Chinese assets are reaching an inflection point (part 2)
(This is the second and final part of the Sunday blotter. Please findpart 1 here)
..... Yes, spreads have widened as the funding costs for emerging market sovereigns and the underperformance of EM equities, especially in China, are portraying a negative message, but does it truly reflect the facts on the ground? I say it doesn’t.
My rebuttal to the Perma-bears
Those who push back on my thesis that EM isn’t heading to the abyss say that US rates are rising, the USD is strengthening, and that USD liquidity is contracting, all are historical signs that there is trouble ahead for EM. My rebuttal is as follows:
With the market and the Fed in alignment about the future path of cash rates, how do you get an interest rate shock? Chairman Powell has done something that his predecessors, (Yellen and Bernanke) could not do and get the market to buy into his path for policy tightening. We are going to get a 25bps rate increase in September, December, March and June and the market is effectively pricing this. Hence, where is the surprise that scares asset markets?
Long duration interest rates across the developed world remain depressed, keeping curves flat. The bond bears have been wrong for years and the current inflation outlook is not supportive of higher back-end yields. Despite widening spreads, funding costs globally remain benign.
Global growth remains in good shape, all boding well for corporate profitability and low default rates. The US remains on a tax cut induced sugar high, China is stimulating on three fronts: monetary, targeted fiscal, and via a trade weighted weakening of the RMB, and Europe is poised to rebound. This is a constructive time for global growth.
With the Shanghai Composite, giving up all of its gains since the lows of Q1 2016 and the so called “Shanghai Accord” where the US and China agreed to try to stimulate growth via easier policy and currency weakness, it is worth noting that Chinese companies are much more profitable (significantly cheaper from a valuation perspective), the RMB CFET is 7% weaker which makes Chinese exports more competitive and while the trade spat with the United States is definitely hurting sentiment, stimulus will more than offset any economic loss.
- As for leverage concerns, they also appear to be overdone. Steel production is solid, and this is one sector that would struggle if credit availability was truly being restricted. Throw in national property data that continues to perform well and I believe that deleveraging concerns are over blown.
An inflection point for Chinese stocks at the 2016 lows?
Taking this all into account, with the Shanghai Composite at its lowest level in 2.5 years, we could well be reaching an inflection point for Chinese stocks. While getting inside the mindset of Chinese retail investors is next to impossible, we are clearly reaching multi-year technical levels that are not reflective of the prevailing outlook for growth, credit quality, and profitability. The next few weeks are vitally important for the outlook for Chinese equities for the next six to twelve months. Either the lows of 2016 hold or investors will completely reject the efforts by Beijing to stabilize the economy and the health of the banking system.
With the Shanghai composite underperforming MSCI world by 22% this year and the outlook for China being one of stimulus, both renters and owners of assets have a decision to make. Renters, who have been short both the equity market and the RMB have to ask themselves the following:
a) Do I want to be short Chinese stocks when I am approaching long term support?
b) Do I want to remain being short the currency versus the USD or the CFET basket as we approach 7.00 to the dollar? At a minimum, logic tells us that the RMB will likely stabilize for a period before, if Beijing permits it, allowing the currency to weaken through levels not seen in a decade. The risk versus reward of being both short the equity market and the currency are now skewed against you.
As for owners of assets, the valuation profile, the relative underperformance versus the balance of the globe and the growth outlook should encourage buying of Chinese stocks on a two to three-year view.
Combining the two, it is difficult for me to see how Chinese equities fall further from here, both on an absolute level and versus MSCI world. As such**, the thematic model portfolio will add a 5% position to Chinese equities on Monday via the Shanghai Composite. We will also take profit on our short RMB CFETS basket trade.** Throw in talk of a November meeting between Xi Jinping and President Trump over trade and the negative sentiment towards trade may ease for a while.
Also, the thematic model portfolio will add a 5% position in Indonesian and Indian local currency 5-year bonds. The widening of credit spreads has created opportunities that I feel are attractive for owners of assets. Contagion risks into India and Indonesia will be minimal.