Market Thinking - Giving thanks for profits and reducing balance sheet risk while trying to make sense of China

Market Thinking - Giving thanks for profits and reducing balance sheet risk while trying to make sense of China

17 November 2017
  • After a tremendous year in Asia, the polarity remains between bulls and bears. Everybody’s strategy has made money, so everyone thinks they were right – especially if they bought Tencent.
  • Profit taking in big winners is causing short term weakness but likely to meet buying on the dips at some point; a more structural shift away from geared balance sheets looks underway as investors think about protecting the downside in 2018.
  • Structural changes in the Chinese financial system are producing misleading indicators in their bond markets, while rapid technology advances are offering new opportunities and new threats.

Asian markets are no different from anywhere else at the moment as the approach of the end of the calendar year triggers some profit taking, selling which appears to be meeting little in the way of resistance as the earlier window dressing into some of the stronger performing stocks and sectors eases back as an influence. Overall what my chartist friend describes as slight setbacks but no real damage. It used to be said that the more active traders all closed their books ahead of the Thanksgiving Day holiday season, which is of course next Thursday and certainly here in Asia where both absolute and in many cases relative performance has been so strong, there is a strong case for locking in those returns and/or performance fees. Asia has been the best performing region globally this year as China 2.0 kicked in as a theme with China (at the MSCI level) being the best performing market and tech being the best performing sector. In Hong Kong the story has all been about Tencent, while in Korea it has been about Samsung. In Hong Kong in particular the impact of Tencent has been extra-ordinary as the largest stock in the market with a current weighting of almost 12% has effectively doubled over the last 12 months, while the second biggest, HSBC, is up a mere 17% - albeit with a significant dividend to yield a total return of 23%. In South Korea, where Samsung Electronics is more than 20% of the index, it has risen by 83%. Probably not since Apple became the biggest stock in the US market back in 2011/2 and then doubled has the index effect had such a big impact on so many active institutional investors.

Of course the argument threatens to become circular. Are Tencent or Samsung up so much because people are buying the index? Or vice versa? For Tencent there may well be some influence from the fact that mainland Chinese investors can buy it through the Southbound Stock Connect, which continues to expand its influence on Hong Kong markets. Tencent is affecting the real economy in China as well as here in Hong Kong. As previously noted by my colleague here in Hong Kong, Will Chuang, it is not only possible but actually significantly easier to spend a weekend in Shanghai without using either cash or a credit card, simply using WeChat pay by Tencent. All you have to do is click on your phone to call up a quick response (QR) code that the merchant scans and you are done. It is now said that you can always spot the tourists in Shanghai as they are the ones using credit cards, or if they are really old fashioned, cash. The fact that the largest note in China is RMB100, which is the equivalent of around EUR15 is probably a factor in using WePay to replace cash, but even here in Hong Kong it is increasingly being used. Incidentally, my colleague Will helped me (easily) set up my own WeChat account so now I can feel properly Chinese – as well as get a taxi in Shanghai!

Tencent is mainly Chinese but it is also having something of a wealth effect here in Hong Kong as the number of people trading the stock and several of the connected spin-offs that have recently IPO’d here are clearly celebrating their ‘success’ in the bars and restaurants in Central. The retail offering of Tencent spin-off China Literature for example was 625 times oversubscribed and effectively doubled on opening, having caused a huge spike in interbank rates as money was locked up in anticipation. Former Hong Kong Chief Executive Chun-ying Leung used to refer to Hong Kong as “where the rest of the country meets the rest of the world” and as well as offering an outbound conduit for mainland investors through its H share listing, the company itself is, like a number of others, investing overseas, most notably when it picked up around 12% of SNAP as that particular stock continued to slide. Many have noticed the contrast between the performance of US tech IPOs and their Chinese equivalents.

Meanwhile, one interesting example of behavioural finance is that because ‘everything has done well’ everybody is convinced that they were right. As Michael Parker, Strategist at Alliance Bernstein said to me this week, something to the effect that China bears are still bearish and the bulls are still bullish, because both are cherry picking evidence that they were 100% right.  Nobody looks to be changing their mind any time soon.

The recent weakness in so called ‘risk assets’ – which basically means anything other than government bonds has partly reflected profit taking in growth equities, but also a divestment of what might properly be regarded as assets with business risk and specifically balance sheet risk. As a proxy for these I like to use the iShares High Yield Bond Index, HYG, as shown in Chart 1 below.

Chart 1: High yield breaking down

Source: AXA IM, November 2017

High yield USA funds and ETFs reported an outflow of $4.3bn last week according to Bank of America Merrill Lynch, the third highest outflow on record and the largest since August 2014.

A closer look would show that the index broke below its long term moving average quite convincingly just over a week ago unwinding the recovery rally that had started back in February last year. Technically it looks rather unpleasant with possible support at 85 and 83. Fundamentally it may also be pointing to a wider shift away from indebted companies as investors shun stretched balance sheets; funds and ETFs exposed to leveraged loans also suffered outflows for example. It may also reflect something of a push back against the notion of issuing debt to buy back equity. Certainly the buyback achievers index that tracks companies that have repurchased at least 5% or more of its shares outstanding over the last 12 months appears to be rolling over. Some of these stocks of course are caught up in the offshore tax situation that is one of the (many) things being discussed in the US at the moment, which means that a simple screen of indebted companies will not reflect the underlying financial strength.

The current tax package is caught up in various issues to do with constraints on budget spending in years 11-20 and as anyone who watches House of Cards will recognise, passing bills through the US legislature is a complex and sometimes arcane business, involving multiple trade-offs and concessions and special interests. At the moment, the tax reform bill is getting caught up with issues on deductibility of state and local taxes, which obviously has implications at the state funding level, but looks likely to also get caught up in issues around health insurance. Markets will therefore likely continue to reserve judgement on the implications for US growth (which remember has already surprised to the upside) and by extension their broader asset allocation. Currently the US dollar is a little weaker and bonds a little stronger than they were at the end of October, but realistically the bond and foreign exchange (FX) markets are moving sideways. There remain many loopholes such as taxing private equity or limiting interest rate deductibility, as well as the long discussed re-on shoring of profits, but we need to wait for clarity.

As he leaves this region, President Trump’s policy appears (to me at least) to be replacing multi party deals with bi-partisan relationships, which seems to be upsetting many in the multi-lateral institutions that represent the old order, especially as he blamed previous US Administration for not optimising relationships with China. Over $250bn of deals was offered to US corporates in the trade delegation and while much of that was undoubtedly the usual double counting it does show the direction of travel. As discussed, undoubtedly much of the backroom talk has obviously been on security, centred around North Korea and it was interesting to see that China has both restored diplomatic relations with South Korea and sent a special envoy to North Korea.

As noted last week, oil and gas is an important part of the new trade relationship between the US and China and coincidentally or not oil has sold off quite sharply as speculators take profits after the recent run and a feeling that above $60 on Brent, the resolve of OPEC (Organisation of Petrolium Exporting Countries) has traditionally proved quite weak. The spread between West Texas Intermediate and Brent Crude has narrowed somewhat, but the former is up 3.7% year to date while the latter is up 8%, reflecting not only recent upheaval in Saudi Arabia, but also the disruptions in Venezuela for Brent and the impact of Hurricane Harvey in the US.

In China, the bond markets remain weak post the Party Congress and many analysts are interpreting this as the market telling us that the economy is in trouble. However as a fascinating presentation from Standard Chartered strategist Becky Liu pointed out this week, many of the signals we are observing need careful interpretation and do not directly translate to those coming from a western viewpoint. For example, the talk of deleveraging the economy is a three stage process. The first stage, taking leverage out of the financial markets is largely done in her view as the various fund management products that were issued to produce leverage that subsequently went into financial markets roll off and are not replaced. The second stage, which involves a further shrinking of ‘intermediary’ financial sector balance sheets is now under way and the third stage, de-leveraging the real economy, which is what many in the west interpret as not only happening but being a ‘big risk’ is in fact far less of an issue.

To return to the second stage, now underway since Q2 when the revamp of the regulatory framework (effectively combining the three different regulatory bodies) started to shrink the intermediary role of the corporate sector, specifically the state owned enterprises (SOEs). To take an example, the cheap funding available to a large SOE such as a steel company meant that it could borrow, say, RMB100m at around 3 or 4% and then lend on to a property company at 12 or 14%. This obviously not only led to some double counting – there were RMB200m of loans recorded rather than RMB100m, but also an issue with due diligence and credit quality. This is now unwinding, showing an apparent shrinking of credit and tightening of monetary conditions when in fact there is rather less impact on the actual economy. This is something we discussed before the Congress when a two tier target cut to the Reserve Requirement Ratio (RRR) for the banks was announced to come in 2018. This is not easing policy, it is part of an initiative to target lending away from SOEs to small and medium sized enterprises (SMEs) in the private sector. The reality is that inefficiencies are coming out of the system so that the actual interest rates paid by most SMEs are falling, even though the headline rates appear to be rising. Similarly evidence of a rise in interest rates is observing the price paid by the highest quality borrowers going from too low (allowing the above arbitrage) to a more normal level, while the cost of borrowing for the broader economy is stable to lower. It just isn’t reflected in the official rates. Other market mechanics are also evident, the longer dated bonds bought with the leveraged money in stage 1 are now selling off as buyers disappear while the cost of funding at the short end rises leading to negative carry in many cases. All appear to show tightening monetary policy, but in reality it is largely confined to the markets themselves. Having said all that, she feels that post the Congress, Xi is probably more relaxed about the pace of growth slowing down a little, so we should not expect a sudden weakening of monetary policy if GDP growth slows a little.

Closer to home, seemingly every broker in town is holding a conference in Hong Kong at the moment and increasingly most are including site visits over to Shenzhen, which is rapidly evolving into a tech-hub and I note all 14,000 of its buses will be electric by the end of this year. As such an increasing number of fintech stocks are being showcased here in Hong Kong and are catching people’s attention. Many are private or too small for institutional investors right now, but nevertheless provide a fascinating insight of what is to come. As my favourite quote from science fiction writer William Gibson puts it – “The future is already here, it just isn’t evenly distributed”.

First up was facial recognition company SenseTime, a spin out from Hong Kong University whose software surpassed human accuracy in terms of facial recognition as long ago and who have now surpassed Google in terms of accuracy. Indeed they believe the software is now as effective as an 8 digit password. As with all new technology, the fascinating part for me is the second stage, the creative uses to which it is put. According to the company over 400 million people in China registered for facial identity last year and that is only going one way. Obviously the more people use it, the more the system learns and the better it gets. Apple’s new iPhone X’s more obvious uses include autonomous driving – the same software that recognises faces recognises the road and its users and also medical imaging. A good doctor will have seen hundreds of examples of a particular symptom, moles, ultrasound, X-rays or whatever, but artificial intelligence (AI) with this sort of imaging software can have studied millions of images. Law enforcement are starting to use it more widely – a recent cultural fair in mainland China saw the police using the facial recognition software to pick up 25 wanted criminals over 5 days! With apparently over 200 thousand criminals at large in China this could obviously become a meaningful law enforcement tool. Traffic management systems and crowd management systems are also obvious uses.

The second company sounded a bit old school as it was a mining company – except it was a bitcoin mining company, or to be more precise a crypto currency mining company, since bitcoin is not the only game in town. Ironically the chairman of this particular company is well known as an entrepreneur in traditional mining companies and he has probably already made more out of this company than he ever did from nickel and gold. For readers unfamiliar with the concept of a crypto currency miner, they are basically the people who maintain the blockchain, the network on which the currency sits. The miner both verifies the transaction and creates new units of the currency. To do so, they essentially have to solve a very complex maths problem, something that requires a lot of brute force computing power. The idea is that it has to take effort, or ‘proof of work’ to produce new coins so that the amount produced every day remains steady. There is a lot more about it here. This particular company actually mines etherium, which is perhaps best thought of as a business to business crypto currency, it is digital oil to bitcoin’s digital gold and to do so it has a lot of computers working very hard around the clock, something that requires a lot of power and a lot of cooling. Their solution is to build their data centres in Iceland – cheap geo-thermal power and (obviously) cold.

While I was at a tech conference in Hong Kong, my colleague Simon was down in Singapore at the Singapore Fintech Festival sponsored by the Singapore government. He commented that, while everyone claimed to be a disruptor, most of the products were really about productivity, making existing processes more efficient and thus the winners were likely to be the larger incumbents who could implement the strategies. The real disruption is yet to come. And to me that will come from the blockchain as the digital gold and the digital oil reduce the frictions in the service industry the same way that the internet disrupted the retail space. We all knew what Amazon could do back in the early 2000s, but it took a few years to unfold. Similarly, the blockchain threatens to become ‘internet 2.0’ for service industries that require a middle man for verification and trust. Payments and contracts are one obvious example and I suspect that many of the emerging fintech solutions will be for improving the efficiency and removing the frictions in middle and back office functions.

To conclude, almost everybody has made money in absolute terms in ‘risk assets’ this year and so the temptation for many is to lock in the performance fees and bonuses before Thanksgiving and leave the arguments as to who actually ‘got it right’ until next year. For the geo-politically minded President Trump’s Asian tour has confirmed a new G2 relationship between the US and China, with some apparent positive takeaways on trade and North Korea. Meanwhile as Saudi Arabia regains its breath, we see what appears to be a coup in Zimbabwe and worrying signs on debt and currencies in Venezuela and now also Turkey making life tricky for those trading emerging markets sovereigns. Equally for yield fans, the higher yielding corporate bond markets also look a bit delicate at the moment, while equity sector rotation appears to be focussing on quality balance sheets. I suspect that as much as anything else this reflects a desire to protect possible downside risk as we look into 2018. For investors starting to look at China, we need to be careful of the traditional indicators as many reflect significant structural changes in the financial sector rather than shorter term signals for the economy, while China 2.0, the dominant investment theme (in my view) for 2017 rolls into 2018 as a myriad of start-ups appear out of Shenzhen and elsewhere to offer us a future of further innovation and disruption.

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