Noise Traders are back and they're negative on China
Mark Tinker, Head of Framlington Equities Asia, comments on Asia Markets:
- The noise traders are back, as negative on China as they were positive only six months ago and driven by FX markets. Investors need to sit tight until they go again.
- While the rhetoric on Trump’s trade war has dominated the headlines and has now moved to ‘currency war’, the real risk for Asian investors in our view remains an accidental over-tightening of China monetary policy as part of necessary financial reform.
- The Chinese are dealing with any liquidity issues arising from de-leveraging by a form of QE and also easing back on any overly aggressive policies.
- This market (over) reaction presents an interesting opportunity in Asia of a bar-bell approach, buying high quality equity with a high yield at one end and lower quality credit with an unusually high yield at the other.
Last week we discussed the value opportunities being thrown up in Asia High Yield bonds and particularly Chinese bonds as the outflow from EM generally has triggered a run on Chinese equities (which are over 40% of the benchmark), putting pressure on the RMB. This has combined with the tightening of monetary policy as the Chinese government restructures and deleverages the banking system which in turn has caused some liquidity problems. While we believe this is actually manageable, it has meant that the noise traders, who drove equity markets up aggressively in the first couple of months of the year (before being sandbagged by a volatility spike and retreating back to their normal haunts of currency and commodity markets) are back again, only this time they are as negative on Asia equity and credit as they were positive only six months ago. Then, as now, they are taking their cue from the Foreign Exchange (FX) markets such that a weak RMB, ‘must’ mean a collapsing Chinese economy and thus they are dusting off their 2015 playbook with talk of devaluations, currency wars, trade wars and of course the old canard about debt to GDP.
To the extent that the currency tail tends to wag the economic narrative dog, it is interesting to consider chart 1. Last week we highlighted how the Emerging Market (EM) versus Developed Market (DM) relative performance tended to follow the Dollar trade weighted index (DXY) over the last couple of years. The chart shows how the net speculative positions in DXY have tracked/driven the DXY itself, from negative last June (for the first time since June 2014) to positive this June, suggesting that speculative long $ flows may be the cause, rather than the result, of negative sentiment on non US (primarily EM) assets.
Chart 1: Net speculation in DXY turns positive again, driving market narrative.
Source: Bloomberg Axa-IM July 2018
While the DXY remains in a bull phase technically (to my reading at least) it does seem to be losing momentum and to the extent that DXY is driving the retreat from Emerging Markets this may fade as an influence in the coming months. Of course, there is a lot of politics involved too and the comments from President Trump this week have persuaded the noise traders in the FX markets that it is all about them once more. Thus we hear tales of the RMB ‘falling like a rock’ to quote the President, when in reality as chart 2 shows, on a basket basis (which is actually what is targeted), the RMB is simply back to where it was a year ago. The truth is that the US$ has been strong across the board since mid-year, something I am sure the US authorities are well aware of and that net speculative positioning in the DXY is thus vulnerable not only to running out of momentum but being actively ‘talked down’.
Chart 2: RMB weakness takes the SDR weighted currency basket back to where it was a year ago
Source: Bloomberg Axa-IM July 2018
Thus for all the rhetoric about currency weakness, the Yuan is behaving more like a DM currency than an EM one. I still maintain my view that when it comes time to rotate back into EM as an asset class, many institutional investors will question the wisdom of combining China/Asia in an Emerging Market basket with countries like Argentina, Turkey, Mexico and South Africa. To repeat the point I made last week, for all the talk about a weak yuan, an index from a year ago has the Yuan against the $ at 100.8 and is no weaker or more volatile than the Yen or the Euro. By contrast, the Turkish Lira index would be at 137 and the Argentina Peso at 157. With the BRICS meeting in South Africa this week, the contrast between China and the rest will be even more heavily exposed.
This is not to say that investors should simply buy the various Chinese market indices, a focus on specific names and themes remains essential in our view. As with everything China, there is plenty of evidence for either bulls or bears. While economists argue if the country is growing at 6% or 7%, in fact half might be growing at 12% and half not at all! Exposure to the new growing China is key for growth investors. In a similar vein, the people who were saying a 25% increase in infrastructure spend was unsustainable back in 2016 are now referring to 8% growth (still growing at 8% that means) as ‘collapsing’, while the latest 9% increase in retail sales is apparently ‘a surprise’. To them perhaps, but when bottom up analysts such as the China Reality Research (CRR) team at brokers CLSA - who work on an on the ground research survey basis - estimate middle class income growth at around 6.3%, the fastest since 2013, then I am less surprised. The reality is that the mental model of China as an export-dependent or investment-dependent economy is long out of date. Indeed in the last two quarters final consumption has driven almost 80% of China GDP.
However, there is no doubt in my mind that even though growth is highly robust in many areas, China’s ongoing deleveraging is indeed producing the anticipated uptick in bond defaults the latest being Wintime energy, a coal miner which exploited the China debt markets in 2014/15, borrowing almost $11bn to expand into logistics and finance. As ever, this is not to be overly sanguine, rather to point out that policy has been in place since 2016 to prevent exactly this sort of thing becoming worse and that ultimately such defaults are ‘a good thing’.
Importantly, the correct response for investors to such data points is not one of “I told you so” with gleeful descriptions of how much more terrible everything is, but rather a sober assessment of what the Chinese authorities will do next. The (rather obvious) answer is that they will act to provide liquidity where it is needed and justified, which is exactly what they have been doing this week. In addition the State Council held a meeting this week ahead of the normal Politburo meeting and announced a series of what we would regard as positive policies, underlining the point that we made last week that necessary structural reforms will not be pursued with such zeal as to damage the underlying growth trajectory of the economy. Pragmatism, not dogmatism has been a hallmark of Chinese policy since the days of Deng and his famous quote about politics “it does not matter if a cat is black or white, as long as it catches mice”. As such, the latest announcements, which are designed to ensure existing infrastructure projects, are funded and completed and which emphasised investment while barely mentioning deleveraging will likely catch out some short positions. From a positive aspect, moves to cut personal taxes, refund VAT and significantly increase R&D allowances will all have some clear sector and stock influences. The CRR team estimate that the personal tax cuts will boost disposable income by 7-8% and that around half of that will find its way into increased consumption. This together with strong balance sheets and solid income growth indicates to us that the Chinese consumer will increase rather than decline as a secular growth trend.
Such collective pessimism in the face of still positive fundamentals is not unusual in Asia and should be regarded as an opportunity in my opinion. . With the sell-off in Asian markets since mid-June we now notice some of the stronger valuation signals appearing once again, notably when stocks have their PE trading close or even below their dividend yield. In our Asia Income Strategy for example around 3.8% of stocks have their forward earnings multiple below their current dividend yield, while 17% have a forward PE no more than 3 percentage points above their dividend yield.
Chart 3 updates an exercise we conducted last year for our Asia Equity Income strategy in the wake of this recent weakness in Asia. The Y axis plots dividend yield for Asia Ex Japan with the colour coding simply showing above or below 2.5% yield, while the x axis shows our assessment of Credit rating, with highest rating as lowest number. We have sought to emulate typical Credit Rating techniques to create theoretical ratings since most Asian equities do not have corporate debt/credit and therefore no official rating.
Chart 3: Take Credit Risk in Credit, not equities.
Source: Axa Investment Management July 2018
The Green line shows the yield curve for the JP Morgan Asia Credit Index on the same basis. This is obviously higher and steeper than last time we conducted the exercise but the key conclusion on equities remains the same; we do not need to take Credit risk in Asian equities to obtain a high dividend yield. Indeed there are many ‘high grade’ equities offering yields above the equivalent credit, with hopefully the added benefit that those yields can and will grow. However, given recent events in credit markets another conclusion appears to us. If we look at the spectrum of Asian companies presented by this universe we could make a case for having a bar-bell approach of high yielding but higher quality equities on one end and (much) higher yielding but lower quality Credits at the other end.
Finally, looking back at a recent discussions on the Australian Housing market, I notice that the Reserve Bank have identified over $500bn on interest only loans that are set to expire in the next four years. The problem is that unless they can roll it into another interest only loan, households will face having to make interest plus principal repayments, which is a huge step up in cash flow. While RBA assistant governor Christopher Kent who made the speech on the subject back in April is relatively sanguine on the overall economic impact, I would consider it rather more significant, not least in the light of recent tightening of mortgage lending in the wake of the Royal Commission enquiry. This does not to my mind suggest a 2008 US style debacle, but looks similar to earlier cyclical housing bubbles driven by easy access to liquidity that suddenly becomes tighter. As the highly regarded Australian Economist Don Stammer always says, the cycle lives on. In a world where people either believe nothing will change or alternatively that everything will change in a dramatic fashion that (along with his faith in the power of compound interest) remains one of the key investment insights.
Shadenfreude (taking pleasure in the misfortunes of others) was certainly evident after the dismissal of Germany in the qualifying rounds of the World Cup, but is also clearly on display in some of the commentary about brokerage houses and their attempts at predicting the winners. Top of the list come Goldman’s, who actually did us all something of an accidental favour in their presentation of their forecast in the context of Artificial Intelligence and Big Data. Apparently they used machine learning to run 200,000 models and concluded that Brazil would beat Germany in the final. This of course was pretty close to an ex-ante consensus view – which questions the need for the 200,000 models – but was of course, delightfully wrong as the World Cup saw most of the big favourites eliminated before even the quarter finals. Interesting that the eventual winners, France, were tipped more highly than Germany with the bookmakers, something that we often see with bookmakers odds being superior to opinion polls in politics and suggesting that, for now at least, the weight of money remains a superior methodology. This is not to dismiss AI in our industry or others; there are many opportunities for co-bots to make humans more efficient, but not (yet) to replace them. Certainly the likes of Goldman’s and Morgan Stanley with record profits this quarter are not worrying too much about their football predicting capability!
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