Is China building up to a financial market ‘Big Bang?Market thinking 25 April 2018
Is China building up to a financial market ‘Big Bang?
- Policy risk remains high globally and ironically China stands out as having the most clarity and predictability. It is also making access easier with every announcement, China looks like it may be building up to a financial market ‘Big Bang.’
- Deleveraging rather than trade tensions remains the real driver of equity markets so far in Q2. While many are taking profits selling rallies at the moment, they will likely return to buying dips.
- Noise traders have quit equities and returned to their long oil/short Treasuries trade, while momentum seems to have run out on most directional currency trades. Ultimately however, they give us little insight into the true macro environment for stocks.
In recent weeks the Chinese authorities have made a number of significant announcements of capital account reform and this week was no exception with the announcements by the Hong Kong Stock Exchange HKEX about allowing dual listed shares in Hong Kong and the Chinese regulator, the CSRC allowing certain shares listed on NEEQ, an OTC venue, principally involving tech and biotech stocks, to be listed as H Shares in Hong Kong – and thus accessible under the stock connect scheme (where the daily transaction limits were recently dramatically increased). In what also seemed like a co-ordinated move, the State Council made further statements on the eligibility requirements for a China Depositary Receipt (CDR), the plan to allow the current China ADR stocks such as Alibaba, Baidu, etc., also known as N Shares, to be listed as CDRs and thus available for mainland investors. Depending on how they are currently comprised this would likely have an effect on Chinese Benchmark indices if these large cap, mainly tech, stocks were included.
Meanwhile Beijing has now initiated a pilot programme that will allow (mainly state) owners of listed H shares to liquidate their non-tradeable shares and turn them into ordinary H shares. This last issue is likely to be hugely significant in terms of structural change for State Owned Enterprises (SOEs), allowing M&A, spinoffs and all manner of restructuring. This not only improves liquidity but also governance and pricing (low free floats are often at risk from manipulation). It is also important for issues such as index inclusion – the low initial weight of China in MSCI Indices for example is because of issues such as ownership, free float and liquidity – as well as empowering the current minority shareholders who currently own tradeable shares by putting them on an equal footing.
As we said a few weeks back, the political reform and consolidation phase is over, now we will see the economic and SOE reforms. These initiatives are coming thick and fast and are building up to what is basically becoming a Big Bang for Chinese capital markets.
Shorter term, as we have discussed previously, the key factor affecting equity markets so far during the second quarter has been the deleveraging that began after the short volatility squeeze back in February. The sudden spike in volatility back then, partly in my view a reflection of investors buying cheap put options against a consensus short vol trade, managed to shut down a lot of leveraged trader positions, meaning that when the March derivatives roll-over came the balance shifted from traders who were short puts and long calls to investors long equities but long put protection. This has left a sense of greater caution with focus on bottom up cash flows and something of a hair trigger around results season.
Meanwhile, the traders seem to have packed their tents and retreated to their more familiar areas of currencies, commodities and bonds, seemingly putting back on their ‘Cyclical Growth’ trades. Chart 1 updates a chart we put out at the start of the year showing the net speculative positions in Oil, US Treasuries and Euro/dollar, highlighting the multi-year highs in net longs for the euro and oil and the near 5 year lows for bonds.
Chart 1. Speculators long oil and Euro, Short Treasuries.
Source Bloomberg, Axa-IM, April 2018
From a technical perspective, the oil price is in a bull phase while the momentum indicators turned positive around the time of the options expiry. Treasuries meanwhile, having rallied post the options expiry, have reversed and are still in a bear trend (below long term moving averages). They have also broken down on momentum. The euro is less clear. While still above its long term moving average, the currency has broken its shorter term trend lines and its momentum is fading rapidly, although the spike at the end of last week may reflect the fact that Iran has announced that it will switch to referring to its foreign currency assets in Euros rather than US dollars.
We believe that these technicals are important context in the sense that the narrative is often driven from these speculative positions and has a tendency to distort our views of the true fundamentals, particularly as they apply to stocks. Thus we are told that higher oil prices and lower Treasuries (higher yields) means there must be inflation and if we throw in worries over trade, then stagflation. At this point the usual suspects say to say sell equities and buy gold (although to be fair they almost always do say that regardless of the macro event being discussed). In fact the gold chart looks remarkably like the euro chart, a sort of ‘anti-dollar’ such that gold in euros has basically gone sideways this year. However, I suspect that the rhetoric over trade has already got too hot, both in terms of what the US appear to be saying and what the market is pricing in. Hence while not being complacent about so called trade wars, we would rather see them as part of a longer term strategic repositioning of the US versus China in a geo-political as well as pure economic sense.
When it comes to macro, currencies and commodities generally have a powerful narrative about ‘somewhere else’. Currencies are bought or sold against the dollar on account of what is deemed to be happening in the UK, or Europe or Japan and in recent years, commodities have almost always been about Chinese demand (and thus speculation on Chinese GDP data) or, more recently about supply, notably shale oil. However, when it comes to bonds, it is always about the US, the Fed, the yield curve and of course the high frequency data such as the non-farm payrolls.
Currently, with the traders back in Treasuries looking for a push through 3% yields (they always like a big figure) there is talk about inflation and full employment but also much talk about the signalling that might come from an inverted yield curve, something I both agree and disagree with. I agree in the sense that it would signify a bad situation but disagree that it would be similar to something we have seen before. The idea about ‘this point in the cycle’ includes an assumption that interest rates are not only normalised but have actually been so at any point in the last cycle. Thanks to QE this has definitely not been the case. The signal from an inverted yield curve is that it ‘normally’ reflected policy tightening at the short end which is anticipated to produce a sharp contraction in demand and hence a rally (fall in yields) at the long end. This is not a good environment for equities, but it is worth pointing out that when it has happened in the past 30 year, 1988/9, 1994 (almost)1998, 2000 and 2005/6, it was largely because short rates were rising sharply, from 6% to 9% in 1989/90 and from 3% to 6% in 1994. The period 2005-6 had seen short rates rise from 1% to 5%. Currently the short end, as proxied by 3 month bonds is around 1.9%, giving a slope out to 10years of about 1%. Nobody is expecting the kind of steepening we saw back then. The authorities are highly aware of the risks. The exception to this pattern was 1998, which is where parallels to today are probably the greatest. Back then it was a short bond position in Treasuries that had become very crowded and ended with the collapse of first Russian Bonds and then in the ensuing flight to quality a squeeze on Treasuries that finished off the hedge fund LTCM. Equities were caught in the fall out and I endured months of the gloomy bond economists talking about ‘Economic Armageddon’ (literally) as a reason to sell equities. Even a rally in equities of over 60% on the S&P did nothing to shake their conviction in the forecasting brilliance of the yield curve, but then frankly I doubt if anything would. Few people picked the absolute top in the equity market that followed in March 2000 (beyond the ones that had been calling for it every week for the previous decade) but most saw the double top in early September 2000 and the inverted yield curve as the short end went above 6% and were leaving the party by end year – ironically just as yield curves turned positive thanks to a sharp cut in short rates. Thus while not predicting it, I would note that were we to actually see an inverted yield curve now, it would much more likely be a function of a distressed even within markets themselves, like 1998 and less down to over tight policy error.
Ironically this would likely make me more positive about emerging markets as a clear trend of decoupling is emerging between emerging (EM) and developed markets (DM). In the old days markets used to take a lead on Japan overnight but that stopped back in the 1990s and all the high frequency data was focused on the US and in particular what the Fed was supposedly up to. This made sense when US $ loans were driving the world economy, influencing both domestic US demand and the balance sheets of EM consumers and producers. Now, however, many emerging markets and in particular the biggest of the lot, China, are marching to a different drum, that of the PBOC. In so far as there was ever a ‘cycle’ there are now at least two competing cycles, as well as structural changes to consider. As we noted at the start of the year, and as the discussion in the opening paragraph highlighted, the PBOC is arguably now more relevant than the Fed for international investors.
Moreover, in a world where policy change is a big feature for investors, it’s about more than interest rates. At a recent meeting with David Murphy of CLSA research outfit China Reality Research (CRR) he made the reasonable point that China now has the most predictable policy environment of any major economy. With Xi now here for the foreseeable future, the plans we are already aware of; One Belt One Road, Made in China 2025 as well as the policies on financial liberalisation, urbanisation, clean energy and anti-corruption are all here to stay. Meanwhile as we discussed earlier the pace of economic reform looks to be surprising and every week seems to bring another announcement opening up the capital markets. His point is that ultimately that should lead to Chinese assets trading at a premium rather than a discount to western assets that are subject to a much shorter political cycle. That may take a while, but it is surely the direction of travel.
David also pointed out that the political power consolidation – which we have already identified as a key stepping stone for economic reform – means that there really is only one team now, team Xi. Rules are being changed and local government made accountable for meeting central government targets. Thus if Xi wants a switch from coal to natural gas (which he does) then it happens. It is not all smooth of course, the switch to natural gas produced a sharp spike before Chinese New Year, but it also produced problems for some poorer Chinese who could not switch to gas at a time of extreme cold weather. Elsewhere CRR’s bottom up survey data showed sentiment on housing to be firm and steady despite a tightening of policy, with tighter lending conditions for small and medium sized enterprises (SOEs) and a slow and steady progress in deleveraging. Entrusted loans in particular have seen their growth shrink to basically zero. These were a key part of the shadow banking system and essentially meant that banks acted as intermediaries between two non-bank actors. There is still a large stock of these (around Rmb14trn) but the growth rate has now gone to zero, which is important for more conventional investing as these Wealth Management Products (WMPs) were crowding out more typical fund type investing.
One interesting aspect of ‘competition’ that he mentioned was that some of the second tier cities such as Xian are now giving Hukou (right of residence) to college graduates without them having to actually buy property. In this they are seeking to attract talent to their cities. Hukou reform is one of the great challenges for the Chinese government in coming years and Li Keqiang has set a target of residency for around 100m of the 277m migrant workers by 2020 that looks well on its way to being achieved. While it is undoubtedly a cause of economic and social inequality and acts as a brake on progress to a highly urbanised consumer driven economy, like much of China a steady approach is preferred. Just as opening up the exchange rate would be destabilising, removing Hukou would cause a flood of homeless workers to the major cities putting huge pressure on social welfare.
Referring back to the ongoing political pressure on pollution in China, as mentioned at the end of last year, 2017 saw the entire Shenzhen bus fleet converted to electricity and every five weeks Chinese cities add a further r 9.500 electric buses – the equivalent of the whole London Bus fleet. The important point, which we have discussed before is that replacing a diesel bus with an EV equivalent is probably 30 times more effective in reducing fuel demand as replacing a car, for not only are buses heavier consumers of fuel per km, but they drive considerably more. The average bus is on the road for much of the day while they average car spends over 90% of the time parked. It has been estimated that the reduction in oil is equivalent to 500 barrels for every 1000 buses on the road, which means that this year may result in the equivalent of the whole demand from Greece coming out of the market. Chinese electric car and battery builder BYD have built 35,000 electric buses so far and believes they have logged over 17 billion km since they started almost a decade ago, saving 18 million tonnes of Co2. The next step, in my opinion, is autonomous electric buses, programmed to run 24/7, effectively providing an instant ‘tram’ network for major cities. Then autonomous electric commuter trains.
Conclusion. As Treasury yields break 3% and threaten to break through their 2013 peak, equity markets continue to deleverage and look for any excuse to take profits – of which there are still a lot – a lot of excuses and a lot of profits. This is a classic environment for the ‘Sell in May’ headlines that will doubtless start to appear soon. However, in my opinion the equity bull market remains intact, particularly in Emerging markets rather than developed markets and especially here in Asia. Thus with obvious respect to bottom up due diligence, I feel that macro selling should continue to provide opportunities to buy on the dips at the stock level. Meanwhile, with political power consolidated in China, the shift is to economic and market reform and the steady stream of initiatives coming out with respect to the opening up of Chinese capital markets should be recognised as the start of a ‘Big Bang’ initiative. Interesting times indeed!
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