China is uninvestable for international investors

Nicholas Glinsman | March 18th, 2022

China is uninvestable for international investors

We need to ask that question again and right now, as the Chinese government faces a new set of pressures, and policy seems to be shifting. Here is a chart of the performance of mainland China, Hong Kong, and US-listed Chinese American Depositary Receipts since the start of 2021:

And here are the price/earnings valuation ratios, in a 10-year perspective:

The stocks, especially the US listed ones, have become cheaper relative to their historical valuations levels. Are the risks priced in now? One might be encouraged by the comments of vice-premier Liu earlier this week, which suggest that President Xi Jinping’s strident approach to reform has been tempered by the need for stability. Liu said the government would “actively introduce policies that benefit markets”, “boost the economy”, complete the reform of the internet sector “as soon as possible”, and generally promote stability and predictability. Here’s a little gem of bureaucratese:

“Any policy that has a significant impact on capital markets should be co-ordinated with financial management departments in advance to maintain the stability and consistency of policy expectations.”

The standard narrative for this turnabout is that Xi is looking ahead to the 20th party congress this autumn. Before his unprecedented third term as the party’s general secretary is made official, he wants calm on all fronts. But markets are beset not just by policy uncertainty, but a laundry list of other concerns, including:

·         that China’s Covid outbreak could before long rival Hong Kong’s in severity, and that in combination with the country’s zero-Covid policy, might mean wide and lasting lockdowns.

·         that the war in Ukraine could put China on the wrong side of international sanctions, should it provide Russia with economic or military support.

·         potential delistings of Chinese companies from US exchanges over audit concerns.

·         a slow-motion real estate crisis that can only be solved with mountains of capital that would otherwise go to a more productive use.

·         rapidly slowing economic growth combined with cost-push inflation.

·         weak credit growth in an economic system that is highly dependent on it.

For the time being, Liu’s comments have stopped the bleeding. Shares have risen smartly in the past few days, with the most beat-up issues rising most. The hard question is whether the apparent shift in policy will last until the party congress or beyond.

It is worth noting that we have seen something very much like this movie before, just eight years ago. As George Magnus’ book Red Flags tells it, the set-up was not unlike today’s, with a reform-minded government supporting the stock market as other problems, specifically in real estate, mount:

“It all began in 2014, with the anti-corruption drive in full swing. In China’s real estate market, sales and prices were dropping . . . With the real estate market off-colour, investors and households started to put money into the stock market, aided and abetted by the central bank . . . and state media, which encouraged people to buy equities, even suggesting it was their patriotic duty.”

It did not end well, as a 2015 announcement of tightening margin debt rules (presumably an effort to cool things off a bit) led to a market collapse that did not bottom until January of 2016, despite various state propping-up efforts.

This historical anecdote does not encourage confidence in the Chinese government’s ability to support the stock market in the face of poor fundamentals and spooked retail shareholders.

To make the same point another way, China’s stock market is tilted heavily towards retail investors. Are these investors going to show sustained speculative appetite for stocks at a moment when their faith in their core asset — property — has been badly shaken?

And here is home sales volume:

Try this little thought experiment: if the above was happening to US home prices and sales, what would the S&P 500 be doing?

Try a third angle on the same point. What stock markets like, as Americans know too well, is loose credit conditions and rising leverage. But China is struggling to create credit growth. Credit data for February was a notable disappointment, despite recent reforms designed to encourage borrowing and lending. Indeed, monetary policy has become easier in recent months, but bank lending continues to slow, growing just 11.2 per cent year-over-year in February, from 11.8 per cent in January. The monetary transmission mechanism is functioning poorly. What is worse, the areas of growth in lending do not look that supportive for the economy. Short-term lending to corporates is accelerating, but long-term lending, and lending to households, continues to slow. Bank credit is primarily providing bridging loans and working capital for firms struggling to survive.

China’s government has steered the country’s economy through treacherous straights before. But even after the current crisis recedes, global investors considering buying Chinese securities must make a political calculation. Once Xi emerges from the party congress secure in his third term, will his reforming instincts have softened — or will the moderating impulse expressed by Liu prove to be a blip?

Unfortunately, hope is not an investment strategy. Long-term, bottom-up investors, who may be tempted by the low valuations of China’s platform [tech] companies, need to consider not only picking their timing but also the fact that the easing of the comprehensive crackdown on those firms is much more likely to be political manoeuvring than a genuine change of heart.

All in all, I am of the opinion that the Chinese stock market is uninvestable for international investors. Moderating forces in the government will be replaced by pure apparatchiks, once Xi secures his third term, and that timing what will be an inevitable tightening of the regulatory apparatus will prove impossible.

History shows us that the Fed is unlikely to deliver a soft landing

The Fed’s projection points to an aggressive hiking cycle to cool a hot labor market and bring down inflation, while avoiding a recession. If it delivers, it will be a first.

Since 1970, there have been only four occasions when all three conditions were met:

1) the Fed raised rates 150 bps or more in 12 months;

2) core PCE inflation fell over the period, and

3)current unemployment below NAIRU (a sign of a tight labor market).

These periods, including 1972-1973, 1978, 1989 and 2006, were all followed by a recession within in the next 10-22 months

The difference now is that the Fed is tightening from a very low level, with deeply negative real rates, compared with the positive yields in the previous periods. It is debatable whether the level (low) or speed of change (high) matters more for the economy.

In any case, the rate market is skeptical about the Fed’s rosy scenario, betting that the economy will be weak enough by 2024 to warrant a rate cut. If history is any guide, the market may turn out to be right.

Indeed, the yield curve has further flattened this morning after Fed Governor Chris Waller said he favors front-loading rate hikes for an impact on “raging” inflation now and next year. To do that, Waller said, the Fed may need to pull rate increases forward and that might mean considering lifting rates by 50bps in coming months.

Having a look at the above chart over the last 40 years is quite informative, given the opening comments to this section.

However, I just do not trust the Powell Fed. I do not think that they will work to crush inflation, and I suspect their incredible forecasts for unemployment implies a swift U-turn should the rate hike and QT process lead to any significant growth slowdown. I will come back to this point later and a suggested longer-term trade to position for such. For now there is another part of the yield curve that agrees with me – the yields on three-month Treasury bills and 10-year notes. Here, the gap this week touched a healthy 180 basis points, the widest since early 2017. Studies over the years, including a groundbreaking one by the Federal Reserve Bank of San Francisco in 2018, explain why this part of the curve “is the most useful term spread for forecasting recessions.”

The simple fact is that consumers, whose spending makes up two-thirds of the economy, are perhaps in their best shape ever financially. Let’s start with excess savings. Thanks to extremely generous social programmes instituted by the US government to support the economy through the Covid-19 pandemic, consumers have built up a staggeringly high cash cushion. Checkable deposits for households and nonprofit organizations rose to $4.06 trillion in December from $1.16 trillion at the end of 2019, according to the Fed. Looked at another way, the previous high for this metric before the pandemic was $1.41 trillion.

What about the Commerce Report on Wednesday, I hear you say, that showed retail sales growth slowed significantly in February to just 0.3% from 4.9% in January? Doesn’t that show consumers are starting to buckle under the weight of the highest inflation rates since the early 1980s? Maybe not. Even though the number was below the median estimate for a gain of 0.4%, the January figure was revised significantly higher from the originally reported rise of 3.8%. Without that revision, February’s increase would have been more like 1.4%, easily topping estimates. In other words, retail spending was stronger than expected in February after incorporating upward revisions to January’s blockbuster gain. 

Of course, nobody likes to pay more at the gas pump. And with the price of a gallon of regular gasoline as tracked by the American Automobile Association jumping to an average of $4.29 from around $2.39 at the start of last year, there’s a lot of griping among consumers. The fact is, though, that spending on gasoline and energy as a percentage of disposable income has dropped by about half since the late 1970s and early 1980s. This is due to any number of factors, but can best be summed up by saying that the economy has become much more fuel efficient.

What also makes this moment so much different from the recent past is overall wealth. US household wealth surged $40.3 trillion since the start of the pandemic to a record $150.3 trillion through the end of 2021, according to the Fed. That’s a whopping 37% increase over seven quarters and almost equal to the previous seven years combined. As impressive as that is, perhaps more encouraging is that net worth exceeds disposable income by more than 8 times, compared with about 4.5 times during the last inflation shock.

There’s no doubt that much of the gains in excess savings and household wealth has been concentrated at the upper end; income and wealth inequality has only widened. Furthermore, it’s true that those at the lower end of the income spectrum are the ones hurt most by inflation. Yet here, too, may lie a silver lining. The government programmes that put cash directly into the pockets of those who needed it most during the pandemic have ended. The thinking is that those who may have been able to stay out of the workforce thanks to government stimulus checks may be forced back in as inflation eats away at their savings. This may not be bad because it could help support that economy by filling the record 11.3 million jobs that businesses are trying to fill. In fact, this may already be happening.

The Labor Department said earlier this month that the labour force participation rate had its biggest two-month gain in January and February since mid-2020, when the economy was starting to open again after being abruptly shut down. And at 62.3%, the overall participation rate is just a couple of months away on its current trajectory from where it was in the years before the pandemic.

Some are saying that the above data suggests a slim chance of a recession anytime soon. They will also say that there is too much cash on the sidelines in terms of in people’s bank accounts. Yes, we’ve had a bit of an oil price spike and we got a gas price spike and these are issues, but if you listen to what the CEOs of American banks are saying … people of all income levels have much more cash in the bank then they had pre-pandemic, so there is a cushion.

The yield curve is one of the few things in financial markets that has attained mythical status for inverting before each of the past eight recessions. Impressive, but there’s a big caveat, which is not every yield curve inversion has led to a recession. If 10-year yields fall below two-year ones again in coming weeks, this may be one of those times it sends a false signal.

It may well be that this happens this time around too. Again, to return to my theme about the Powell Fed, I believe that they will stop hiking at the first sign such is beginning to stress the economy. If that happens, then they will have de facto given up the fight against inflation to ensure no recession, which would lead to a yield curve steepening, and likely an aggressive one at that.  However, and this is where the ultimate trade for a yield curve steepener becomes so attractive, a recession also leads to a yield curve steepening, as can be seen in Bank of America’s Michael Hartnett piece today – take a look:

OK, so here we have it. In the two likeliest scenarios, we end up with a yield curve steepening. The trick is of course when to time it. We are watching accordingly.

Stagflation playbook

In the interim, my own fundamental view coalesces around the idea of stagflation, with an emphasis of the EU. The difference in the investing environment can be best summed up at follows:

End Cold War = peace dividend = positive supply shock = deflation

New Cold War = tax = negative supply shock = inflation

I continue to believe believe 2020 marked the secular low in interest rates and inflation with the 2020s likely marked with quick and volatile boom-bust economic and investment cycles. The 1970s show this bullish real assets, commodities, TIPS, small cap value, EM.

Note during big stagflation shock of 1973/4 only commodities worked; once stagflation reality set in, small cap value, real estate, commodities worked 1974-1981