Market Thinking - a view from the equity market - commentary from Mark Tinker, AXA IM
Tuesday May 16th 2017
- What might seem an ‘old’ story to us in Asia - China’s One Belt One Road initiative – is clearly a new story to many people around the world following the Summit last week.
- Competitive response from Japan and India suggests the positive benefits from improved trade infrastructure can come from multiple sources, just as Apple and Android transformed smartphone infrastructure so Asian countries will compete to transform trade infrastructure.
- We continue to believe that China’s actions need to be understood in the context of building systems not chasing targets. Just as consumer analysts failed to understand the initial business models of Amazon, Google and Apple, so western economists need to understand the long term structures being built in Asia.
The One Belt One Road (OBOR) initiative discussed at the Beijing Summit last week has attracted a lot of international attention and clearly much of it was ‘new’ to a lot of people, even though here in Asia we might regard it is an ‘old’ story. One aspect that has perhaps not been discussed as much however is the competitive response to China’s policy, particularly from India and Japan. India did not attend the Summit and has long had disagreements with China about its involvements in Pakistan and the ongoing dispute over Kashmir. The Pakistan Economic Corridor is one of the faster moving aspects of the OBOR strategy and the Chinese show little sign of slowing down as a result of Indian protests. What is interesting therefore are the initiatives from Japan and India to develop similar infrastructure projects elsewhere in the region in order to compete with China. Opening up ports in Sri Lanka or Iran for example might be seen as a competitive response from India and Japan, but regardless will help increase trade.
Last week I discussed how it made more sense when looking at China to approach GDP from the income rather than the consumption approach as, in my opinion, Chinese policy makers are more interested in how different parts of the economy are benefiting rather than simply having a ‘target’ for GDP that is met by pulling one of the consumption levers through monetary policy – an approach that seems to dominate western economic thinking. The following is a (rather long) email that I recently sent to a client who was asking about China, which I think on reflection is worth sharing (I have edited it slightly).
Firstly, when looking at the Chinese economy it is important to recognise that it is part way through significant structural change. China is neither an emerging market nor a developed economy and as such most of the policy recommendations from western academics and investors are either inappropriate or will be ignored. Or both.
In my opinion a large part of this misdiagnosis reflects a wider problem, that of target driven policy making. The ability to hit a target depends on the system within which it is operating and too often academics model outcomes, and thus make policy recommendations based on historic analysis of one system (usually the US) without recognising that even relatively small differences in system structure can and will produce markedly different outcomes. Perhaps the most obvious example, and one relevant to China, is the impact of monetary policy on demand, specifically consumption. We all 'know' that raising interest rates will slow consumption because that's what econ 101 tells us. Raising interest rates encourages people to save more and spend less and vice versa according to theory and while we might intuitively and anecdotally think of cases where that wouldn't happen, the history does seem to support the theory and is thus deemed to prove it. We also notice that in certain economies it works much better than others and that this effect changes over time. If we look for a common factor for more interest rate sensitive countries, one stands out, the level of debt. This makes sense of course, since while raising rates might cause savers to receive more, it increases the interest expense of debtors and, all else being equal, reduces their consumption. While traditional models largely think of debt as being in the corporate and government sector, the growth in mortgage debt in the west over the last 50 years has made this very much a consumer issue. Higher mortgage levels in western countries have thus made the impact of monetary policy much more powerful, particularly where the rate structure is floating rate, since a cut in interest rates frees up cash flow and in many instances facilitates greater levels of borrowing leading to a much sharper contraction as and when rates do go up again.
For a period in the 1990s and early 2000s the US became less vulnerable to higher rates due to a change in its system, the development of securitisation and fixed rate re-financeable mortgages in particular. When rates fell consumption was stimulated as debt financing costs fell leaving more money for consumption and leading to more borrowing, but when rates rose the consumer was insulated. This was THE key reason in my view why the US consumer consistently failed to collapse as predicted during the 2000s, their balance sheet was hedged. It is also the reason why Portugal, Ireland, Spain, Greece, the UK, Australia etc. had a much harder time when short rates rose, similar to places like Thailand here in Asia who suffered a similar problem with floating rate mortgage debt. Not un-ironically, by 2007/8 the same financial innovation that had reduced risk of US consumers put the risk back to them through the 'reinvention' of cheaper floating rate loans and we know what happened next.
In emerging markets (EM) there are further system issues that make debt a problem, over and above the sensitivity of consumption to mortgage interest payments, most notably for countries with a current account deficit. By definition such countries have a capital account surplus and while some will be funded with foreign direct investment (FDI), most of it will be debt finance, either to governments or via the banking system. This creates the obvious problem that you then control neither the price nor the availability of your debt. Price being set by both the lending rate of the lending country and the exchange rate, while the often short duration of the loans produces constant re-financing risk. Almost all the financial and economic crashes associated with 'too much debt' in studies such as Reinhardt and Roghoff are down to too much overseas debt.
This is all relevant to an understanding of China, because in the first place the Chinese consumer has an extremely cash rich balance sheet with minimal mortgage lending and thus the experience of western markets or indeed various mortgage driven emerging markets is not so relevant and second because China has a current account surplus and a capital account deficit. Overseas debt is minimal and certainly not a systemic risk. China has issues, but almost none of them are the ones western investors are apparently worried about.
Which brings me back to systems and targets and a further problem with policy makers and econ 101. If I were to design a robo op-ed writer on economics I would start with the economic identity for GDP from the consumption angle; C+G+I+(X-M) and then declare that country X (could be China or anywhere else) 'needs' higher GDP and thus to achieve this they need to 'boost' consumption (C) or investment (I) by cutting taxes or, usually, interest rates. Or that they need to increase investment by building more houses or bridges or High Speed railway (HS2) or perhaps that they need to boost net exports. In reality of course western governments may get their central banks to use monetary policy to try the former while they just take on more debt and increase government spending (G).We thus end up with the sort of policy paralysis that we have in the west, where we don't really have GDP targets but inflation targets, which have embedded within them the assumption that higher demand leads to higher inflation, taking no account of how prices are actually set in the real world - not least the role of competition and supply. Applying this to China is to totally miss the point, for while China does have a GDP target it is much more concerned with systems than targets.
China recognises that simply boosting GDP via a target is not the right policy. On the one hand we can say that it is getting the right balance to GDP that matters, but in reality it is about getting the systems right that is shaping Chinese policy makers. It is often acknowledged that the main concern of the Chinese Communist Party (CCP) is to minimise social unrest and thus they are interested not only in economic growth, but how the benefits are shared, hence their focus around issues such as corruption and pollution. In neo classical economics Alfred Marshall et al used to refer to the returns to factors of production, land (including resources) labour and capital and that economies grew by increasing total factor consumption, more land (resources), more labour or more capital. Each phase of Chinese growth over the last 30 years has been about using more of each factor and similar to the works of Robert Solow in the 1950s the subsequent growth has been about greater efficiency of each factor - factor productivity. As such we could do worse than consider GDP from the income rather than the consumption equation. Instead of C+G+I+(X-M), we should think of national income (Y) as being the sum of wages+ rents+ interest income +profits (note that for completeness we add a set of statistical adjustments for net foreign factors and indirect business taxes, corporate income taxes, dividends and undistributed corporate profits to reconcile GDP (I) to GDP(E)). So from a Chinese government perspective using more land and resources as well as labour and then making first land and then labour more productive so as to achieve higher wages is a priority that has so far exceeded that of a higher return on rents or profits. This of course is a complete puzzle to the western financial system which is focussed on achieving the exact opposite.
Chinese policy makers do recognise that the financial system now needs to be restructured so as to boost the productivity of capital. China understands that four large banks with centralised lending decision making revolving short dated loans to state owned companies (with little focus on ROIC) might have worked in the past for a $1trn economy, but definitely doesn’t work in a $16trn economy. Its approach has been '"where the market can set prices it should be allowed to set prices" as Xi put it in 2013. In other words, in finance it now allows the markets to discover pricing and inefficiency and for shadow banking to deliver a partial solution. Then it will regulate shadow banking to formalise that part of the financial system. Far from being a problem, shadow banking is part of the solution. Again ironically the Chinese appear to be exporting shadow banking systems to the rest of the world, who aren't really noticing what is happening. Look at major city house prices and the recent problems for Canadian mortgage lenders for just one example.
So far this has given us money market funds and various wealth management products that have raised returns to savers and lowered the cost of capital to small and medium enterprises (SMEs) i.e. increasing capital in the system as a factor of production and making it more efficient. Capital markets are still a small proportion of total funding in China, but are growing. Quotas for foreign capital and capital outflows have evolved into stock and now bond connects that while still liable to limits of capital flow are much more flexible in allowing diversification of Chinese savers out of China and overseas investors in. This is particularly important with the bond connect and goes to the heart of the "I am worried about debt" meme in China.
When we look at any western economy we see four different balance sheets - one for each of the household, corporate, government and financial sectors. Flows between balance sheets tend to go via the financial sector and, as already discussed, while the Chinese household sector may be starting to expand its balance sheet, almost all the 'debt to GDP panic' debt is in the other three sectors. Except of course in China where those three sectors are pretty much all one. Most debt is in central government, local government or state owned companies, or state owned banks. The whole point of the financial reform in China is to carve up those balance sheets. So local government will issue longer term debt that will be bought by local banks and the proceeds used to buy back the short term revolving loans. Bank loans become bonds, maturity transformation, but also the debt can now become tradeable. Loans to build the central business district can be turned into real estate investment trusts (REITS), toll roads spun out etc. So instead of a pile of illiquid bank loans held by banks, we have the creation of an asset backed securities market and a tradeable bond market in government debt. In equities the regulator is cracking down on secondary placing and forcing more regulated IPOs, while plans for 401k type products, allowing in foreign buyers of bonds via the bond connect and the general build out of a social safety net are all consistent with structural change.
Against this background we have western investors demanding an opening of the capital account while simultaneously running scare stories about debt and the exchange rate and focussing on the Forex reserves. The reality is not that $3trn of foreign exchange (FX) reserves is a problem, it's that the previous $4trn was the problem. China runs a capital account deficit and recycling that has always presented a problem. When the dollar was weak, Chinese companies were not only swapping earned dollars for renminbi (RMB), but they were borrowing dollars and swapping those. This created several problems: 1) a growing FX reserve, 2) increased sensitivity of the corporate sector to US rates and exchange rate, 3) asset price inflation as those borrowed dollars (now RMB) were put to work in the Chinese economy. A stronger dollar has solved a lot of these problems, helped by government 'encouraging' companies to pay off dollar debt. The latter of course was interpreted by the markets as 'capital flight' when it was nothing of the sort. The government has also managed expectations around the exchange rate - it is not trending up or down (so no momentum and carry trades), nor is the volatility too low so as to reduce risk of leverage.
Noise traders try and make a trend with a narrative - boom or bust - and on the depreciation side at least it is usually back to the X-M component of the GDP(E) calculation. We are told that the Chinese government can only meet its growth targets by boosting exports and so needs a 'massive' depreciation of the currency (it's always massive) as having made their money with EM depreciation trades that is almost literally the only thing these guys understand. They have a big hammer and everything looks like a nail. As we saw last year, China's response to these guys is "I must have missed the bit where I asked your opinion". Capital markets will be opened when it suits China, not when it suits east coast hedge funds. Remember while China would like western long term money to help with price discovery as bond markets become traceable, it doesn't need any more capital. Its priority is to direct existing savings into investment more efficiently.
To conclude. China does not have a debt problem, primarily because its debt is domestically held and the household sector is very under-leveraged. It has an asset problem in that it needs to transform that debt into suitable assets for a long term savings system. This is exactly what China is now building, transforming bank debt into tradeable asset backed securities, bonds and equities. They are building a system not chasing targets.
China is recycling its savings through more direct investment into real assets, which is part of One Belt One Road (OBOR) rather than US Treasuries. While the bond markets worry about what this means for bonds, it is more meaningful for where the money goes to rather than where it comes from. China and North Asia, with their current account surpluses are recycling capital through the Asian region into infrastructure, property etc. I suspect China will probably buy into Saudi Aramco for example as part of a strategic deal to secure longer term oil, but note that this will be imported via the port in Pakistan (the Pakistan Economic Corridor is a major thing) or the new pipeline just opened through Myanmar. The US seventh fleet can perform exercises off the straits of Malacca as much as they like, but the oil won’t go that way anymore. Similarly with Chinese trains crossing Central Asia, connections to Europe are not vulnerable to actions in the South China Sea. OBOR is as much about security of supply as expanding trade.
To conclude. The traditional approach of economics in the west is to look at GDP through the consumption approach and advise governments to boost growth (as a proxy for wellbeing) through stimulating consumption, investment or net trade. The problem is that the policies used to try and achieve this – mainly lower interest rates and a lower exchange rate – do not work as well as they used to, primarily in my view because the personal sector is deleveraging along with the regulated financial sector. What is happening is that the corporate sector and the shadow financial sector are increasing leverage and distorting the market for savings and investment. This is boosting profits and asset prices, but the wealth effect is not evenly distributed and is causing a lot of social tension. In China by contrast the focus has been less about hitting a target and more about building a system. Analysing China through the perspective of the income approach to GDP – wages, plus rent, plus interest plus profits makes it clearer which parts of the economy are prospering and helps better understand why China appears to be ignoring western policy prescriptions.
From an equity viewpoint it reminds me of the original tech boom. Companies like Amazon, Apple, Google and Netflix were dismissed by conventional retail and industrial analysts for ignoring (earnings) targets and instead building out systems and infrastructure. Excessive focus on China’s debt is in my viw akin to saying Amazon’s price/earnings ratio was too high or that Google was wasting money paying $2bn for Youtube. That is where China and Asia are right now. Conventional economists and central bankers should perhaps focus less on GDP and inflation targets and more on the likely winning supply side infrastructure. Meanwhile investors should focus less on temporary cyclical boosts to demand and more on finding the China economic equivalent of the Apple supply chain.
Head of AXA IM Framlington Equities Asia
- ENDS -
Notes to Editors
All data sourced by AXA IM as at Tuesday 16 May 2017.
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