Market Thinking - China A share inclusion is significant over the long termMarket thinking 17 May 2018
China A share inclusion is significant over the long term
- China A share inclusion from the end of the month is largely symbolic at the moment. However it is far more significant for what it signals about the potential for investors in China over the next decade.
- Malaysia’s shock Election result is another rejection of the status quo and offers a small window of opportunity for genuine reform. It also highlights the diversity emerging within the broad grouping of emerging markets and Asia.
- The US has walked away from the Iran deal, but Europe has not, threatening tensions over potential sanctions.
- Meanwhile the ongoing cyclical tightening means avoiding weak balance sheets and those with negative cash flows, be they countries, corporates or consumers.
The inclusion of China A shares into the MSCI indices was announced this week and is due to happen at the end of this month. This is something that we would regard as both largely irrelevant but at the same time extremely significant. Firstly, the index effect is minor, at initial inclusion A Shares will amount to less than 1% of the MSCI emerging market index, while secondly, although the size of assets benchmarked against the MSCI Emerging Markets index is huge (over $1trn), that is not to say that they are fully tracking it. Rather it is the benchmark and most active managers reference it and would be relatively relaxed about having a position that was less the 1% away from the benchmark. As such there is unlikely to be a wall of money coming in as some are predicting – it is worth noting that it was expectations of such a wall of ‘dumb money’ that had led speculators to chase the A Share market in 2015, leading first to a boom and then a spectacular bust as the speculators realised that ‘the bigger fool’ who was supposed to come in and buy the elevated shares off them was never going to arrive and indeed that they themselves were the bigger fool for the traders who had stoked the speculation on the first place.
However, this is not to say it is not important. It is perhaps better thought of a shining a spotlight on the opportunity set in China A shares and in this sense it is hugely significant in my view. For example, if we take the fact that in the first instance A shares will only have a sub 1% weighting in the benchmark, but that over time this could rise to 18%. The explanation for why this will occur is largely a function of lack of liquidity, low free float and tradability and restricted ownership.
One early opportunity may come with the start of the exit plan for the National Team – Z-Ben advisors in Shanghai are suggesting that the National Team – Central Huijin, CSF and SAFE - who all bought into the market to stabilise it during the 2015 collapse are about to start to unwind their positions. They estimate around $210bn of equity is liable to be offloaded, but rightly suggest that this will not be done in a fashion likely to undermine the markets. One obvious solution – which they suggest and I would agree with – is to effectively to launch some form of Tracker Fund of China, rather like Hong Kong did after its actions during the Asian Financial Crisis to support the Hong Kong Market.
As far as international investors are concerned, to date the main way to invest in China has tended to be through indices and pooled vehicles rather than directly into stocks and it has also tended to be via Emerging Market indices rather than direct China indices – hence the interest in the MSCI Emerging Market index. However, I believe this is changing and international investors are becoming increasingly interested in investing in China as a pure play. As such , it was interesting to note that this week, ETF giant Vanguard launched a new China ETF that tracks the all China Index, covering A Shares, H Shares and N Shares (ADRs). At the same time as investors are looking to break China out of Emerging Markets as a group, we find that the remaining markets are re-discovering idiosyncratic risk. We have seen dramatic moves in places like Argentina recently, but a particular example this week is Malaysia. The surprise return of former President Mahathir was as big a shock to the population as Brexit or President Trump were in 2016. Indeed, it was arguably an even bigger rejection of the status quo given that the Barisan National (BN) coalition of parties has effectively been in power for almost 60 years. International investors reaction has been in the first instance to sell the markets, with bonds, equities and currencies all hit. However, Mahathir, who only intends to be a temporary leader until his Deputy Anwar Ibrahim is pardoned and released from prison, has promised a business friendly government and has appointed a finance minister seen as a safe pair of hands. The opposition party, now government, had campaigned on a platform of reducing debt but also of scrapping the controversial Goods and Services Tax (GST) and replacing it with a sales tax as well as reintroducing items such as gasoline subsidies. The potential pressure on the Budget is obviously something worrying to bond markets.
The market reaction to Malaysia is yet another factor in breaking down the correlation between emerging market countries. Historically they have tended to move quite closely together, reflecting their more cyclical growth nature, but this is becoming increasingly less relevant The economic conditions of China – easily the biggest ‘emerging market’ - are increasingly divergent from other countries. As noted in recent weeks, the breakdown in Latin America, especially Argentina is highly significant, highlighting the very big difference between that part of the world and Asia, while Turkey is correlated with Argentina only in that they are both going down. What is most obvious though is that the fortunes of Brazil, Russia, India and South Africa are heavily tied to the commodity cycle while China’s only real connection with the rest of the BRICS is that it is largely determining the demand side of the demand/supply equation.
Thus when looking at potential economic headwinds and tailwinds for corporate profitability (which is the key use of macro for equity stock pickers) we tend to think much more about thematics and strategy rather than cycles and tactics. The notion of cycles nevertheless continues to drive sentiment and market rotation, presenting opportunities to take the ‘other side’ if the trade, not to be deliberately contrarian, but to buy on dips or sell into rallies where we see the structural trend in a different direction to the tactical trade.
The announcement last week that the US was going to walk away from the Joint Comprehensive Plan of Action (JCPOA) otherwise known as the Iran Deal did not come as much of a surprise having been heavily trailed as being regarded as ‘a bad deal’. Some are comparing it to the decision to leave the Trans Pacific Partnership (TPP), which if true would actually be a good thing in my opinion, but only because I believe that the US only stepped away from the TPP in order to subsequently re-engage (on better terms). That is not what most people think of course, hence the comparison is meant in a bad way. Whatever the intent (and some insiders have suggested that there is actually a plan to re-engage) there will undoubtedly be an escalation of tensions with Europe and other nations that signed the UN brokered deal with Iran in the first place. Imposing sanctions on European companies for ‘breaking’ restrictions newly imposed by the US having left a deal the Europeans are still part of risks a tricky standoff. One obvious area is aerospace, where both Boeing and Airbus have signed large deals with Iran Air. While Boeing has not received licences to supply (and thus has not put the sales on its books), Airbus has. The problem Airbus has however, is that even if the Europeans ‘stay in the deal’, it uses a large amount of US components, which rather like the situation with phone maker ZTE means that without access to these components they cannot meet their order book. It is difficult to tell whether the relative strength of Airbus shares last week meant that the market saw airbus simplistically as winners over Boeing and had overlooked the component angle, or had decided that the US wouldn’t impose sanctions/restrict Airbus.
Having said that and having mentioned ZTE, the recent announcement by President Trump that he was working to get ZTE ‘back in business” only weeks after effectively closing them down by denying them access to US components does tend to support the notion that his opening moves are often part of a longer negotiating play. Treasury Secretary Steve Mnuchin has already said that the stance on the Iran Deal is about deal making.
Finally. In the last note I discussed at some length the concerns I have over the Australian credit cycle, in particular the risk arising from a tightening of lending standards in the wake of the Royal Commission reports into the financial sector. Monetary tightening is as much about the availability as the price of money, so that even if rates don’t go up a restriction in availability of credit through increased regulatory pressure (higher capital requirements, tighter lending controls etc.) can induce a forced deleveraging. This can tip supply and demand out of balance and lead to further price drops and further deleveraging. Against that background a comment from UBS this week highlights g how auction clearance rates are falling as are the number of auctions implying demand is weakening.
To conclude. In a number of ways the markets look and feel like 2008, not in the crazy bull leveraged bull market sense, but in the sense of late stage credit cycle where the liquidity tide was just going out. Then, as Warren Buffet puts it, “when the tide goes out you can see who has been swimming naked”. This is not to be apocalyptic, the reason the Global Financial Crisis was so dramatic was not the uptick in US home loans defaults (although of course that is what many people who claimed to have forecast the GFC say it was), rather it was the damage that higher defaults did to the vast inverted pyramid of leveraged CDS and CDS like structures. Instead it is to remind ourselves that when credit conditions tighten, as the steady rise of LIBOR over the last 12 months has already been telling us, then the countries, corporations and strategies dependent on that cheap ‘fuel’ will come under increasing pressure. Strong balance sheets, solid cash flows and real rather than leveraged returns will be An unwind rather than a crash, but an unwind nevertheless. Countries running current account deficits, households relying on easy credit to drive housing markets, corporates relying on easy access to cheap capital. All will struggle in the coming months. At the same time as these cyclical events look likely to unfold, dramatic structural changes are also taking place, particularly here in Asia.
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