Market Thinking - Party Politics, People and Policies

18 October 2017
  • The big meetings in Washington at the IMF and World Bank no longer count for much in Asia. It’s all about the 19th Party Congress and while this is more about people than policies, the two are obviously interlinked.
  • The wars on corruption and pollution will continue, but it’s the big thematics of the digital consumer, ‘Made in China 2025’, One-Belt-One-Road and the building of a financial service infrastructure that will drive growth and earnings across the region.
  • Asian markets are hitting new highs even as they de-couple from the west, but in total return terms, Asian equities look even more attractive as they compound up healthy yields and strong dividend growth.

It’s thirty years since the crash of Black Monday and it’s a very different world. Thirty years ago, China had a gross domestic product (GDP) of $253bn, which is less than the GDP today of just the city of Shenzhen and the big bang in financial services in London and New York was transforming a bank dominated world to one focussed on capital markets. Back then, with the recent legacy of a sovereign debt crisis, a big meeting in Washington between the assorted members of the International Monetary Fund (IMF) and the World Bank would have probably been the key focus of markets, even here in Asia, where the economies and markets have traditionally depended on the strength of the west in general and the US in particular. However, this no longer appears to be the case as the main focus here in Asia is clearly on the 19th Communist Party Congress in Beijing and the rest of the world is now also starting to pay attention. The old expression that when the US sneezed the rest of the world caught a cold is no longer accurate. In Asia, China, not the west, is what matters now. This Congress takes place every five years and is the second Congress under President Xi and it is widely expected that he will have used the occasion to consolidate his power. The occasion is more about people than policy - although obviously the two are linked - with as much as 70% of the top party positions being turned over, whether it is among the 350 members of the central committee, the 25 members of the Politburo or the top seven members of Politburo standing committee. The one position that won’t change is the President.

There is nevertheless ample speculation in the media and markets about policy. As usual, many of the possible initiatives being discussed in the western media reflect the west’s own obsessions with issues such as fully accessible capital markets, currency convertibility, state-owned enterprise (SOE) reform and insights into the direction of monetary policy. This is not to say that they won’t be discussed, but if the last five years under President Xi have taught us anything, it is that he cares little for a western imposed timetable of reforms upon China. This was a point I made at a dinner here in Hong Kong this week with Eswar Prasad, Professor of Trade Policy and Economics at Cornell University who was here in the context of his former role as head of the China division for the IMF. Even though it is quite an uncomfortable thought, perhaps we need to recognise that the prescriptions from the IMF and the other institutions of the Washington Consensus (WC) are no longer (so) relevant for emerging markets in a world increasingly dominated by China?

Under Xi, the Chinese economy has not only expanded, but seemingly done so in a more balanced manner than many western economists predicted, ‘despite’ not following the WC recommendations and while many (including many at the US investment bank hosting the dinner) continue to cling onto their framework, it seems clear to me that China will continue to form its own priorities and run to its own timetable. To the extent that it is the job of market analysts to try and predict what government ‘will’ do rather than what they personally think they ‘should do’ this is an important point of introspection.

Even though it has undergone spectacular GDP growth, China is still undergoing its transition from a bank dominated economy to one more involved with capital markets, and reforms need to be viewed firmly in that context. The Chinese clearly saw a priority in getting the renminbi (RMB) into the special drawing rights (SDR) basket this time a year ago and convertibility was advanced just enough to achieve that. Now it will slow down, however loudly the East Coast hedge funds insist it should speed up. Similarly the initiatives on the Stock and now Bond Connect are meeting Chinese needs for controlled outflow and diversification, not western needs to make profits in China. It’s not all about us. The Chinese need western capital for its associated skills in price discovery and valuation, they need the flow, not the stock as they have plenty of savings. Professor Prasad highlighted the trend of a falling savings ratio, but it is still over 45%. The challenge is to allocate internal savings, not somehow attract foreign savings. China has a savings surplus; it does not need to borrow from the west, which is why simplistic measures such as debt to GDP need to be treated with caution. This nevertheless remains a mainstream WC obsession and as Bloomberg pointed out recently, Federal Reserve (Fed) governor Jerome Powell has apparently “singled out China as the poster child for heavily indebted corporate sectors in emerging markets”. Given that Governor Powell is a favourite to succeed Janet Yellen, this may be a pointer to future Fed concerns, although in the context of an emerging new world order, perhaps we should be more concerned about who will be the new governor of the People’s Bank of China (PBOC)?

Arguably, this is already happening as not surprisingly, over in Washington a G30 meeting held to coincide with the IMF and the World Bank meetings was also dominated by China as outgoing PBOC Governor Zhou Xiaochuan discussed the need for Chinese companies to deleverage. As I have suggested before, a lot of the speculative panic over China in 2016 was based upon a mis-reading of the Chinese national balance sheet and the notion of a ‘debt bubble’ and it was interesting to note that beyond the headlines of China de-leveraging and debt bubbles were some valid comments from Governor Zhou about not confusing corporate debt of SOEs with what is really local government debt. This is not to be complacent, but rather to understand why the Chinese do not obsess as much as the WC does about these numbers. More important it points to a different path for policy.

The notion of building a system rather than simply targeting GDP extends to the building out of a fully functioning financial services sector. Currencies will be made fully convertible, but not straight away, similarly with SOE reform. At the previous Congress, two of the key initiatives were to allow the market to play a decisive role in allocating resources and to establish a modern financial system and both of these remain central to opening up financial markets. This includes home grown institutions for allocating capital. The Asian Infrastructure Investment Bank for example is now in direct competition with the World Bank, while other initiatives such as the BRICs conferences and the Shanghai Cooperation Organisation (SCO) are challenging the traditional roles of the IMF, OECD (Organisation for Economic Cooperation and Development), G7 and so on. The SCO for example, has eight members that between them account for approximately half of the world’s population, a quarter of the world’s gross national product (GNP) and 80% of Eurasia’s landmass.

Although China’s big bang has a long way to go, we have already seen significant progress in Chinese savings and investment markets away from the dominance of the big banks, while new players have appeared in areas such as digital payments, money market funds and the various Stock and Bond Connect programmes with Hong Kong. In terms of monetary policy, prior to the 19th Congress, the authorities made an announcement on bank lending reserve requirement ratio (RRR) that won’t actually apply until next year, but is part of a plan to direct bank lending resources away from SOEs and towards small and medium sized enterprises that have traditionally had to rely on the informal shadow banking sector. There remains much to be done of course and it is not without uncertainties and risk, but the key is now that it’s China sneezing that we all need to worry about.

Even here though it is important to look beyond the scary ‘China has too much debt’ headline and, as PBOC Governor Zhou pointed out to the audience, there is a need to define more accurately what is really corporate debt and what is actually local government financing. Back in the days of GDP targeting it was very common for local governments to build things - central business districts, airports, mass transit railway systems, public housing, motorways and so on and to fund it through debt issued by local banks. A lot of that government debt is thus mis-classified as corporate debt. Correctly identified, government debt to GDP would rise to 70% from 36%, while corporate debt would fall from 160% to 120% according to Governor Zhou. This is not to be complacent, but is a further word of caution for those trying to boil everything down to a single number like debt to GDP. Moreover, as that one year rolling debt to fund a motorway gets turned first into 10 year bank debt and then into 10 year asset backed securities we will find ourselves with new assets into which the new long term savings vehicles can start to invest. This is the ‘build a finance sector’ story.

Elsewhere, the anti-corruption measures will not be scaled back as many had predicted, similarly the focus on reducing pollution. These are arguably the two issues that most upset the population and dealing with them is thus central to maintaining peace and stability, itself a primary aim of the party. One chart that sums up these two themes would be the long electric vehicle (EV) anti-pollution play, BYD, and the short anti-corruption Macau play, Galaxy.

Chart 1: Anti-corruption and anti-pollution still a thematic call

Source: Bloomberg October 2017

The black line shows battery and EV play BYD, while the gold line shows the previous ‘hot’ Macau Casino stock Galaxy, whose founder was briefly the richest man in Asia in early 2014 (something we noted as a strong sell signal at the time). Even as late as the end of 2014, Macau fans were still talking of an imminent end to anti-corruption measures, while traditional car companies were dismissing EV as a short lived fad. While anti-corruption is not going away, the impact on Macau stocks is now more muted than in the days when Galaxy fell from almost HK $80 to below HK $10, as expectations have reset and the dependence on high rollers from the mainland declined. What it does represent however is an ongoing headwind for the sub-sector. By contrast, the recognition that lowering roadside pollution is a priority for the Chinese government has turned anti-pollution measures into a tailwind for EV plays such as BYD and EV cars.  

In addition to these, we would suggest continuation of a number of other tailwind initiatives that are already well known, such as ‘Made in China 2025’ or the One-Belt-One-Road initiative of port and rail infrastructure across Asia. Investors everywhere are already starting to take these initiatives much more seriously as thematic drivers of returns and this will only continue.

Meanwhile as we pass the 30th anniversary of the stock market crash (and the equivalent anniversary of my first week in stockbroking), nerves once again turn to portfolio insurance and its ability to turn things upside down, especially as we look ahead to the prospect of the Fed shrinking its balance sheet, if not a full ending of quantitative easing (QE). Last week we discussed how the market for mortgage backed securities meant that the traditional buyers would often develop a powerful momentum trade while hedging thanks to the peculiarities of the underlying instruments. In effect the hedgers were buying more on the way up and selling on the way down. This week we look once again at our old friend XIV, the exchange traded fund (ETF) that tracks the inverse of the VIX implied volatility index. We can see that after a healthy correction back in the summer (that encouragingly did not lead to a rout) the index is once again hitting new highs, so (my) nerves are stretching once more.

Chart 2: The inverse VIX - better known as The Greed Index?

Source: Bloomberg, October 2017

To reiterate, the concerns that I have here is that the (largely retail) investors buying this fund, which is one of the largest ETFs out there, are chasing a momentum trade, not exactly like bitcoin, but not far off in terms of ‘a guaranteed winner’ and a ‘no brainer’ among the day trader community. However, what they are effectively doing every time they buy a unit is to sell volatility short, or more accurately the ETF provider is doing that on their behalf. This time thirty years ago we discovered the UK retail banks had been lending money to individuals who were selling puts on the market (after all it was only going up?) such that when it fell they didn’t have the collateral to meet their obligations. In effect the buyer of portfolio insurance found that the counter-party to their risk management had no capital and thus the hedges not only no longer existed but in their desire to hedge they were creating a leveraged momentum trade instead! This looks eerily similar, volatility is low not because investors are not concerned but because of the surplus of sellers of volatility, most of whom do not really understand what they are actually doing.  This does not represent a fear index, it represents a greed index.

To conclude. The established worldview expressed by the institutions of the Washington Consensus is being increasingly superseded by a new model, as China grows and develops following its own rules, something that this week’s 19th Party Congress is making very clear. Who takes over at the PBOC may now be more important than who takes over at the Fed in terms of global growth, although the pace and impact of a long overdue unwinding of QE is probably one of the biggest risks to financial market positioning. At the same time the globalism the institutions represent is coming under attack at home from an administration that believes in bi-partisan deals rather than the US funding a ‘global community’ and while this is obviously upsetting for those at the centre, as investors we need to remain pragmatic outsiders and importantly recognise that we need to anticipate what people ‘will’ do rather than what they ‘ought’ to do. In contrast to those political headwinds, Asia generally and China in particular is driving the tailwinds of economic growth and the clarity and vision of policies here is in stark contrast to the heavily politicised deadlock in Europe and the US. Tailwind themes such as anti-pollution, financial sector reform, One-Belt-One-Road and ‘Made in China 2025’ all have a strong top-down element while others such as the digital consumer and automation are more bottom-up, but all offer interesting stock thematics. Meanwhile as headline numbers point to new index highs, we shouldn’t lose sight of the fact that much of North Asia also has high and growing dividends, backed by strong cash flow and sound balance sheets. As such the total return story (including re-invested dividends) seems to demonstrate in my view an even more powerful argument for Asian equities.

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