Market thinking

US outperformance over China has not only ceased, but reversed

Interesting to note that after we discussed last week how the last surviving equity bull markets were pulled in to test their long term moving averages ahead of the options expiry, they seem to have broken down this week. I suspect that this is classic portfolio insurance at play, investors having bought puts close to the long term moving averages then effectively ‘sell’ to the investment banks as those levels are broken and the IBs then scramble via their delta one desks to cover their positions by selling futures. At the same time, the risk parity funds have likely been triggered by the spike up in the VIX implied volatility index (often referred to as the Fear index, but in reality it is better thought of as the price of puts) to automatically sell equity. We saw similar behaviour back in mid-2015 for example. However, as chart 1 shows, the spike in bond volatility (particularly bond volatility which was falling all last year) means they are probably switching to cash, which is now a genuine ‘alternative asset class’.

Chart 1. As bond and equity volatility spikes, passive and semi passive funds may switch to cash.

Source Bloomberg Axa-IM, October 2018

Such behaviour then triggers other automated selling from passive investors leading to a liquidity mismatch for a period.

One potential silver lining from all this is that the outperformance of the US over the Chinese equity markets we discussed last week has not only ceased, but reversed. While some might attribute that to last week’s comments from assorted Chinese government officials, who appear belatedly to have recognised the importance of the stock market to business if not consumer confidence. If we look at Chart 2, we can see that it actually peaked in mid-September and the relative has moved almost 10% since then.

Chart 2: US outperformance of China reversing?

Source Bloomberg Axa-IM, October 2018

The reason for referring to it as a silver lining is that, in my view, the relative strength of the US versus China as measured by stock market performance appeared in some quarters to be some sort of market vote of (relative) confidence in US trade policy – implying that somehow the US would benefit and others (not just China) be the losers. Most market participants, including myself, do not see that to be the case and it is to be applauded if policy makers also come to this viewpoint.

Incidentally we can also see that this week we see that WTI Oil price has also broken its long term moving average, off around 13% so far this month and tending to suggest perhaps a cross asset de-leveraging. This may also, finally, be the inverse correlation with the US Dollar kicking in as the DXY, trade weighted, index is one of the few tradeable prices above its short and medium term trend lines as well as its long term one. It is also probably why it is one of the few ‘conviction trades’ I heard from a macro trader the other day.

Weak US Dollar was a key driver for emerging markets last year and this year the inverse is clearly true. And for EM, read China, which the macro traders appear to be trading as one and the same thing. One of the things we like to look at is the correlation between various stocks and macro variables, and particularly how they change over time. If we look at table 1, there is a simple, weekly correlation matrix of BMW and BHP Billiton and a number of what most would regard as ‘China Plays’.  In order, they are the Shanghai Composite, Great Wall the Chinese auto maker, the copper future, the Australian dollar, the VIX implied volatility index, the I-Shares emerging markets ETF that tracks the MSCI Emerging Market index, the Iron Ore price, the JP Morgan emerging markets currency index and finally the I-Shares China large cap ETF that tracks the FTSE China 50 Index.

Table 1: China plays, correlations since 2016

The first thing we can see with reference to both BMW and Billiton is that they are more highly correlated with the ETFs on Emerging markets and large cap China than they are with things we might have expected. BMW is seen by many to now be a China or emerging market play and indeed, BMW is more highly correlated with the emerging market ETF than anything else. However, BMW is more highly correlated to BHP for example than it is to its Chinese competitor Great Wall. In the same way, despite Iron ore being responsible for the majority of BHP Billiton’s earnings, the correlation is quite low compared to that of copper (incidentally the same is true of Rio Tinto – not included here- where Iron ore earnings are five times that of copper). In my view this is likely to be because the copper price, like the Australian Dollar, is one of the favoured macro plays for those speculating on China, so we are observing ‘fast money’ at work (or play).  If we take a slightly longer term correlation, say monthly, the correlation between mining stocks and their ‘fundamentals’ such as iron ore does pick up significantly however, as does the influence on BMW of other more fundamental variables like the PMI surveys. However, a change of time frame barely affects the strongest correlation in the whole table, which is that China and EM are almost 90% correlated as far as the FXI FTSE China 50 ETF is concerned – indeed the correlation exceeded 90% back in May this year. Thus although the high inverse correlation with the VIX (higher than with the Shanghai composite for example) suggests that both ETFs are regarded similarly as ‘risk assets’, it means that fears or concerns about emerging markets or even simple rotation and profit taking in emerging market equities have translated into selling large cap China, which has fed a false narrative that there is something fundamentally ‘wrong’ with the Chinese economy. It is a desire to correct this rather than to prop up the market per se that has in my opinion promoted the Chinese authorities to comment this week.

Chart 3, shows how that very significant correlation between the FXI and emerging markets evolved over the last two years and puts it in the context of the longer term.

Chart 3: China and Emerging markets seen as the same thing by traders

Source Bloomberg, Axa-IM October 2018

In fact as we can see, such a close correlation is more the norm; the recent increase in correlation has largely come about as a result of the dropping out of the 2015 boom/bust in China markets. Meanwhile, the highest correlations for the JP Morgan Emerging currencies index  - Turkey, Russia, Hungary, South Africa, (all 8.3% weight) and then Brazil, Mexico, Chile, China, Indonesia and Singapore (all 11.1% weight) is not actually with the Emerging Market Equity ETF – although it is close, but with the Australian Dollar. Again, back in May this reached 0.73.

The second table looks at how these same variables were correlated in the  two years prior to this, i.e. 2014-2016, when of course everything in Asia was largely going up and we can see that they are not entirely symmetrical. Emerging market currencies for example were all heavily correlated with emerging market equities – weak dollar was helping lift all boats – while stocks like BMW and BHP were even more highly correlated with emerging markets and also more sensitive to falling volatility. ‘Risk On’ meant a buy all the China trades enthusiasm. Notice also that the correlation between China as represented by the Shanghai Composite and emerging markets was a lot lower, at 0.32 versus 0.59 in the first table, but as represented by the China 50 ETF, FXI it was little changed at 0.85 versus 0.89. In other words the buyers of onshore China took a different view than the buyers of offshore China. (In fact, much of this was probably a Tencent effect) Interesting that Iron Ore prices were largely negatively correlated with other variables over this period, (monthly or weekly) while copper was also much less correlated across the board. This was a weak dollar story, not really a growth story.

Table 2: The trouble with correlations, they are not stable.

This of course is the problem with correlations, although directionally they may be relatively stable, their strength can vary enormously so as to make trading them very difficult – not least because the real value of a model is for moves in variable 1 to predict moves in variable 2 to let you make money!

For this exercise however, what we are trying to discern is how the markets are connecting various prices. Between 2016 and early this year what we seem to have experienced was a weak $ driving up all emerging market currencies and with it emerging market equities. So called ‘China stocks’ like BMW and Billiton went up along with the offshore ways of ‘playing China,’ like the FXI ETF. The correlation with VIX highlighted the strong beta effect and explains the proximate cause for the reversal – as discussed at the time the spike in the VIX in February this year. But just as the up side wasn’t about fundamentals, nor is the downside. Bottom up comments this week about Chinese demand from companies like Treasury Wines (“fantastic”) or Gucci owner Kering reporting a 35% rise in sales in Q3 are consistent with the strong data from last week’s China GDP data.            

It is important therefore not to confuse market moves with predictions on fundamentals. As far as China is concerned, there are a number of important things happening in the real world at the moment. First we should note that there is a large expo going on in Shanghai – almost certainly no coincidence that this China International Import Expo is scheduled just ahead of the US midterm elections, with a keynote speech by President Xi on November 5th. Perhaps Xi will use the occasion to make some (politically useful) concessions to Donald Trump? Alternatively he may allude to the situation depicted in the following map?

Chart 4: Chimerica and the New World Order

Source Parag Khanna 2016

The map shows the importance to other countries of China as compared to America. China is the largest trading partner for almost twice as many countries as the US is, so if it is a case of ‘them or us’ (US) then a lot of countries might feel the need to say, “sorry, but it’s them”.

The second interesting point to come out in news this week was the announcements around personal taxation. Reform of the tax system is a key part of the China development plan and this week’s announcements reinforce the point that the consumer is now very much at the heart of the economy. This was a point I made last week on Bloomberg TV when discussing the latest China GDP numbers, written off by the usual suspects as slowing dramatically while still delivering 9.4% nominal GDP and 9.2% year on year growth in retail sales. Indeed, the real GDP number of 6.5% described as ‘disappointing’ was almost twice the level of 3.4% predicted for q3 in the US and described as ‘stellar’. For the last few quarters, Chinese GDP has been dominated by the consumer and this is not by accident, it is by design. Exports, while as the chart above shows are very important to the rest of the world, are less important to China than they used to be, while investment, having been deliberately slowed down, is higher, but in high single digits, not double digits. The original opening up policy that began 40 years ago next month was based around exports and what was known by economists as ‘consumer repression’. Wages, interest rates and the exchange rate were all held down to deliver the growth in the export sector needed to fund phase 2, which was the investment and infrastructure boom that came to a particular head with the spike in 2009/11. Since then it has all been about shifting back to the consumer. The tax changes announced this week are consumer friendly and are focussed in the blue collar emerging middle class. Essentially they are deductions for basic ‘desirable’ consumer spending such as Children’s education, medical, mortgage relief (first home), rent deductions and deductions for expenditure on parental care. This is consistent with the broader message we have highlighted before; this is about sharing wealth to the masses. Investors looking to top tier cities as the barometer of the country’s wealth are missing a bigger picture.

One striking thing about the earlier map – Chart 4 – is that the blue lines from the US barely touch Africa. This isn’t exactly news, but it came up in a fascinating conversation I had earlier this week with my colleague Simon Weston here in Hong Kong about the mining developments in Africa. Simon had been at a small conference of mainly Australian miners and, as is always the case, they all have a great story to tell and a great product to sell. In this instance he was talking about Lithium, which is apparently available in great quantities from this particular site in the Democratic Republic of Congo (DRC), a country that is also seen as key for the other tech minerals such as cobalt and coltan/tantalum. Chart 5, is an excuse to republish the One Belt One Road map, but in this sense focus on Africa and note that the Chinese have established a port at Dar es Salam and are building road and rail links across Tanzania. According to this mining company they are also building a proper road from this mine for products to reach the western shore of Lake Tanganyika, thence to barges and onto the rail link from the eastern shore across Tanzania and onwards to Dar Es Salam. While the west complains about OBOR loading foreign governments up with debt, the infrastructure is getting built which will benefit more than just the Chinese importers of Cobalt and Lithium. Lack of road infrastructure is a massive impediment to all sorts of elements of growth.

Chart 5. One Belt One Road spreading to Africa

In a similar fashion, a few months back the government of the DRC announced plans to start the much delayed Inga 3 Hydropower project in the west of the country, designed to produce 11,000 megawatts and predicted to cost $13.9 billion according to Bloomberg reports (although this is likely to be a low ball estimate) and this week the parties actually signed an accord. The progress follows a joint bid from two previously competing companies, ACS of Spain and China Three Gorges Group, who built the eponymous Dam, which for context is around 22,500MW. However, when built the Inga project would rival that of the second largest hydro project in the world currently in Brazil. Ultimately the DRC government are aiming for as much as 40,000 MW of hydro capacity and a business model to sell to the rest of Africa.

To conclude. The sell-off seen in the rest of the world since mid-year has finally caught up with the US and with Japan and Oil joining the trend of breaking long term moving averages, there are no longer any clear bull trends in major markets. This cloud of uncertainty may have a number of silver linings however. First, if by falling not only in absolute but also in relative terms versus Asia, and particularly China, the US equity markets provide a wakeup call to their policy makers that the impacts of trade wars are not asymmetric then that is to be welcomed. Second, if the absence of a momentum market in the US causes global investors to look beyond the headline noise into the actual economic fundamentals in Asia and importantly recognise the significant structural shifts that have taken place in China over the last five years then that is also good for long term portfolios. A country growing at a nominal rate of 9.4%, now led by consumption, with fiscal policy clearly aimed at blue collar workers and with the upcoming spending (and saving) power of over 400 million millennials should not be written off. 

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