, and Charles I had decided to coin money in Mexico directly and use it to trade with as a way to reduce monetary expansion in the metropolis.

This commercial boat was going to be rocked by the arrival of the English in Southeast Asia at the close of the 18th century. In 1757, a dispute with the East India Company set off a local Bengali forces attack on Fort William in Calcutta. The British response was conclusive and marks the de facto beginning of the colonial period in India with the conquest of Bengal.

Unlike the Spaniards, who basically traded with money that they had mined from the ground, the British were authentic traders who earned profits from moving goods from one place to the other. While the British bought precious goods from China like porcelain, silk, and tea, Chinese demand for their products was lacking. The famous negative balance of trade was settled in silver and this outlay in cash was intolerable for the British. They looked for another way to even out the score and they found it: selling opium produced in India that they introduced into China and sold in silver that was then used to pay at the port of Canton.

The opium trade burgeoned and in 1839 was a major health problem in China, where wide stretches of the addict population spent up to two thirds of their income on the drug. In response, the Daoguang Emperor took measures and prohibited the opium traffic in China, destroying large amounts of merchandise and arresting smugglers and corrupt civil servants. The United Kingdom’s response was to declare the first Opium War, 1839-1842, with a resounding victory for the British. The final result was the Treaty of Nanking which opened five Chinese ports to trade with the British under excellent conditions (for the latter, of course), reparations for the opium destroyed and war expenses, and the island of Hong Kong was ceded in perpetuity. The treaty, however, left several very important matters open like opium trade


in the future, which continued to devastate China.

Precisely the need to make the legality of this trade explicit was argued by the British in 1855. They used this to encourage the Chinese to renegotiate the Treaty of Nanking, including other claims like opening an embassy in Peking (at that time a closed city), abolishing taxes on foreigners living in China, and improved access to local labour. The Chinese, once again, refused. War would break out under the pretext of the capture of a Chinese ship, the Arrow, for pirating and smuggling. The ship had recently been registered in Hong Kong, which instigated a diplomatic conflict and then open hostilities.

The British attacked Guangzhou and took Canton. France, the United States, and Russia were invited by Great Britain to join the conflict, all of whom did under different pretexts. Chinese defeat was obvious and the country was forced to sign the Treaty of Tianjin in 1858. Among other things, it expanded Hong Kong’s territory, adding to it the continental Kowloon peninsula. It also legalized the opium trade, opened up new commercial ports and embassies, allowed foreign ships to navigate on some rivers, and established cash compensations.

The sudden change in trade conditions would generate a major political and economic crisis in China which would continue until the mid-20th century, practically until the victory of the communist revolution. The Imperial Government of the Qing dynasty would fall in 1912, giving way to the Republic of China led by Sun Yat-sen’s nationalists who did not gain control over the inland territories. This was not achieved until the government of Chiang Kai-shek, who aimed to lead China to modern democracy. However, this process was brought up short by the Japanese invasion during World War II and then the Maoist revolution that defeated the nationalist government and imposed a communist system in 1949.

Today, China’s trade with the rest of the world continues to generate major problems in the balance of trade, frowned upon by business partners, like the US, who buy vast amounts of goods but are hard pressed to place their own products, and conflicts continue to break out over control over certain regions and maritime routes in the South China Sea. And a new Silk Road, known as the One Belt One Road initiative, has emerged as a central strategic element in the design of Chinese infrastructures and investments in decades to come. I invite you to look into this initiative: you’ll see that some elements have hardly changed over history.

Monthly Strategy Report July2017

Equipo de Estrategia de Mercados de Banca March:

Alejandro Vidal, Unit Director, Market Strategies

Rose Marie Boudeguer, Service Director, Research Services

Pedro Sastre, Service Director, Market Strategies

Sebastián Larraza, Director, Discretionary Management Services

Paulo Gonçalves, Specialist Technician, Research Services

Miriam Ordinas Sanjuán, Specialist Technican, Market Strategies

Joseba Granero, Specialist Technican, Research Services

We close a positive quarter for world stock markets


We close a positive quarter for world stock markets

Stock markets close a very positive quarter, trading the improvement in activity.

As the first quarter of the year draws to a close, the expectations that world activity would improve have been confirmed. This reactivated growth combined with the increase in corporate earnings buttressed the jolly mood in world stock markets which in MSCI World closed the first half of the year with a 10% appreciation. However, in June, stock market behaviour was a bit more erratic since new nuances in central bank messaging increased the possibility of a less expansive monetary policy in coming months, flooding the markets with uncertainty.

In June, central banks gave a more flexible message: the Fed is raising official rates again...

In the US, the Fed raised the price of money for the second time this year, putting it at 1%-1.25%. The monetary authority stood by its forecasts which point to a new hike in official rates before the end of the year. It also revealed its plan to start a normalisation of its balance sheet whereby it will first reduce public bond holdings at a pace of $6,000M a month and another $4,000M in mortgage-backed securities and increase those figures every quarter.

...and the ECB is paving the way to larger reductions in monetary stimulus.

The ECB’s monetary policy in the meeting held at the beginning of June did not budge. The winds of change blew in weeks later at its annual meeting in Sintra, Portugal, where President Mario Draghi released a statement saying that, “the ECB is going to accompany recovery by adjusting its policies,” a message that means a review of monetary policy expectations, raising the possibility of a withdrawal of stimulus.

Division is also growing in the Bank of England.

The June meeting at the Bank of England showed a divided membership. Although the authority decided not to touch the price of money, now three of the eight members are voting in favour of raising official rates while in previous meetings only one of the members was.

Official start of Brexit negotiations.

In politics, Europe this month was marked by the official start of Brexit negotiations. In this first chapter of the proceedings, the British executive showed itself willing to negotiate the priorities defined by the EU: exit bill for the United Kingdom, the future of region citizens residing in the United Kingdom, and the Irish border.

E. Macron wins the majority in the elections.

Political stability was confirmed in France with the victory of President Macron’s party in the parliamentary elections, gaining an outright majority in the National Assembly with 350 seats of a total of 577.

Festive mood continues in activity data, especially in the euro area...

The background of the macroeconomic data published was still rosy, confirming that economic recovery is still underway. The growth of the Eurozone has intensified in the last few months with fewer differences between countries, and a recovery in investment and in job creation. In the last 12 months, the unemployment rate dropped almost 1 p.p. in the region overall which drove consumer confidence in June to -1.3, the highest since 2001. The CPI levelled out one tenth in June to +1.3% year-on-year but rallied the underlying rate two tenths up to +1.1%.


...while in the US growth’s jump start sputters.

In the US, figures were less heartening but continue to point to an expanding economy. Retail sales in May dropped 0.3% monthly but in y-o-y terms growth was 3.8%, holding close to 1 p.p. higher than last year’s average. Industrial production stalled in May but progressed at +2.2% y-o-y compared to the dips of 1% recorded in the previous two years.

Emerging economies continue with their economic recovery.

In emerging economies, the recovery trend and growth stabilization continued. In China, retail sales hit +10.7% y-o-y in May, demonstrating consumption’s exuberance. Brazil and Russia pulled out of the recession and both economies’ GDP grew in the 1Q; business confidence expanded, which flags a continued recovery for the next few months.

The mood swing in monetary policy hit the highest credit quality public debt market hard...

The less expansive message from central banks and improved activity in the euro area was assumed quickly in fixed income securities and foreign exchange markets. The ECB’s change of tone marked a rise in the yield required of Germany’s debt with a 10-year bond increasing 17 bps during the month to 0.47%. This increase in base rates also affected peripheral-country bonds but for the most part was offset by the decrease in risk premiums and in the case of Spain’s 10-year bonds, yield held steady at around 1.55%. In this context, Spain’s state debt index closed the month with a slight advance of 0.1% while the combined euro area public debt index slipped 0.5%.

…but shrinking spreads supported peripheral-country debt and credit.

Credit was also supported by the decreases in spreads and overpowered the hike in public debt rates. High yield debt was the top performer, registering a 0.2% increase globally while investment grade debt closed flat.

The euro is trading the improvement in activity and dried up ECB stimulus.

Foreign exchange also reflected the ECB’s changed tone and the euro appreciated in its major crosses. One major change was the euro’s strengthened position vs the dollar (+1.7% in June) which brought crosses to higher than 1.14 EUR/USD. The common currency to pound sterling exchange rate was also reappraised, reaching 0.88 EUR/GBP, and to the yen climbed even higher, registering +3.2%, topping out at 128 EUR/YEN.

Mixed balance for stock markets in June not dampening the year’s accumulated earnings.

Global stock markets closed one of the best halves in recent history with the MSCI World increasing 0.3% in the month, putting the year’s earnings at +10.25%. In June, however, performance varied among regions: emerging and American stock markets ended on a good note with +0.5% for S&P 500 and MSCI Emerging. The euro’s rise had a say in exporter names from the euro are and the Eurostoxx50’s good performance slowed down, closing at -3.2% in June.

Excess supply still weighing down crude prices.

High volatility continued in crude oil prices: Brent closed with a 5% drop to $48/barrel as supply continued to increase. Gold also registered losses, falling 4.7% under pressure from rising interest rates.


Strategy for July 2017

ASSET ALLOCATION

Overweight Neutral Underweight

Shares Cash Bonds

Alternatives

ASSET ALLOCATION

Overweight Neutral Underweight

EquitiesEurozone Asia

Emerging

Bonds

Emerging debt High-yield corporate debt

Investment-grade corporate debt

Convertible Bonds Sovereign bonds

Alternatives Multi-strategy absolute return Mixed absolute return

The global economy is speeding up.

The global economy is speeding up, especially in the euro area and some emerging countries, although without pressure on inflation.

Central banks are preparing the market for the normalisation of their policies.

In this context, major central banks are preparing the market for the normalisation of their policies: inflation in FMCG prices could be slowing down but the price of financial assets are reaching very high levels. The chair of the Federal Reserve pointed out that interest rates will continue to gradually increase, which indicates a new upsurge in the second half of the year. In the euro area, after the improvement in the political arena and with positive surprises in growth, the ECB stated that in September they may begin to assess a reduction in the bond purchase programme. This less expansive report was also being read at the Bank of England and the Bank of Canada. The market’s reaction to these changes of perspective were immediate, with spikes in debt profitability, especially long term.

Although they will give the market time to adapt to their changes.

This quick and generalized reaction could be a slight exaggeration since the proposed tightening will not be drastic. Central banks are testing the ground, preparing the markets beforehand and observing how they react to the statements. The change they are proposing is not inconsequential - a global market that has spent years with low interest rates and a wealth of liquidity faces the risk of ending up with overvalued financial assets - so they deem it important to warn investors that this situation will vary although they know that they need to give the markets time to adapt.

In this context, our basic strategy remains the same.

In this context, our basic strategy remains the same. We believe it is prudent, for instance, to keep the weight of monetary assets in portfolios the same. This category of asset does not generate yield but does act as a buffer at times when central banks tweak their policy and set off decreases in fixed income securities and equities.

We will maintain the weight of the global fixed income securities, avoiding sovereign bonds except for peripheral-country bonds.


We also maintain the weight of global fixed income securities, avoiding sovereign bonds, expect for peripheral-country bonds where drops in the risk premium due to a sunnier European political climate and the expected upwards review in credit scoring for those countries are expected. We maintain the preference for short term (2-3 years on average) to alleviate the effect of rising interest rates and because short term rates will be less volatile, as they are tied to central bank policy.

Shortened bond length is offset by a higher weight of private debt to increase yield.

Shortening of investment length is offset by a higher weight of private debt to increase yield and also because the current context of growth and low inflation favours credit. Although the valuations are very stringent, credit provides extra profitability and in the fixed income security category we continue to see more potential in short-term high-yield credit, emerging bonds, convertible bonds, and international fixed income managed actively and flexibly.

We will maintain our slight overweighting in equities.

We also maintain our slight overweighting in equities. Forecasts show that the next few weeks should be less volatile because central banks are toughening their message at a time when valuations are stringent and stock markets are treading water waiting to know the business results of the second quarter which will begin to be published this month. Double digit increases in net income are expected which should limit corrections.

When studying equity prices, remember to differentiate between internal and main indexes’ prices. Technology stock (especially in the American stock market) are at highly demanding levels while bank and industrial stocks are at their prices or inexpensive.

In terms of regions, we continue to prefer European stock exchanges.

In terms of regions, we continue to prefer European stock exchanges for valuation, high operating leveraging, and because expectations of a faster growing America have been reined from zero investment in infrastructure. However, due to the solidity of American businesses’ earnings (their ROE is one of the highest) and the possibility that in the second half measures are passed that could revitalize the American economy, we are still reasonably optimistic about the US’ equity.

Of the emerging stock markets, the context is most positive for Asia.

In terms of emerging equity, the context is brighter for Asian companies, with more growth and lower input and commodity costs. However, there is also value to be found in emerging Europe and Latin America from accelerated growth and attractive valuations.

We change the objective range for the euro to 1.12-1.07 EUR/USD.

The euro has been driven by the upgraded economy and European policy and the disappointment of a lack of progress in the US. However, the dollar could continue to increase its value if the American economy heralds in a more active fiscal policy. The ECB’s recent about-face requires a change in the objective for the euro-dollar range in 2017 to 1.12-1.07 EUR/USD.

The pound could devalue to 0.89 EUR/GBP.

The pound sterling would continue to sustain pressure while Brexit negotiations are going on, which could bring it to 0.89-0.90 EUR/GBP even though rates raised by the Bank of Spain could bring the process up short beforehand.


Oil prices will approach $50 the barrel.

Oil prices are expected to have hit bottom at 45 dollars per Brent barrel, a price which curbs the increase in production of less efficient operations. In coming weeks it is expected to increase up to 50 dollars.


Equity Indices IBEX35 (3 years)

Euribor Euribor 12 months (3 years)

EUR/USD (3 years)

10 years government yields

Currencies

Government Bonds

Corporate Bonds (1 year spread)

Commodities

Data: Bloomberg


Equity Indices performance (3 years)


Important Remark:

This contents of this document are merely illustrative and do not pretend, are not and cannot be considered under any circumstances as an investment recommendation towards the contracting of financial products.

This document has only been prepared to help the customer make an independent and individual decision but does not intend to replace any type of advice needed for the contracting of such products.

The terms and conditions described in this document are to be viewed as preliminary terms only, subject to discurssion and negotiation as well as to the agreement and final drafting of the terms affecting the transaction, which will appear in the contract or certificate to be issued.

Consequently, March Gestión de Fondos, S.G.I.I.C., S.A.U. and its customers are not bound by this conditions concerning the final documents to be approved. March Gestión de Fondos, S.G.I.I.C., S.A.U. does not offer any guarantee, expressly or implicitly, in relation with the information shown in this document.

All terms, conditions and prices contained in this document are merely informative and subject to modifications depending on the market circumstances, changes in laws, jurisprudence, administrative procedures or any other issue which may affect them. The customer should be aware that the products mentioned in this document may not be appropriate for his/her specific investment targets, financial situation or risk profile. For this reason the customer must make his/her own decisions by taking into account such circumstances and by obtaining specialized advice in tax, legal, financial, regulatoy, accounting issues or any other type of information required.

March Gestión de Fondos, S.G.I.I.C., S.A.U. does not assume any responsibility for any direct or indirect cost or loss which may result from the use of this document or its contents. No part of this document can be copied, photocopied or duplicated in any way or through any means, redistributed or quoted without a previous written authorization by March Gestión de Fondos, S.G.I.I.C., S.A.U.

Please note this document has been translated for your information only. In case of any errors or misinterpretations, the Spanish text will always prevail.

Documents

The Opium Wars - Banca March · The Opium Wars PLand and sea trade flows between China and the West have been a central issue in global geopolitics for centuries. Different segments