Hacking Shock Latest US ‘Global Risk Manager’ Failure…

‘In broader terms, the FAA response (to the Boeing 737 scandal) underlines yet again that the US now risks losing its post WW2 leadership role as the global default ‘risk manager’ in everything from aviation to disease control (the CDC) and ultimately even trade and finance (via SWIFT) because of a steady erosion of credibility and capacity under a dysfunctional administration, as highlighted in the latest book by Michael Lewis, ‘The Fifth Risk: Undoing Democracy’. That lack of competence/capacity will raise the stakes when an inevitable international crisis occurs…’ Weekly Insight, 19th March 2019

‘CrowdStrike’s strength is in the high-growth endpoint security market but also offers services like threat intelligence and cyber-attack response services. Identity management specialist Okta is another cloud-based security software player also now worth over $15bn after a spectacular run (up 5x since early 2018). The shift to cloud-based architecture in the cybersecurity space means that even SMEs will be able to benefit from pre-emptive machine learning led threat intelligence and quarantine. Aside from this cloud shift now underway, blockchain technology could potentially help enhance cyber-defence as the architecture helps prevent malicious activities via consensus mechanisms and to detect data tampering. Blockchains resolve the ‘lack of trust’ problem between counterparties and owing to their distributed nature, blockchains provide no ‘hackable’ entrance or a central point of failure and thus inherently provide more security when compared with legacy database-driven transactional structures. ‘- Weekly Insight, July 22nd 2019

The point made back in that note in March last year about a dangerous lack of US ‘competence/capacity’ has sadly proved valid this year – the disastrous ‘regulatory capture’ failures at the FAA (and China was the first country to ground the 737 MAX) have been repeated across multiple other key Washington agencies (including most disastrously the CDC) which were once the global standard. We end the year with the US accidentally discovering that it has suffered the most audacious hacking attack ever (which seems to have begun at least a year ago – FireEye’s blog covers what we know at this stage well). Investigations into the hack are ongoing, but the failure of national security agencies, like the CDC’s costly failure to roll out effective Covid tests earlier this year, highlights chronic underinvestment in technocratic capacity and a huge degree of complacency.

Yet again, the US has shown stunning ineptitude in exercising its historic role as global reinsurer/risk manager, the topic of Michael Lewis’ timely book. This goes far deeper than the dysfunction of the Trump White House and can’t be readily fixed by the appointment of a more competent and mainstream cabinet. The ‘anti-government’ (ex-sacrosanct military) ideology which has defined Washington politics since the 1990s has hollowed out most key institutions with chronic underinvestment, and has seen government R&D spend on basic science fall to record lows versus GDP. A generation of retiring public servants with decades of expertise have simply not been replaced with people of the same calibre, given Congressionally mandated headcount and budget constraints leading to an accelerating ‘brain drain’ to the private sector among technical specialists in particular. There are certainly now many areas which can for the first time be outsourced to the private sector such as NASA/Pentagon satellite launches, but the capacity to prepare contingency plans to manage tail risks and effectively regulate the destabilising perverse incentives of capitalism remain core government functions.

US market oversight has been eroded to such an extent that the US Treasury market came close to imploding at the depths of the pandemic deleveraging panic – indeed pricing dysfunction and moral hazard have been a key aspect of this year’s events. Liquidity disappeared in bond markets in March as highly leveraged hedge fund basis swap trades collapsed and ‘one click’ bond ETF liquidity exacerbated the fallout. We saw similar chaos in the US oil futures market a month later, after Saudi and Russia briefly abandoned OPEC+ and a small group of UK traders helped crash the expiring physical delivery WTI contract into negative levels.

China’s long-term strategic goal is to become a leading force in setting global standards (as it has successfully in 5G and Asian trade, with a huge EU investment deal pending despite US efforts to derail it) and to make its capital markets competitive with the US in terms of depth of liquidity, breadth of asset classes/products and regulatory credibility, a key precursor to RMB internationalisation. One of the ironies of this year is that US markets have become characterized by a narrative driven retail frenzy, just as mainland ones have become less so on relentless domestic and foreign institution inflows (indeed, ex-China EM portfolio flows have been negative this year).

While there clearly remains a long way to go, Beijing has continued the liberalization of its markets this year and is now leading in pre-emptive policies to ensure long-term stability (the crackdown on Ant Financial should be seen in that context, specifically consumer credit growth as other platforms copied its model). It’s also leading in payments innovations like the digital RMB (likely launching within 12-18mths) and the blockchain infrastructure to manage it. Indeed China is the first country to pose a threat to the US in software (already consumer, with for instance TikTok clearly superior as an engagement engine to US social media peers), because it culturally has no problem accepting the iterative, launch to market and patch errors model it entails in a way perfectionist Japan and Germany never could. That comes at a time when US regulators are behind the curve and allowing dangerous levels of speculation to develop via single stock options etc.

Pandemic tail risk was regularly highlighted by epidemiologists and healthcare policy makers but not remotely reflected in government preparedness ex Asia. We’ve covered cybersecurity tail risk over recent years as an attractive investment theme via stocks such as CrowdStrike, and we are clearly getting closer to a nation state level cyber conflict after a series of escalations in recent years. After this event, issues like cyber security and data privacy can no longer be left largely to the private sector – we will need new oversight and governance structures for the tech giants built around national security priorities as much as consumer data privacy rights. 

US officials are still working to understand the full consequences of the hack, which is a hugely successful attempt to spy on internal communications and steal critical national security information (it hasn’t been a destructive attack that damaged or shut down computer systems, as some major cyberattacks have done in the past, but clearly makes that potential future escalation far easier). This doesn’t look great news for the rollout of the ‘Internet of Things’ model in the US (accelerating via 5G in firewalled China, with Beijing pushing Alibaba/Tencent to develop relevant enterprise software), which inherently means a massive increase in the number of potential hacking entry endpoints via industrial and logistics infrastructure etc.

Indeed, the implications of this event may prove net bearish for the software sector ex security next year – US networks have become dangerously open and interconnected and as with healthcare post Covid, rebuilding resilience will become a long-term policy priority. The full ramifications will become clearer in Q1, but after the shambolic pandemic response, it should be sobering amid the current hubris in markets that the US has found itself so astonishingly vulnerable to brilliantly engineered malware. Threats which could disrupt our entire digital infrastructure at any moment will have to be taken as seriously as viral ones. Perhaps the Russians should reverse their cyber intelligence division into one of the exploding list of Wall Street SPACs, but I suspect the Chinese will make them an offer they can’t refuse first.

Huawei Quarantine Accelerates Tech ‘Balkanization’ Trend

“The three core issues of concern to China are the cancellation of all tariffs, that trade purchases be in line with reality, and that the text of the agreement be revised so as to be more balanced. These issues must be resolved. This trade friction has made us more aware that we have shortcomings in terms of economic structure, quality of development, and core technologies. [We must] enhance the sense of urgency in accelerating indigenous innovation and resolve the bottleneck imposed by insufficient mastery of core technologies. CCP Propaganda Department Commentary on the US confrontation in People’s Daily newspaper last Friday

We have regularly covered the rise of China’s tech sector over the past decade and the complacency in Silicon Valley which has only recently been shattered by Huawei’s threatened dominance of the global 5G rollout. The ‘balkanization’ trend already evident in software ecosystems from messaging to payments will now extend to hardware throughout the supply chain – there will be a China centric physical internet architecture over the next decade centred on Huawei as much as a software one around companies like Alibaba, Tencent and Bytedance with the big ‘neutral’ EM markets like India a key battleground.

In the near term, the notion that China can be quarantined as a technology supplier looks naïve – alternative vendors like Nokia and Ericsson make 5G hardware with Chinese partners in mainland factories for sale globally, leaving their equipment vulnerable to malicious tampering – will they have to relocate production to ‘safe’ locations to sell into the US? If so, the global rollout will be significantly delayed…

Huawei has been rapidly vertically integrating with its own chip making subsidiary, HiSilicon, producing highly advanced 5G designs, albeit fabricated (as for Apple and Google) by TSMC. As a Chinese tech VC contact told me in Shanghai last October, cut China off from TSMC and it would be casus belli like the Japanese oil embargo in 1940. If the US is serious about confronting China’s competitive threat on a sustained basis, it needs to boost government R&D spend on basic science (instead it’s been cut), deepen the capacity of domestic tech supply chains via education investment and targeted tax credits or cutting off broader Chinese access to advanced GPU chips and postgraduate student access to STEM courses at colleges such as MIT and Stanford. Those moves would be expensive and disruptive for the US economy and are still possible future steps if relations become even more antagonistic.

China offers uniquely low (marginal) consumer electronics assembly costs plus high-volume flexibility. You can never replicate the mainland factory dormitory model in the US or even Korea and Taiwan. The increasingly well educated rural migrants filling Foxconn factories are the ultimate ‘on demand’ workforce – manufacturing elsewhere would mean higher assembly costs/decreased flexibility thanks to the constraints of current generation assembly line robotics.

Even with high levels of automation, a fully US assembled iPhone would likely cost about 40% more at the factory gate (with Apple gross margins at ~37%, the current tariffs imply a price rise of about 15% to offset the impact, unless the RMB plunged toward 7.5 versus the USD). For instance, Quanta Computer, the largest laptop maker in the world with clients from Apple to Dell, warned last week that the logistical costs of shifting consumer electronics production out of China could prove as expensive as the tariffs themselves. 

Automation is part of the answer to offshoring from China but changes the business model – assembly by Chinese migrant workers is a marginal cost for a factory owner; robots are a fixed cost, although the assembly of an additional unit has zero marginal costs (excluding overheads like maintenance etc.). New AI software will help but it’s still expensive and time consuming to program factory robots to perform multiple tasks.

The implication of this shift from marginal to fixed costs is that there is a heavy incentive to stick with a specific design: any change requires significant capital investment to update the robotic assembly line – the flexibility of the entire consumer electronics sector will deteriorate, with higher inventories and fixed overheads once it loses China’s unique attributes as a global production base – given wafer thin margins, consumer prices will trend higher even if a face saving deal could avoid further tariffs.

Relocating the supply chain for smartphones or laptops will be hugely disruptive, wherever the destination and it certainly won’t be the US – the much-hyped Foxconn factory to make TV screens in Wisconsin has become a fiasco, despite $4bn in tax breaks and subsidies. The lack of a skilled manufacturing workforce will be a key constraint on US re-shoring, as much as logistics considerations – flying components in from Taiwan/S. Korea to assemble phones in the US makes little sense.

The effort to lobotomise Huawei looks ill thought out and will have generated intense lobbying by the most adversely impacted US suppliers – there will likely be some nuance in the implementation. However, the endgame is now clear and US tech companies will have to mitigate ongoing compliance risks by reducing exposure to Chinese SOEs. We’ve seen a few companies like Go-Pro begin relocation (to Mexico in this case), but this will now accelerate while China will race to become a ‘full stack’ technology power by mastering semiconductor fabrication and an indigenous mobile operating system.

In the case of both Iran and Huawei, the US has unilaterally exercised its global power over international bank payments systems and key technologies like the Android OS to exercise brute force geopolitical leverage – the lesson drawn by many in Europe and Asia is that alternative architectures are now needed. Ultimately, China which remains the only country apart from the US to understand the critical value of ‘platform’ software and is catching up rapidly in AI and quantum computing research, will become an even more formidable competitor to the US tech giants. The Xi 2025 plan, whose ambitions triggered panic in Washington from the Pentagon to Congress, will now be implemented sooner, by any and all means possible.


China Consumption Shifting From Property to Pensions…

One of the biggest issues for global investors over the next 3-5 years is that China may be running out of prospective home buyers as the prime household formation age cohort shrinks, creating a secular slowdown in a sector which directly generates 13-15% of GDP and in its wider spillover impact closer to 22-25%. Consumption in China doesn’t neatly fit the Western ‘life cycle’ model of neoclassical economics (e.g. housing tends to be bought in advance of marriage/household formation and left unfinished and empty until that point) but the structural demographic shift will transform housing demand as much as the shape of monetary and fiscal policy. Beijing’s efforts since 2015 to boost the birth-rate by easing restrictions on family size always looked likely to fail, given the ever-rising costs of child rearing and fertility trends across developed urban Asia.

Japan’s experience in recent decades indicates that when rapid growth begins to slow in an economy with very high corporate and household savings driving fixed investment, demand can prove extremely difficult to manage, particularly when demographic decline sets in simultaneously. This is particularly true if the deliberate promotion of credit growth and asset price bubbles has been part of the mechanism used to sustain demand. The tactical stance has been overweight China and AXJ despite still poor earnings and macro momentum but structural growth constraints are becoming binding as rising debt and declining demographics interact to radically change policy trade-offs, while the US is now intent on blocking or at least slowing significantly the technology upgrade path.

The real story behind China’s well documented economic imbalances is not just about structurally weak consumption versus investment as a share of GDP but also a large-scale net transfer of savings from abroad (and particularly the US) to the mainland corporate sector, a process which the White House, with broad bipartisan political support now seems committed to ending, whether a new trade deal is concluded or not. China’s plan to move up the value chain rapidly by ‘acquiring’ foreign IP to boost productivity as the workforce and investment intensity declines will now be much harder to achieve, even if it doesn’t in the worst case lose access to advanced semiconductor imports.

The country has an ongoing growth tailwind from urbanization (currently at 59% on official data, but by global standards likely 5-6 points higher), a remarkably advanced digital economy and payment systems, first world transport infrastructure in and between the major cities (and soon communication via 5G), and a growing number of globally competitive companies in mid-tech industrial and consumer markets. However, its economic dynamism will face a growing demographic drag as resource are diverted (whether public or private) to fund rising healthcare and pension costs.

Births last year dropped by 2m to 15.2m, and the median age will reach 48 by 2050, or about 10 years older than the US now. The total number of working-age adults (aged 16-59) fell by 0.44 % to just over 897m while the growth in the pool of rural migrant workers fell sharply, rising just 0.6% to 288m, down from 1.7% in 2017. The national old-age dependency ratio is already at 15%, and twice that in some depopulating peripheral provinces. The population on official data grew by 5.3m last year or 0.38% and Beijing has estimated that China’s population won’t peak until 2029 at around 1.44bn, but some demographers believe that tipping point has already arrived.

The ‘extensive’ growth model of adding more workers and capital becomes untenable as demographic decline starts. So too is the highly expansionary monetary policy that saw the PBoC balance sheet and M2/GDP ratio explode. That never generated much consumer inflation, as it was largely sterilised via housing which absorbed excess migrant labour and industrial capacity as a concrete inflation sink isn’t sustainable much longer. At the same time, the sterilisation of exporter dollar earnings and build-up of net foreign assets on the PBoC balance sheet and Treasury buying by SAFE is also winding down, as FX reserve growth peaks peak.

US demands to eliminate the bilateral deficit simply hasten the existing trend toward a current account deficit. Whatever the exact demographic glidepath, China is going to have to employ its human capital much more efficiently over the next couple of decades and refocus on intensive, productivity led growth. Global investors are going to have to adjust to the perpetual motion machine that drove global capital flows from the late 1990s not just stalling but going into reverse i.e. China will likely become a substantial net portfolio capital importer over the next decade, as it needs to fund soaring fiscal deficits, just as aging households begin running down savings…

With 12% more males than females in the 15-29 age cohort, having an apartment boosts prospects for marriage, and that factor as well as migrants buying properties to retire to in their home provinces helps explain much of the 45-50m ‘empty’ apartments that generate scare headlines. In China, housing has taken on the role of a ‘dowry’ for male offspring that gold has traditionally for female ones in India, but the 34m overall male surplus will rise and create a growing pool of involuntarily unmarried men (so-called “bare branches”). The home ownership rate among young Chinese households is consequently very high, thanks to help from parents who in a major city will have built up huge housing equity. Demographics will clearly begin to impact this cultural support for real estate, as the number of 20something males enters steep decline.

The 20-29 age cohort, the main source of new demand for housing, will have declined by about 80m by the mid-2020s from its peak in 2012/13 and the proportionate decline is similar for the teenage cohort behind them, slowing pre-emptive parental demand. A rising divorce rate and proportion of never married (in the case of many males, not by choice but economic circumstance) will offer some support to housing demand, but alongside a dramatic slowdown in migration, the overall fundamental demand picture will deteriorate materially.

Pension coverage is now relatively high for a country at China’s income level but the income generating assets to fund defined benefits are hugely inadequate and this is where boosting private assets and returns becomes critical to maintaining systemic solvency. The pension funding deficit covered by central government is likely to reach over $150bn annually by next year. Deeper capital markets (including ultimately access by foreign mutual funds with local distribution partners) supported by pension savings inflows are a key part of the wider reform agenda. Current contribution rates for state/SOE pensions are far too low; private pensions and employer annuities (i.e. the addressable market for the insurers) are just over a quarter of total assets with the basic pension/national social security fund comprising the balance.

That ratio will gradually shift over the next decade in favour of private assets – the public pension system’s 43% replacement rate (ratio of annual benefits to final salary) implies a significant cash flow deficit will open up that could amount to over $1.5trn within a decade. Insurers will be a key part of the funding solution – weak capital markets and regulatory changes slowing premium growth have been a drag but they remain a key China exposure as inadequate social provision, from healthcare to pensions, is funded directly by individuals.

Total pension assets are just over 10% of GDP compared to 35% in Korea and HK. Assets will have to grow dramatically over the next decade to close the funding gap and the private share of total pension assets (currently sub 30%) will become dominant. Beijing already has the fallout from local government deleveraging and SOE restructuring to absorb which will see central government debt/GDP double to 70-80% over the next 3-5 years from the currently reported 37% – bailing out the pension system as well simply isn’t realistic. Assets managed by Chinese insurers have already reached over $2.6trn, even as new policy premium sales have slowed since 2016.   Solvency rules are now closer to international norms – capital requirements had been based on simple metrics of size but will now vary in line with how quickly policies turn over and how premiums are invested. Firms that rely excessively on short duration policies or invest heavily in equities must hold a much bigger capital cushion.

The slide in bond yields and A-shares has inevitably hit investment returns (as evidenced by the recent China Life profit warning), but offsetting this is an improving competitive landscape. The restrictions on wealth management product issuance (bank WMPs were offering yields of about 5.4% a year ago versus an average guaranteed rate offered by universal insurance products 30-70 bps lower) has seen retail investors return to insurers. Even with foreign firms likely to grow their share from the current low 5% base as the market opens, investors seem too bearish on life insurer growth prospects, with the key stocks on sub 1x price to embedded value multiples. As with education, investors in the asset gathering/private pension theme have to see through regulatory volatility to focus on the secular tailwind for revenue growth.

Cyclical Bet Remains Attractive…

‘I would overweight MSCI China in a GEM portfolio, and particularly H-shares. Deep cyclicals in China remain favoured on growing evidence of a fixed investment recovery. That backdrop would force side-lined investors, as yet unconvinced by the sustainability of the Q1 rally, to reallocate. From a technically driven repositioning rally, the next leg globally would see a shift to a positive net earnings revision trend and multiple expansion.’ Weekly Insight, 12th April

That unfashionable cyclical bet has paid off but while the RMB proxy short via H-shares (particularly banks) has been much reduced over the summer, global funds are still underweight offshore China by almost 300bps, near a decade high. A key theme is that you have to ‘reality check’ economic data points more than ever in the current environment of rapid structural change and low amplitude trend growth that leaves Japan and Europe repeatedly on the cusp of apparent recession.

That’s even truer in a global economy where incremental growth is digitizing and the global economy is becoming ‘lighter’; it is significant that services added more to global trade growth than manufacturing last year for the first time ever. The standard macro data points used by consensus analysis are increasingly misleading and as Silicon Valley giants start employing large teams of PhD economists, it seems clear that the web giants now have a uniquely powerful perspective on economic data flow from ‘live’ consumer prices to merchandise inventory levels. Investors will likely be buying proprietary data packages from Amazon, Google etc. within a few years that are far more powerful than anything Wall Street can offer (the ‘billion prices’ project at MIT is an early view of the potential of big data and real-time online transaction networks).

There are now hundreds of data releases every week that didn’t even exist a decade ago, with dozens of bank economists commenting on almost every one, but little of that activity is of any practical help in generating actionable insight.  Back in Q1, scanning the outlook statements from key global cyclicals would have reassured any investor paralyzed by ‘sell everything’ headlines from excitable IB strategists. The granular corporate evidence has been more reliable than economist extrapolations all year and remains broadly encouraging.

As for China, Komatsu has seen a 10% rise in excavator utilization hours, the seventh consecutive month of growth. I spoke to a client recently who had attended a major tech conference in Taiwan and thought confidence among companies he met was at levels he had rarely seen over the past decade. To do this job, you need to have an analytical telescope and microscope and most importantly know when to switch between them.

Growth, inflation and earnings expectations are all turning modestly but decisively higher. That  more than central bank actions will generate volatility near-term as complacent bond investors front running central bank buying reposition for a less pessimistic economic outlook. It’s also clear that even central bankers are accepting that monetary policy is at the limits of both creativity and effectiveness, and as Harvard’s Larry Summers has recently argued, fiscal policy focused on infrastructure spending now looks a more rational policy response. By boosting the velocity of money in the real economy, that would be inherently more inflationary medium term than endless monetary stimulus that ex asset inflation effects simply gets trapped in bank excess reserves.

While recent US data has been mixed in housing etc., historically low level of combined debt service and energy outlays at just 14% of disposable income are offsetting soft wage growth, while balance sheets and net worth continue to improve. We have seen some slowing in growth in corporate bank borrowing as more companies tap booming credit markets, but the slowing in corporate bank loans has been offset by an acceleration in real estate and consumer lending.

An interesting lead-indicator granular data point is the Chemical Activity Barometer, published monthly by the American Chemistry Council, up 3.9% y/y recently and suggesting that US industrial production will accelerate into early 2017 now that the energy/inventory adjustment drags are abating. The biggest surprise to a consensus still suffering ‘macro hypochondria’ would be a synchronised cyclical growth rebound over the next 3-6mths and our overweight cyclical risk asset strategy since Q1 remains in place.

‘Peak Pessimism’ on China and EM Suggests Q4 Rebound…

The narrative of slowing global growth, rising deflation pressures and monetary impotence to do much about it remains dominant in markets – that’s reflected in very bearish positioning among global asset allocators on most survey evidence and certainly conversations we’ve had. Back in our last blog post on the risks to emerging markets at end July, we concluded that: ‘While the modest recovery in Europe and Japan looks sustainable, a full blown EM crisis would be a global deflationary shock, particularly if associated with an RMB devaluation. The PBoC is now fighting deleveraging risks/propping up asset collateral values on so many fronts, from the ever growing local government debt swap to the attempt to stabilise collapsing A-shares, that something will have to give…’

Our view since last year was that the RMB’s real effective appreciation against EM peers was unsustainable and likely to reverse with a target of 6.8 versus the USD by end 2016. The ‘shock’ RMB depreciation move in August deepened anxiety about the scale of China’s slowdown and the credibility of policy makers to deal with it. The poorly managed and communicated FX shift, like the preceding stock market intervention, indicates that Beijing’s clever and largely US educated technocrats face a steep learning curve in managing capital market expectations.

The subsequent collapse in commodity and resource stock prices looks more reflective of a 20% RMB fall versus the dollar rather than a 2% one. After the worst quarter in several years across global markets from high yield US debt to Japanese equities, will a degree of stability in China boost risk appetite in Q4? Recent measures to restrict capital outflows have seen the CNH/CNY rates converge and volatility subside, while the margin debt deleveraging process for A-shares now looks complete. The slowdown in China led by investment/heavy industrial activity has long looked inevitable and is ultimately healthy; the services sector is likely being systematically underestimated (possibly by upward of $1trn) given the Soviet style ‘count the bricks’ GDP methodology – whatever you believe ‘true’ GDP growth to have been this summer, with a fast improving property market and recent stimulus measures, momentum should be soon improving from that cyclical nadir.

From a  tactical perspective at least, we’re likely approaching ‘peak pessimism’ for both EM and commodities – negative sentiment and flows for both have been driven by deepening China fears. Even slightly better China data through year-end after the concerted fiscal and monetary stimulus of recent months would lead to stabilizing commodity prices and hence EM currencies; that would trigger a resumption of carry trade inflows as well as equity fund net flows turning positive. Turkey and Brazil remain high risk given political uncertainty, high bank sector loan to deposit ratios and weak net international investment positions (-50% of GDP in Turkey’s case). Real rates in Brazil are already touching 5% and further rate hikes to support the real would push the economy into an even deeper recession next year and drive a surge in corporate defaults.

However, EM Asia looks attractive after the summer selloff; the MSCI AXJ is now on just 11x forward earnings, and while net earnings revisions remain net negative, the pace of downgrades is abating – HK listed H-shares, Taiwan and Korea look likely to outperform if broader sentiment rebounds and unusually high levels of institutional cash are deployed. So does Japan, which despite the softening economy raising deflation risks remains attractive on the multi-year bottom up corporate governance/payout ratio theme. The odds on further BOJ intervention are rising, likely focused on equity ETF and REIT buying given liquidity issues in the JGB market. Overall, improved cyclical macro news flow from China remains key to a rally across global markets into year end and should be imminent, even if the huge structural challenge of deleveraging and rationalizing the SOE sector remains…

China’s Deflating Housing Market Inflating Mainland Stocks…

The spectacular A-share rally which has made mainland equities the best performing major global market over the past year and YTD derives not only from historically low starting valuations (the rationale for our overweight stance a year ago and since), but also diverted real estate flows. The ongoing anti-corruption campaign and sustained overbuilding have depressed long booming housing prices (down 5.5% y/y in February, with sales down almost 18%). Most analysis on China focuses erroneously on GDP and earnings momentum as the equity market driver as it would be in a normal economy, when within China’s hybrid structure the allocation of household capital flows is far more important. Indeed, the inverse correlation between Chinese equities and the housing market has long been evident, given the absence of liquid alternative investment opportunities for wealthy Chinese households (the wealthiest 1% of households own at least 30% of all residential property, while there are about 2.5m USD millionaire households in China).

Easing monetary policy, looming SOE reform, the perception that the 1trn RMB debt swap between local government and Beijing is a form of de facto QE and the further deterioration of the housing market in Q1 have all helped drive the CSI 300 above 4,000. The rally has until recently had official media sanction, as it helped offset the tightening of financial conditions via the RMB’s rapid real appreciation (and a trading band widening remains likely this year) and still rising real borrowing costs as producer price deflation intensifies, against the backdrop of vast excess capacity in fixed investment related sectors.  

There are now clear signs of speculative froth as reflected in margin debt surging by over 1.5% of GDP since late summer (and margin trading comprises about 20% of daily volumes regularly exceeding 1trn RMB), record first week rallies for recent IPOs and A-share trading account openings total a remarkable 2.8m for the past couple of weeks – overall valuations have reached about 18x forward earnings for the large cap CSI 300, on a par with the S&P 500 but small cap valuations are have soared to 60-70x.

From a 10% discount last summer, A-shares are now on a near record 35% premium versus HK listed H-shares. Back in December, I suggested another 15-20% rally was feasible in mainland shares this year; H-shares on 8x 2016 consensus EPS and 25% average discounts to dual listed mainland peers are now the preferred China exposure, and the difference between this episode and 2007 is the rise of aggressive domestic hedge funds to both exploit and eventually counter the retail mob. They have already generated volatility in global commodity markets like copper and can now short the A-share market via futures and via the HK connect scheme take advantage of the huge ‘free lunch’ cross border arbitrage opportunity which was clear in the opposite direction last summer. As well as H-shares, the broader MSCI China looks set to play catch up with the huge move in mainland equities, even as the latter enter a more volatile period in Q2…

Tech Driven ‘Creative Destruction’ Remains Key Global Trend…

‘Admittedly, during the First and Second Industrial Revolutions the magnitude of the destructive component of innovation was probably small compared to the net value added to employment, NNP or to welfare. However, we conjecture that recently the new technologies are often creating products which are close substitutes for the ones they replace whose value depreciates substantially in the process of destruction.’ New NBER paper on the latest wave of technology driven ‘creative destruction’

Academic economists are beginning to wake up to the macro implications of the accelerating digitization and dematerialization of the global economy, which has been a key structural theme both in terms of its impact on interest rates, inflation etc. but also portfolio weightings – earnings power across many established sectors will be destroyed by new entrants, who will see earnings explode even as they offer services at a fraction of the cost of incumbents e.g. instant messaging versus SMS revenues. The point the study is making is that unlike previous disruptive cycles (the industrial revolution from the mid-19th century, the first IT revolution from the 1970s) much of this mobile/cloud based service innovation destroys value within the overall economy to the extent that there is a net loss of profits, jobs etc., a topic I’ve covered recently in notes looking at deep automation/robotics and the sharing economy trend. However, one thing I’d note is that nearly every tech innovation of recent years from instant messaging to social media has been initially dismissed as trivial, but that ignores the huge impact of rapidly scaling network effects in creating utility for consumers and market value for investors. The value of LinkedIn or WeChat to users lies in the critical mass of peers they offer access to and the value to investors is the near zero marginal cost of adding new users. There are certainly too many mobile messaging services and the sector in aggregate is overvalued, as highlighted in previous notes, but the opportunity for the winners to take revenue from the established offline media and financial services sectors remains compelling. Against this secular backdrop, the NASDAQ Internet Index hasn’t quite regained its March peak but is 20% above the low set in early May after a brutal selloff as momentum positions unwound; the US Biotech Index, which led the momentum stock selloff in Q2, has broken out to a marginal new high and is up almost 30% from its mid-April low. Analysts have been upgrading their earnings estimates for the Biotech sector, with earnings now expected to rise almost 40% this year.

Meantime, Facebook, Google, and Twitter all reported above consensus results for Q2 and forward earnings for the internet sector have risen to a new record with about 20% compound earnings growth expected across the sector over the next few years. Chinese web stocks have generally continued to beat expectations from Tencent to Alibaba, the former driven by mobile gaming leveraging the 350m WeChat user base and the latter by mobile e-commerce, with active users up to 188m in Q2 and mobile up to almost 33% of gross sales volume. I noted in the 10th September note last year on the sector that: ‘China’s combined dominance as a smartphone market and manufacturing base has very bullish implications for domestic web software and service companies. For software companies from Google to Microsoft, smartphones are simply the platform for profitable content delivery. The value of content consumed on Android devices will explode in the coming years, starting with ‘in -app’ click through purchases in games and ads viewed while browsing, but smartphones will become the terminal of choice for e-commerce and the decision point for offline retail purchases too.’ Alibaba’s float is likely to drive volatility in smaller Asian tech sector names as portfolios reposition to fund their allocation, particularly as the internet sector has regained its Q2 losses, but it’s hard to see Alibaba generating the 13x 10-year returns of Google which was a very misunderstood business model at its $95 IPO price. For non-benchmark huggers, there will be a tactical trading opportunity in the wider Chinese tech ecosystem over the next couple of months – the secular outlook for the digitization of the Chinese and other EM economies remains very bullish. On that note the more modest but still multibillion float of e-commerce start-up incubator Rocket Internet bears watching. It’s an odd company which has been accused of ‘cloning’ established online business models, with its hugely well-funded operations led by former management consultants rather than entrepreneurs and little of the typical Silicon Valley start-up culture. Nonetheless, it has established leading positions in e-commerce markets across ASEAN, which ex Singapore are several years behind China in terms of development but will catch up rapidly as smartphone penetration rates rise and mobile payment systems mature.

Chinese Housing Market Risks Subsiding…

Whenever I walk around a Chinese city, I’m struck by how poor the finish can be on ‘luxury lifestyle’ new developments of bare shell flats which rarely match up to the billboard images of foreign sophistication. A key issue is that with no national building code, the quality of construction is generally very poor and sometimes downright dangerous compared to HK or Singapore (thin floor plates with exposed rebar, disconnected sprinkler systems etc.) and the depreciation rate will be far more rapid. There have been numerous cases of new towers subsiding into the ground soon after construction, and the same is now happening to prices in several markets. Average new home prices in China’s 70 major cities rose 7.7% y/y in March, slowing from 8.7% in February but activity and prices are slumping in some second and third tier regional cities.

For instance, although national home sales declined 7.7% in Q1, in the weaker provincial markets they collapsed e.g. -38% in Hangzhou, -25% in Wuxi, reflected in developers slashing prices to sustain cash flows, a trend I highlighted in a note last month. Indeed local media have reported that the cities of Changsha, Hangzhou and Ningbo have been openly discouraging property developers from cutting prices further. The coastal city of Wenzhou, which saw an SME liquidity crisis, and Ordos in Inner Mongolia where coal mining profits spawned a well-publicised boom of empty towers have seen their property markets hardest hit by the shift in sentiment. In Hangzhou (home city of Alibaba), the average selling price for residential units in the downtown area is down by over 11% y/y while as of March, 76,004 residential housing units were available for sale, an annual increase of 36%.
<New property construction starts fell 25.2% y/y to 291m square meters (the lowest quarterly amount of new floor space started since Q1 2009).

Urban real estate investment accounts for more than 10% of GDP, so ongoing weakness in the property sector would be a drag on H2 GDP growth. Some degree of policy loosening has already begun, with a few of the worst hit cities discussing removing curbs on property purchases but the key remains to boost supply of low-income rental housing (with a 7m unit public housing target this year, and 4.8m completions – the latter is actually over 600,000 fewer than last year) and accelerate the property introduction (being piloted in Shanghai and Chongqing) to curb speculative hoarding and expand the local tax base. Low income housing only accounted for 13% of total real estate investment last year (or 2% of GDP), so it can’t offset weaker trends in the wider market – the focus in any case seems to be on renovating existing 1950s/60s shantytown flats rather than Greenfield new build.

Beijing and other Tier 1 cities remain resilient although momentum is slowing; developers remain aggressive buyers with the total value of YTD land sales in Beijing reaching 102bn RMB as of last week, a level not seen until late September last year and even allowing for a moderation, the total is likely to exceed 200bn RMB this year for the first time. Meantime, commercial property investment also seems to be stalling after a huge rise in values (e.g. prime office space up 65% in Shanghai in the past 4 years, with gross yields sub 6% and flat to falling). I think indoor shopping malls (of which the country has 2,500 and still rising) remain the most egregious example of real estate over-investment and looming write-offs now that the online share of retail sales has reached 10%. At the moment the risks of a property crash look more regional than systemic, but contagion risks to Tier 1 cities bear close watching in coming months. In the meantime, with China’s total foreign debt at only about 9% of GDP and export demand still sluggish, the RMB will continue to take the growth strain.

PBoC Struggles to Cope with China’s ‘Bottom Up’ Rate Liberalisation…

China’s 7-day bond repo rate traded at an average of 8.2% on Friday, nearly double its level a week earlier. Interbank borrowing rates also surged, although not to the double digit levels seen in June. After markets closed, the PBoC announced that it had injected a total of Rmb300bn via special liquidity operations (SLOs), and in a sign of panic, has even used social networking service Weibo to declare its actions, rather than waiting a month as usual. In one way, both this spike in interbank rates and the one in June reflect incompetent PBoC technical management of a fast evolving financial market, as bank deposits disperse in a ‘bottom up’ form of interest rate liberalization. 

The bank will provide more liquidity this week to cap rates if needed to calm the year-end liquidity squeeze; while durations of a month and less have surged, those three months to one year have remained much flatter (albeit liquidity is overwhelmingly at the short end). However, Chinese financial markets are evolving rapidly via the shadow sector and competition for deposits is becoming intense, making it harder for the PBoC to micromanage the supply of liquidity. The PBoC hasn’t yet moved to a monetary policy framework targetting benchmark rates, as in developed economies.

On the operational level, the PBoC was complacent because it expected the central government, which has more than RMB4trn of commercial bank deposits and has traditionally allocated a large amount of that to local governments in December, to follow the usual script. That pattern appears to be much more muted under the new regime of official frugality. The key underlying structural issue is deposits have been fleeing the banking system for higher yielding wealth management products and online money market funds, reducing transparency. Additionally, the pressure on banks to secure deposits is always intense at the end of the year when they have to satisfy the regulatory requirement that their outstanding loans total no more than 75% of deposits on their balance sheets. The central bank crackdown in H1 on speculative forms of financing which used the interbank market and WMPs to fuel a property and investment bubble has been successful; monthly total social finance growth peaked back in March and had halved by July.

New total social financing in November stood at RMB1.23trn and total outstanding RMB loans were up 14.2% y/y, the same as overall M2 growth. However, total credit in the economy will grow almost 20% this year.Raising the cost of capital is the only effective way to encourage companies to borrow and invest more efficiently, as part of still very early stage efforts to restructure the economy away from its credit-intensive model that the government admits is unsustainable. The volatility in credit markets this year is a signal of just how difficult and disruptive that process will be.

Both now and in June, the bank refused to inject liquidity until signs of stress were generating panic headlines. The difference is that shadow finance has been reined in since Q2, so using interbank rates as a crude weapon to beat excess credit growth into submission makes even less sense, but also that the 1-year bond yield has been trending higher for months and has reached an almost decade high. It seems that more by default than design, China is now irreversibly shifting to positive real funding costs which will further pressure headline growth rates next year but also boost rebalancing momentum.  Overall, the diversification of China’s deposit markets and rising funding costs are healthy developments medium term but while the immediate money market squeeze will subside, I’ve always maintained that the Chinese economy would ultimately suffer a ‘margin call’ in slow motion from its own bank depositors as they conducted their own version of the global reach for yield.

Ultimately, the onset of demographic decline will see total deposits within the bank and shadow sectors peak through mid-decade as savings start to be run down. In the near-term, while interbank rates will subside and Chinese financial stocks rally into early 2014, 5-year generic credit default swaps look cheap at under 70bps and an increasingly desirable hedge for many investors in 2014, as these episodes of credit market instability are likely to recur and place the spotlight again on the challenge of stabilising overall systemic leverage growth.

Chronic Air Pollution Drives China toward Synthetic Gas and Solar

4th November 2013

Whenever I pass through HK airport, it strikes me that those grim glass boxes in the terminal crammed with smokers getting a pre-flight fix would be a good spot to acclimatize for a trip to Beijing; PM2.5 readings of 400-500, as seen in the Chinese city of Harbin recently (and Beijing in January), are roughly equivalent to those smoking boxes and levels at which schools have to be shut and strenuous outdoor activity is dangerous. Heavy smog afflicted Beijing once again during the recent Golden Week holiday, causing emergency airport and highway shutdowns, and this winter is likely to see the worst urban pollution yet and more importantly from a political perspective, far greater public awareness of the health risks. Policymakers are grappling for a solution, but the only real ones are to replace coal with cleaner energy sources like gas, nuclear and alternatives as well as suppressing energy demand growth via market pricing/’polluter pays’ green taxes.

This summer, the Brazilian government announced that it was launching an energy plan that looks to increase the role of renewable energy sources significantly over the next seven years. Development of the bioenergy, wind, and solar sectors were key points in the plan, with the goal to generate nearly 70% of its electricity from renewable energy sources by the year 2020, up from 55% today and ultimately China will have to make a similarly radical shift, in particular away from burning some of the world’s dirtiest coal. Renewables, natural gas and nuclear are likely to double as a share of total energy output from last year’s 13% to at least 26% by 2020, with wind and solar rising to 3-4% and gas (synthetic and shale) more than doubling its share to 12%.

In September, we reached a seminal moment in energy markets as China surpassed the US as the world’s largest consumer of foreign oil, importing 6.3m barrels per day. China’s growth in import demand can largely be attributed to its domestic oil demand growth, driven by gasoline demand due to the near-exponential increase in personal auto vehicles and diesel demand related to commercial trucking as China’s economy grows. By 2020 China will be second only to the US for the number of vehicles in circulation and oil imports will by then likely exceed 9m bpd. The per capita consumption differential remains vast, with an average Chinese citizen consuming a mere 2.9 barrels of oil per year or 14% or US per capita levels, and so far very low annual mileage Chinese drivers just beginning to explore the vast network of highways built in the recent infrastructure boom, albeit many of them expensive toll roads.

The core issues with pollution in China are a very wasteful energy model (e.g. fleets of trucks carry coal to power stations, sprawling cities with poor mass transit networks) and the pricing model for both energy and the pollution externalities from its use. In the near term, interim technologies like coal blending (to optimise burn efficiency by mixing different grades) and flue gas capture are gaining traction, but a wholesale move to cleaner energy is the only long-interim solution. As far back as 2007, the World Bank concluded that air and water pollution costs amounted to almost 6% of Chinese GDP; energy use per unit of GDP is vastly higher than other Asian countries like S. Korea and more than twice US levels.