Market Thinking - The long term view on China

  • The markets are already positioning for the new quarter/financial year. Traders have retreated from leveraged long equity positions while investors are hedging/taking profits. In bonds, the extreme short positions look vulnerable to a squeeze.
  • The economic data is likely to slow a little, which together with other perceived risks around a trade war is likely to shift the narrative from optimism to caution. The rise in Libor will likely continue to undermine leveraged products.
  • A number of recent trips to China, meeting economists, officials and investors reinforces the view that there is great potential for upside surprise on economic reform and that international investors need to seriously think how they are going to position themselves to ‘play China’.

The markets effectively began the second quarter/new financial year following the options expiry last week and clearly moves by underlying investors to hedge and the traders to either not roll or even cut long positions has shifted sentiment to the sell side, in contrast to the semi euphoric long call trades put on at the turn of the calendar year. The latest round in the trade ‘wars’ announced this week has been the proximate cause, but as we have seen with the reaction to the Facebook data issue, the mood is generally more nervous and the instinct to take profit after a tremendous 2017 for many is heightened. Meanwhile, with the high frequency data so beloved by macro traders - and even more loved by the algorithms that seek to mimic them - showing some slowdown, it looks like we might get a short squeeze for the bond bears. To use an old traders’ expression, on a number of big macro trades like short dollar and short Treasuries, the short positions are such that they are said to have ‘got over their skis’ a little. Any short term rally could upset a lot of the ‘no brainier’ consensus trades and a scramble for short covering combined with weaker short term economic data could easily have the narrative switched to ‘slowdown’ for Q2. Equities have remained resilient in the face of higher bond yields because of strong cash flows. In the light of opinion switching back to gloom (and not forgetting that the economic narrative is often targeted by political actors) a focus on positive cash flow at the company level should in my view offer downside protection.

Meanwhile, it is perhaps worth repeating a couple of points from the year ahead piece we wrote. We have already seen the impact of an unwind of some of the short volatility strategies that we discussed back then with the implosion of the reverse Vix ETF XIV in early February and it looks like the aftershocks are still reverberating through markets. The VIX is often referred to (incorrectly in my view) as the ‘Fear Index’, but it is perhaps better regarded as the price of put options. At the start of the year, traders had jumped into equities with leverage and were very long margin and call positions such that the skew between the cost of puts (cheap) and calls (expensive) was very wide. This was exaggerated by the strategy of selling volatility that was embedded in the managing of the reverse ETF for the VIX, the XIV. Back then I referred to XIV as ‘the Greed Index’ since effectively it was a momentum trade that had become very crowded. It’s unwinding triggered the sell-offs we saw in February and post the options roll-over it seems the traders have well and truly left the building on this one, suggesting we have seen a peak in that type of leveraged carry trade. However, a second point that we mentioned was the inexorable rise of Libor, see chart 1, which as previously noted is perhaps best thought of as the raw material price for leveraged and structured products.

Chart 1: The inexorable rise in Libor, the ‘raw material price’ for leveraged products

Source: AXA IM, 26 March 2018

In percentage terms, this ‘raw material cost’ is up 35% year to date and must be putting a whole range of quanitative easing (QE) products, that essentially take a relatively low yielding and low volatility asset and ‘juice it up’ with leverage,  under serious pressure.

Here in Asia, the talk is naturally of trade wars, which are taken seriously because the economic impact of the rhetoric about China is really in wider Asia. China’s trade deficit with the US reflects a lot of ‘re-exports’ - imports that are then sold on with only modest value added - from Taiwan and South Korea mostly but most of Asia is in the supply chain somewhere. Asked by an audience in Thailand last week about trade wars my first response was to repeat the (helpful) mantra I heard from a year ago about President Trump, that it is sensible to take him seriously but not literally as opposed to the other way around and to point out the economic realities; that steel and aluminum tariffs, as well as raising prices for domestic US consumers can actually do more damage to Canada, Mexico, Europe and South Korea than to China (a point I made in the previous note) and that almost by definition, the Chinese response would be limited (albeit targeted) for the very reason that they don’t import ‘enough’ from the US to have much impact.

As the news cycle has unfolded it has become clearer (to me at least) that this rhetoric is part of an ongoing ‘new deal’ by the Trump administration to use its economic, rather than its military, power to try and reset relationships to better favour the US. This has always been President Trump’s stated aim, to renegotiate the various global institutions and agreements that used to benefit all Americans but now seem only to favour a global elite. He wants a reset to once again benefit the whole of the US. He threatens to pull out of North American Free Trade Agreement (NAFTA), the Trans-Pacific Partnership (TPP), the United Nations (UN) and even the North Atlantic Treaty Oranisation (NATO) and waits for the response. If it isn’t forthcoming quickly enough, the rhetoric increases. The steel and aluminum tariffs look to be aimed more at Canada and Mexico to renegotiate NAFTA in the same way that last year’s rhetoric about China appeared to not only promote some important moves on allowing US financials access to China as well as a deal on importing US liquid natural gas (LNG), but also appears to have achieved some traction on North Korea. Talking to some US economists based in Beijing last week (see below) it seems that this is more about setting the ‘rules’ for the new economy - electric vehicles, digital pavements etc. - than protecting jobs in the old economy. Thus if we look beyond the foreground noise on tariffs, we can see manoeuvring going on in the background to do with not only intellectual property issues, but global standards in the digital world.

This is something of a ‘notes from the road piece’ as I have been travelling almost nonstop since the last note and wanted to commit some thoughts to (electronic) paper before everything gets lost in the Easter break. I am writing this from what feels like the middle of nowhere, in the far south west of China in the Yunnan province on the old southern Silk Road, where I have been invited to address a high ranking group of Chinese investors on the view of international investors on China in the light of the imminent A Share inclusion in the MSCI indices. My view, briefly, and for what it is worth, is that the widespread perception that it will bring a wall of passive money into Chinese markets is fundamentally misplaced. Certainly trillions of dollars of international investments are notionally benchmarked against the MSCI indices, but that is very different from saying that they actively track them. Issues such as free float, ownership and liquidity are the reasons why the initial weighting of A Shares into the MSCI emerging markets index is going to be nominal, but to say it doesn’t matter is to miss the point in my view. Index inclusion is but one of a number of forces coming together to catalyse a meaningful shift in the international investors’ mindset towards China. More important I believe is the economy itself, the progress not only in the level of GDP but the shift to ‘China 2.0’ requires a different type of investment while the building out of a hybrid banking/capital markets system as opposed to a pure banking model for savings and investment means that investors are keen to get exposure to ‘New China’ just as they wanted exposure to the new economy during the TMT boom in the west in the mid to late 1990s and, despite the dot com bubble have remained focused on new economy equities ever since. The fact that China is (currently) not very correlated with other equity markets is certainly attracting the attention of a number of institutional investors - who have rightly in my view become skeptical of the view that either benchmark tracking or low volatility is the essence of risk management - while the fact that the MSCI China was up over 50% last year has grabbed the attention at the retail level.

The problem for investors therefore is which benchmark to use if you want to ‘invest in China’? To date, most have been happy to bracket greater China (including Hong Kong and Taiwan) and do it through an emerging market index or fund - hence the focus on the A share inclusion in June. But the reality is that the inclusion is more about signalling than anything else. Today, the MSCI emerging markets index is already 40% greater China and much more exposed to technology than basic industries as it was in the past, as can be seen from the following snapshot of the i-shares EEM ETF that tracks the index.

Chart 2: The emerging market benchmark is already heavily skewed to Greater China and technology

Source: AXA Investment Managers, 26 March 2018

As such, inclusion of a modest amount of A shares should not really change the way an active manager constructs his portfolio and could likely have only a very marginal effect on the big ETFs like EEM that currently replicate the indices. It is important here to differentiate between people who use the benchmark - to measure performance mostly - and those that seek to replicate it and it is also important to recognise that China doesn’t need western money; it has plenty of savings and it certainly doesn’t need a flood of index tracking  money. I think it needs ‘smart money’ through actively managed funds that help to price Chinese assets at the margin.

Another factor driving interest in China is of course the politics. The announcement that the Chinese constitution would be amended to remove Presidential term limits appears to have got a lot of commentators in the west very excited, with much talk about a walking away from democracy, but it also appears to have concentrated minds that not only does it look like President Xi is going to be around for a long while yet, it also means that the idea that as an international investor you can somehow ignore China as ‘too complicated’ is no longer viable. It was against this background that I have just been on a timely macro tour of Shanghai and Beijing with the economics team from Citi, doubly timely in that last week was the National People’s Congress (NPC) in Beijing which not only votes on the measures such as the end to term limits, but also the individuals set to become ministers, all the way up to the President.

The western consensus seems to be that China may now be closing a door on both political and economic reform. The context is that a few years ago the west saw some early signs of political reform and welcomed them as a precursor for economic reform - the idea that more democracy would mean more ‘opening up’ of Chinese markets. However in the last couple of years they have observed a slowing, indeed apparent reversal of their wish for political reforms while being frustrated at the lack of what they see as economic reform. The removal of term limits has therefore been seen by many in the west as not only abandoning a democratic symbol, but as China closing a door on all reform. However, as with much of the western observations on China over the four and a half years I have been here in Hong Kong, I feel the need to disagree.

As with most things, and certainly most things in China, the situation with the term limits is rather more complex and nuanced than it might at first seem and I was grateful to get the insights from some of the think tanks in Shanghai as to how they saw the situation. Firstly, as one pointed out, there is actually no limit of the term of the Leader within the Party Constitution and thus to some extent it could be seen as aligning with the Party but second and more importantly, that far from regarding the change as providing unlimited power, it should be recognised that it delivers at least some power. The current set-up actually makes for weak government, which many here view as incompatible with the need to deliver meaningful change. For example, unlike, say, in the US, an incoming Chinese President has inherited his ministers from his predecessor and cannot immediately change them and thus his first term tends to involve an inability to change much in the status quo. There follows a brief period of power at the start of the second term before everyone starts to focus on the next man in line. Because Xi is focused on achieving economic change, they argue, he actually spent the first term on political change, establishing his power base, which now leaves him able to focus on the economic reforms that everyone had been calling for. The plans for reform were clearly set out at the 18th Congress at the start of Xi’s first term, but he recognised that to take on the vested interests he needed to be stronger, hence political reform came before economic reform, rather in the manner of “put on your own oxygen mask before attempting to help others” (you can tell I have been on too many airplanes recently!) In Shanghai and Beijing at least it was seen as meaning that now there is no distraction of a successor. If Xi is here for an indefinite period, then the vested interests have no option but to accept that there is a new status quo. As the China Daily put it recently, the delegates at the NPC are ‘applauding a new era’. Ironically, by consolidating political power, Xi can now deliver the very economic reforms that the west sees as ‘good’.

This also applies to international investors of course, there is no pretending that China will somehow ‘go away’ and our clients and investors from Japan to Europe and even in China itself are trying to work out how best to invest in what we are calling ‘Evolving China’. As ever, we should wait to see what he actually does, but I feel right now the consensus is potentially under-estimating the prospective for meaningful economic change over the next 5 years and we know that in markets, being more confident about the 5 year horizon is where value can be found. One expression kept appearing at all the meetings that we had which was ‘innovation’. Innovation is seen as the way of ensuring stability by providing new jobs when the inevitable reform of the state owned enterprises (SOEs) and so called ‘zombie‘ companies begins, while innovation is also seen as a key part of shifting the economy away from production and toward consumption. At one meeting in Beijing, the speaker asked us what we thought had changed since we were last in China and my reply (again for what it was worth) was not only the physical aspects, especially in Shanghai, which ever more resembles something from a science fiction movie, but in the attitude. People want to fix things and make them better. This was echoed by a friend and former colleague in Beijing who observed that over the last two or three years people in China are constantly coming up with solutions to make life easier rather than regulations to make things harder. Just as the west refers to China as ‘not a market economy’ while simultaneously fixing the price of everything from interest rates to labour, so it is ironic that China, while still restrictive in many ways is nevertheless allowing innovation to solve day to day problems. In the west many such innovations are sometimes threatened by vested interests. It is not all perfect of course; the four and a half hour 1000km ride on the ultra-impressive bullet train from Shanghai to Beijing was rather let down by the fact that the coach could not get within half a mile of the station to transfer us to the hotel and the traffic remains horrific at times, but the ‘on the ground’ experience is notably different from when I arrived four and a half years ago.

As well as talking to think tanks we met with many of the officials and economists in the government agencies like SAFE (who manage the foreign reserves), the China Foreign Exchange Trade System (who operate the foreign exchange markets) and the China Development Bank who play a key role in the One Belt One Road initiative. We also me with the People’s Bank of China (PBOC) and the financial affairs office in Shanghai, both of whom essentially wanted to know ‘how can we help?’ The end of the tour was a dinner with some of the economists from the US embassy who, as mentioned earlier, were very much of the opinion that a real trade war was in no one’s interest while acknowledging that the surprise developments in North Korea were clearly largely down to pressure from China.

Overall, the advantage of meeting the investors as well as officials and economists involved in the day to day practicalities of trade and real politics is that they are far more pragmatic than the (occasionally hyperbolic) viewpoint from the armchair trade warriors and the macro traders that both follow and use them. As I pointed out to the investors in Tengchong, the real story on China is not the technicalities of A share inclusion in a western benchmark, but the inclusion of China generally in international portfolios. The moves that will allow that eligibility - free float, ownership, liquidity etc. - are actually the changes that will define the opportunity set for investors in the next few years.

Finally, an interesting final twist to the political reform saga came from Dr Gary Liu of the China European Business School in Shanghai. Not only does he think political reform in China will now be put on hold for a decade or more, but he also believes that, having taken ‘superman’ powers in order to build the Chinese economy in the manner of Lee Kuan Yew in Singapore, President Xi will not only step down, but will actually re-instate the term limit before he does so. 

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