China is not stimulating

Key points:

  • This time a year ago markets were over confident, now they are overly gloomy. Valuations have adjusted already, and the headwinds from a strong dollar and hedge fund distress are fading.
  • China is not stimulating per se, its balance sheet is actually strong and it is ensuring enough liquidity and stability for the upcoming Chinese new year as well as undertaking ongoing structural reform
  • As the UK looks to be approaching the endgame on Brexit, equity investors still face an absence of meaningful information at the stock level, leaving them on the sidelines.
  • Meanwhile, as China deleverages its informal banking system, the biggest risks are that the west needs to do the same. Slowing growth makes it harder to cut debt, corporate level, household, or even sovereign.

This time a year ago markets were over confident, now they are overly gloomy. Valuations have adjusted already, and the headwinds from a strong dollar and hedge fund distress are fading.

China is not stimulating per se, its balance sheet is actually strong and it is ensuring enough liquidity and stability for the upcoming Chinese new year as well as undertaking ongoing structural reform

As the UK looks to be approaching the endgame on Brexit, equity investors still face an absence of meaningful information at the stock level, leaving them on the sidelines.

Meanwhile, as China deleverages its informal banking system, the biggest risks are that the west needs to do the same. Slowing growth makes it harder to cut debt, corporate level, household, or even sovereign.

This time last year the macro consensus was for strong global growth, led by China and emerging markets. Accordingly, the Fed was expected to raise interest rates more aggressively. And yet, consensus on the US dollar was negative after a weak 2017. Of course, by Q2, the dollar was starting to appreciate and the inverse correlation that had powered EM markets in 2017 went into reverse as the EM/DM chart rolled over into mean reversal and the region saw significant fund outflows – especially from ASEAN. The trade war concerns hit mid-year and, just as we were stabilising in Q4, a big round of market mechanics left US Bonds squeezed 20% higher and US Equities 20% lower as hedge funds and prop desks got cleaned out. Vix hit 37 on Christmas Eve (while no one was looking). Thus 2018 in Asia began as a dollar story, morphed into a trade war story, and ended as a liquidity story.

So now the consensus is for weak growth led (down) by China and EM and the Fed to be easing interest rates and yet the consensus on the dollar at least for the start of the year is for it to remain strong. So basically, the mirror image of a year ago. Will it be equally wrong? Well the dollar has weakened a little, which has helped EM and China stabilise as a headwind eases. Second, the distressed selling from Q4 looks to have passed. As a result, Asia markets have seen some strong inflows since the start of the year, although confidence remains very fragile, certainly in contrast to the situation last January. At the stock level, there are undoubtedly some concerns of slowdown thanks to trade war, but valuations are now very attractive – not just on earnings, but also on core measure like Price to Book. As we said before, it pays to be greedy when others are fearful – especially if we think those fears are not only already in the price but also exaggerated.

This week’s China GDP data remained strong, even though there is clear evidence of the trade war slowing things down. Partly things are distorted by a bringing forward of activity on trade, although this has been something we have been talking about for months now, so should hardly be a surprise. The authorities are reacting, but this is not in my view an attempt at stimulus, as many are trying to suggest, rather a series of measures designed to achieve ongoing structural reform without knocking the economy off its growth path. For example, last week there were some announcements of tax cuts for small and micro enterprises (corporation tax and VAT) while over the weekend the People’s Bank of China announced further cuts in the reserve-requirement ratio to ensure enough liquidity over Chinese New Year. This is less a stimulus, and more about ensuring that there is not an impediment. At the same time, it looks like banks will take more non-bank lending onto their balance sheets as part of the ongoing unwind of the shadow banking system. These are market positive actions underlining official support for the stock markets. This is all a process to ensure financial and social stability over the upcoming CNY period.

We had a client symposium in Hong Kong this week on the topic of Longevity and aging societies, where we addressed a wide range of issues around structural shifts in the way we save as well as the way we consume. While this is a global phenomenon, China is one of the countries to be particularly hard pressed by the demographic challenge as its old age dependency ratio (population over 65 as a ratio of the 15-64 population) moves from 10% today towards 45% by 2050. This takes it from an Emerging Market level to a developed market level. Obviously, given the size of China, that means around one in four of the world’s elderly will be in China by 2050. In effect, the demographic dividend enjoyed over the last few years becomes a demographic tax. This is the ‘demographics is destiny’ story behind ‘China will get old before it gets rich’ story that appears whenever the China bears are out (as now). However, as my colleague Aidan Yao pointed out at the symposium, there are several interesting twists to this story. First, if we look at prime working age (35-55) then the most productive cohort doesn’t roll off until perhaps 2040, and then only relatively slowly. Second, as with all things China, western pessimists seem to assume that not only is the Chinese Government not aware of this, but that it doesn’t plan to do anything about it. Neither of which of course are true. China has a number of tools to help it deal with this problem, including delaying retirement ages and building out savings infrastructure.

I particularly liked the point he made about the asset side of the balance sheet. If we look at chart 1, we can see that while the Chinese government might have considerable liabilities on its balance sheet on a look through basis from the assorted State Owned Enterprises (SOEs), it also has the assets, leaving them net long around Rmb60trn.

Chart 1. The Chinese government may have a lot of SOE debt, but it also has a lot of assets

Source: Southwest University of Finance and Economics (2014), CEIC, MOF, IMF, Research, Jan 2019

This is an important counter to the “China is drowning in debt’ story that resurfaces periodically, one that I heard yet again on a client conference call this week. If we take Aidan’s Chart 1, we can put it in the broader context of Chinese debt as neatly summed up in Chart 2. Here we can see that of the widely touted 270% of GDP, a third of it is SOE debt, which we have just noted is more than cancelled out by their underlying creditor (the government) owning a greater amount in assets.

Chart 2: China’s debt is not a problem for the world; it is an ongoing work in progress.

If we then look at another part of this debt – local government debt – then we need to recognise that while it grew rapidly in the infrastructure stimulus post the global financial crisis, much of it is backed up by tangible fee generating assets such as toll roads, REITs, airports, etc. that were built with the loans, unlike, say, a lot of US muni bonds that are only backed by current tax income. The restructuring of these two parts of the Chinese government balance sheet will be a key driver of the development of the Chinese investment landscape in the coming decade. Muni bonds, infrastructure bonds, spin offs, and IPOs from SOEs and so on. All will go to build the asset side of the future pension funds for the aging Chinese population.

This leaves private sector debt at a little over 100% of GDP, split roughly evenly between households and corporations, a far more manageable level, particularly since, unlike most emerging economies, very little of it is offshore debt. As noted on earlier occasions, while the Chinese household is now increasing its debt as it builds up its balance sheet of assets and liabilities, it has a long way to go before it catches up with the west. This is particularly true in the field of mortgages; China has four times the population of the US, but the US has four times the mortgage debt of China. Moreover the US mortgage debt is increasingly sensitive to short rates and backed with very little home equity. (By contrast Chinese property requires deposits in excess of 50%). Table 1 is also taken from Aidan’s presentation and shows IMF estimates of the so-called pension gap between assets and liabilities for households.

Table 1: Pension Gap and household Asset/Liabilities


Source IMF, AXA-IM Research. January 2019

There are a few things worth noting here. First our estimates of household debt are slightly lower than the ones in the Deutsche chart above, but in the same order of magnitude. More important to note that the data on the asset side excludes real estate assets. This will seriously understate the Chinese asset position, as around 70% of their assets are in Real Estate and second or even third properties are common. Finally, of course it brings us back to the importance of looking at both side of the balance sheet when assessing debt to GDP, the household sector is a net holder of assets, not a net debtor.

Chart 2 also highlights that China has gone through cycles of leveraging and then deleveraging, but against the background of building up balance sheets in a country that until recently (in economic, if not hedge fund trader terms) had no private ownership and thus no debt either and it is worth noting that the ratio is barely changed since 2015. Second if, as noted above, we recognise that state owned enterprises and local government are really on the government balance sheet then the private sector and household debt on this measure are around half the headline level, with the household sector in fact a net creditor. Third, and very importantly, almost none of this debt is held in foreign currency – it largely represents Chinese assets as well as Chinese liabilities. Finally, we would suggest that, once again, western analysts are projecting western or emerging market balance sheet trends onto China when it is not appropriate to do so. As noted earlier, the Chinese authorities are engaged in an ongoing process of restructuring the financial system and the greatest challenge is not the balance sheet but ensuring there is enough liquidity while they do so.

On the other great ‘fear’ at the moment, trade wars, remember there are two components. Trade War 1 (TW1) is the normal trade concerns, effectively that the US is resetting multi-lateral agreements such as NAFTA to restore US advantage. Tariffs on steel, aluminium, etc. are aimed at Japan, Germany, and South Korea as much as they are at China. It is likely that this war will end soon as the US soon figures out that the next round of tariffs would be on goods with no viable short term alternatives, and thus will simply raise US domestic prices. Moreover, China is happy to make concessions in certain areas that matter to the US, importing commodities such as Liquefied Natural Gas and Soya and allowing in products such as autos and financial services. This ‘resolution’ should help restore some much needed market and business confidence.

However, we should not lose sight of the bigger picture. TW2 is the US fight to limit the rise of China and a (totally unrealistic) demand that China abandon its made in China 2025 ambitions. This is an economic cold war and is not going away. This means a likely resetting of a lot of global supply chains and as investors our concern is that this now introduces levels of idiosyncratic stock specific policy risk that we need to account for in our valuations.

Over to Europe and, over the last two years I have tried to avoid talking about Brexit, not just because of the politics involved (Donald Trump is a similar issue banned at our dinner table) but because, from an equity market perspective, there has been little useful to add. In the immediate aftermath of the vote in 2016 the big, macro moves were done by the currency markets, while bottom up investors waited to find out the likely winners and losers as the details of the arrangements became clearer during the two-year negotiating period. Sadly, we are still waiting, as the negotiating period has been dominated by various factions trying to overturn either the spirit or the reality of the vote.

As the usual network-fest that is Davos takes place this week, I was amused by the comments from Gillian Tett at the FT that we should be nervous in financial markets because for the first time in a decade, the grandees at Davos have not put concern about financial markets as a priority. Rather in the manner of the front cover of Time Magazine, or The Economist, by the time something gets to the Davos agenda it is already heavily discounted by markets. However, it does not mean that there is not new information available. With no US delegation thanks to the US government shutdown, it was left to Wang Qishan, the Chinese vice president to point out that the US Trade War was affecting everyone, not just China. As we have noted before, a lot of China exports are re-exports from elsewhere in Asia, notably from countries such as Japan and Taiwan. This week Japan noted sharp falls in exports to the rest of Asia; Japan exports to China were down 7%, while exports to Hong Kong were down 17%. Mr Wang also pointed out that for all the noise, China was still growing at a healthy pace and that the main driver of the slowdown was the (necessary) deleveraging of the shadow banking system rather than the trade war. As we have noted before, at 6.4% on an $11trn economy it adds the equivalent of a country the size of Australia to global demand every year.

One area they might consider is almost right in front of them, Europe and certainly the Euro has been under some sort of pressure of late as markets consider the potential risks inherent in Europe that could arise in response to a Brexit inspired slowdown compounding a trade war inspired one, a point raised this week by M Draghi at the ECB. Once again, the problem is debt and the inability to deleverage when growth is slowing. It was not that long ago that we had the Euro crisis when markets panicked that their loans in Euros might get paid back in Lira or Pesetas and while M Draghi with his ‘whatever it takes’ comments certainly kicked the proverbial can down the road, it hasn’t addressed one of the key fundamental imbalances, that Germany runs a current account surplus with the rest of Europe equivalent to 8% of its GDP. Chart 3 reminds us what has been happening since then to Euro system Target 2 balances, effectively the balance sheet mechanism whereby Germany offsets its huge current account surplus with the rest of Europe. It could perhaps be thought of as a form of Vendor Financing. Just as we saw large telecom companies such as Nokia and Ericsson caught out post the dot com bubble in vendor financing their customers and in the same way we saw China buying US Treasuries to effectively lend the US money to enable US consumers to buy Chinese products, so German Target 2 imbalances are to the consumers in the rest of Europe to keep buying German products.

Chart 3: The Target 2 imbalances are not a problem…until they are

Source Bloomberg, AXA-IM, January 2019

The chart is simplified to the main countries involved; Spain and Italy – in green and gold respectively, France in Orange, and Germany, the main creditor, in black. In effect Germany has lent almost 1 trillion Euros to the rest of Europe – mainly Spain and Italy as the massive current account surplus in Germany requires around $300bn of Target 2 balances to be recycled every year through the European banking system. This is now even larger than at the Euro crisis in 2012. Meanwhile one of the hidden consequences of the US shutdown is that the SEC are not processing the pipeline of IPOs scheduled for this year, including the large-scale raises intended to come from the likes of Uber and Lyft. As we have discussed on a number of previous occasions, this is a potential systemic risk to what we would regard as the US shadow banking system, the non-public eco-system of venture capital and private equity, private credit and leveraged loans that has been driving the Silicon Valley bubble of the last few years. As we noted last year, when outspoken tech investor Chamath Palihapitiya called the start-up economy “nothing more than a Ponzi scheme”, the end game for the Venture Capital and Private Equity titans (doubtless among the guests on the estimated 1500 private jets that flew into Davos this week) is to extract their returns from the public markets, through valuations based on seemingly little more than a model of 10x actual capital invested. Thus Uber, which as a major disruptor to an existing industry (taxis) has raised around $12bn of actual equity and debt, is now apparently ‘worth’ $120bn, yet has few assets and no positive cash flow. It is one thing to break an existing monopoly, quite another to become profitable yourself by doing so. Selling one dollar bills for 70 cents as someone put it can generate plenty of ‘growth’ but that is not the same as sustainable earnings. For now, the fact that, as Palihapitiya points out, 40% of the capital raised goes straight back to Google, Amazon, and Facebook, has undoubtedly been a meaningful factor in their sales growth (the rest probably goes to west coast real estate). But what if the shadow banking money machine stops? The 2008 crisis that nobody apparently foresaw was about unregulated shadow banking running out of runway. The continued obsession with low volatility as seemingly the only measure of risk has undoubtedly contributed to the evolution of a lot of ‘off balance sheet’ risk across developed markets. Like the target 2 balances, it is fine, right up until the moment it isn’t. Something perhaps for the Grandees of Davos to think about?

To Conclude. Asian markets have begun the year strongly, as the 2018 headwinds of a strong dollar and distressed selling by hedge funds in Q4 have abated. China is undergoing structural reform to deleverage their shadow banking system, a necessary policy, and something vice President Wang Qishan, pointed out this week was the main driver for the slower growth in China. In the meantime, they are introducing policies to ensure that there is enough liquidity to keep the economy on its consumer driven growth path, particularly over Chinese New Year. In developed markets, the trade war is also having a cyclical impact; while potential systemic risks from imbalances such as the Target 2 imbalances in Europe, and the Private market driven bubble in US tech start-ups, are not being addressed. As European Bankers, Venture Capital, and Private Equity titans, politicians, and Silicon Valley billionaires all gather in Davos this week and talk about China, they might consider that the next financial market disruptions might start rather closer to home.

Regards,

Mark

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