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.

As Chinese Trend Growth Slows To 6-7%, Is the RMB Now Overvalued?

Well, it’s certainly getting to harder to argue that it’s cheap. The Bank for International Settlements produces a real exchange rate calculation (adjusting for relative inflation rates) which shows that the RMB since 2010 on a trade weighted basis has risen faster than any other major currency. Using unit labour costs rather than CPI would show an even more dramatic loss of competitiveness, and every manufacturing SME owner I met on a recent trip to Zhejiang province was feeling the pain. The latest surge in the nominal RMB exchange rate is odd as it comes at a time of soft growth, falling inflation (only 2.1% y/y to May) and flagging exports (which grew by only 1% over the same period), and largely reflects a surge in hot money inflows until last month, when a regulatory clampdown on fake invoicing began. The RMB appreciated by an annualised rate of 5.5% in May, after rising at a 9.2% annualised pace in April but that is likely to slow dramatically and even go negative in coming months.

Slower capital inflows due to the crackdown on over-invoicing of trade, and the wider retreat from riskier assets by investors in global markets have reduced net capital inflows, exacerbating liquidity tightness inside the banking system are tight in China, reflected in interbank rates. Beijing is committed to increasingly the volume of buyers and sellers of the currency, thereby boosting liquidity and forcing financial institutions to adapt gradually to FX risks. While recent interbank tightness and endless growth downgrades have raised hopes of a rate cut, raising interest rates to slow investment growth and credit expansion is key to promote financial liberalisation, exchange rate reform, and capital account convertibility.

However, the financial constraints to raising interest rates are large because of the existing debt burden of Chinese local governments and SOEs, which, in the absence of alternative revenue streams, requires cheap and abundant credit from the banking sector. Interbank rates will come down over the next month as the central bank injects more cash through its open-market operations; funding can’t be sustained at such a high level because it will disrupt the whole lending market. If liquidity is so tight that it is even difficult for government to raise funds, it will be even more difficult for highly leveraged companies, many of which have short duration debt. Ultimately, it’s inevitable that we will see local equivalents to the current financial chaos surrounding Brazil’s EBX group, and indeed that process is crucial to establishing lending discipline.

On my recent trip around China, rising graduate unemployment and unsustainable levels of pollution were identified by many well-placed sources as key political threats which only a wholesale reform push can help solve. There is no going back to investment led stimulus to goose growth, and the diminishing marginal return in GDP terms makes it pointless anyway. Credit growth accelerated in Q1 to around USD1trn and in April and May and total social financing increased by RMB1.6trn in April and RMB1.19trn in May. New credit is generating ever weaker returns in the real economy, suggesting that there has been a breakdown in the credit transmission channel, such that credit is being directed into sustaining debt servicing burdens and loan roll-overs. Once interest payments consistently grow faster than income at a national as much as household or corporate level, debt becomes unsustainable and that ‘tipping point’ is the crucial one for China, with aggregate interest payments already amounting to about 10% of GDP.

For the past few months, as noted above trade data has been inflated by over-invoicing as speculators sought to bring in capital, largely through higher export receipts for tech goods via HK. The weak exports and imports data suggest consensus GDP growth forecast downside, although limited ‘hard landing’ risk at this stage. As the RMB has floated up within its daily band, the central bank has largely accommodated its movements, raising its morning reference rate by a similar amount, perhaps guided by larger reform plans.

Last month PM Li Keqiang said that an operational plan for easing capital controls would be put forward later this year; if the RMB was significantly below its market value, relaxing capital controls could attract destabilizing speculative inflows so the stronger RMB might be seen as a necessary precondition for looser controls. In the past few weeks, regulators have clamped down on hot-money inflows disguised as export earnings and the RMB appreciation has leveled out – a widened trading band should see downside volatility reemerge.

Investment in real estate is slowing and fell from 24.4% in April to just 23.6% in May. Meanwhile, investment growth in manufacturing has slowed from an average of 43% each month in 2011 to 25% in 2012, and to just 17.8% in May. The combined reading of the official and HSBC/Markit PMI for manufacturing has now slipped from an average of 51.4 in March to 50 in May. In addition, the employment sub-index for the PMI for manufacturing has now had 12 consecutive months of sub-50 readings. New exports orders remained in contraction for the fourth month this year so far in May. In fact, with the exception of a run of 10 consecutive months of sub-50 readings from July 2008 through April 2009, China’s new export sub-index of the PMI hasn’t had a worse year-long stretch since data started being collected in 2005. Given that 58% of exports now go to other emerging economies, few of which are in good shape, that’s not surprising.

The virtuous trade circle around the emerging economies which insulated them from the worst effects of the 2008/9 crisis and which saw intra GEM trade soaring is now a drag as they simultaneously slow. China is better placed to adapt to the new reality (and its markets better discounting the impact) than many of the countries which profited from entering its economic orbit in recent years. The World Bank has forecast that real interest rates are likely to jump by up to 270 points in the more heavily indebted emerging markets as the Fed unwinds quantitative easing, and the tightening cycle starts in earnest. Coming on top of the terms of trade shock from weaker commodity prices as China shifts its growth focus that will create sustained volatility and a polarisation in valuations across GEM between the relative macro winners and losers (the former net commodity importers, particularly those which haven’t seen excessive real estate/lending booms) in this on-going paradigm shift. Once the dust settles on the current Fed tapering volatility, that structural shift will be the key GEM investment theme through mid-decade.



Chinese New Year Credit Fireworks…

The fireworks display was underwhelming this week in Beijing to reflect the new mood of official frugality, but China’s spectacular credit growth in January was more jaw dropping than any pyrotechnics. New RMB lending surged to 1.07trn RMB ($172 billion) in January, the highest since January 2010 amid the last cyclical credit boom, when loans hit 1.39trn RMB, while M2 money supply growth accelerated to 15.9% y/y. Aggregate financing in the month exploded to 2.54trn RMB ($410bn). Overall, 60% of total credit creation originated from the shadow sector of trusts, corporate bonds, loans by investment companies, direct intercompany lending and banker’s acceptances and the 40% share of core banks was up from its lowest ever level in December, but well below the 52% of annual 2012 aggregate financing. Overall, the recent credit injection (even allowing for fast deteriorating incremental credit efficiency, with each new RMB of output now requiring about 6 RMB of credit) suggests that the Chinese economy is likely to accelerate in Q1 to 8.5% plus growth, but systemic risks are once again building.

It’s getting increasingly hard for the central authorities to clamp down on ever mutating off balance sheet credit conduits, and brokerages are the latest one to emerge. When the government tried to clamp down on investment companies known as trusts, securities brokerages stepped into the off-balance sheet breach. They have been allowed to invest their own money and assets managed for clients in a much wider range of financial products, including bank wealth management schemes, since the securities regulator started implementing a series of new policies from October 2012. Banks favour securities firms over trusts because loans made through their asset management schemes do not count towards bank lending quotas. Trust companies have a fiduciary duty to investors (though their role has been limited to being only a capital conduit in the bank schemes); securities firms don’t even have this minimal responsibility, and hence charge much lower fees to the banks, a further incentive for banks to redirect flows their way.

The amount of assets managed by Chinese brokerage firms exceeded 1.2trn RMB at end 2012 from 280bn at the beginning of the year. Up to 90% of that total was tied to banks; in a typical structure, the bank entrusts the securities firm with funds raised from wealth management products, and the securities firm uses the money to buy the bank’s notes or invest in other types of financial instruments. The arrangement allows the bank to shift assets off its balance sheet and circumvent lending restrictions. The securities firm, in return, charges the bank a fee for using its service. The schemes mirror arrangements that allow banks to channel money through trust products to borrowers otherwise ineligible for bank loans. 

That tactic is used much less frequently because the CBRC since August 2010 has required all trust companies to cap the value of trusts tied to bank loans at 30% of their total outstanding products, while banks were required to include loans made through trusts on their balance sheet. It looks like similar measures may have to be implemented regarding brokerage products. Overall, the investment surge since mid-2012 is being enthusiastically funded, underpinning near term growth momentum. However, this is likely the last throw of the fixed investment policy dice. After a five year 60 plus percentage point surge in the outstanding credit/GDP ratio, China’s capital balance is approaching a similar and globally disruptive inflection point to that seen in coal or soybeans in recent years. The country looks set to become a sustained net importer of capital by late decade as domestic corporate and household savings peak, amid widespread post credit bubble asset deleveraging and balance sheet recapitalization. Enjoy the party while it lasts…

Macau’s VIP Gamblers Go AWOL, Like China’s Capital Inflows…

I was bearish on Macau casinos throughout 2011, viewing them as a conduit for money laundering as well as a temporary beneficiary of the credit and liquidity explosion in 2009/10, noting in February last year that: ‘A lot of official statistics on the Chinese economy are at best of dubious quality, but casino revenues for Macau are reliable and the trend is worth watching closely. On a back of the envelope calculation of average casino margins the total cash wagered by Chinese gamblers must be in the order of $750-800bn, from an economy which officially had nominal GDP in 2010 of $5.7trn…the activity of Chinese high rollers in Macau is also a useful leading indicator of domestic liquidity conditions and I would keep a close eye on trading in those casinos as much as money market rates.’ That insight remains valid, and those liquidity conditions are de facto being tightened by rising capital outflows, as much as weak bank deposit growth.

With restricted corruption opportunities for mainland officials from land sales as real estate investment slides,  a squeeze on the shadow banking system since early 2011 as well as growing political pressure to ‘tone down’ conspicuous consumption, fewer have been making high-roller trips to Macau and the tough junket market can’t be replaced by a still healthy mainstream tourist market.  After surging 58% in 2010 and 42% in 2011, gross gaming revenue growth looks to be slowing to 12% this year and at best half that next. Gross gaming revenue growth was 12% y/y in June but softened to just 1.5% in July, and gaming activity is correlating with high-end retail activity in both China and HK. As in retailing, it looks wise to concentrate any exposure on the mass market players, because the VIP squeeze will worsen in coming months as the political mood shifts further, and overall growth in VIP revenues for 2013 may well struggle to be positive.

In expectation of RMB weakness, Chinese companies have been accumulating dollars at a record pace this year and total foreign currency deposits have increased $137bn, or 50%, since January. However, reduced flow of funds into China’s financial system mean inherently tighter conditions in money markets, making it more difficult for banks to make loans, and frustrating Beijing’s attempts to boost economic momentum.

This week, the PBoC injected a net RMB 278bn into the interbank money market, the largest net injection since early January. The overall monetary/credit backdrop remains subdued; M2 money supply increased by 13.9% y/y in July while M1 narrow money was up just 4.6% y/y while currency in circulation increased by 10%. RMB deposits are also falling again; total bank deposits fell by RMB500bn compared to the end of June, and both deposit growth and the reversal in capital flows are both acting as constraints on the default bank credit driven response to a cyclical slowdown in China. This is apparent in the lending figures; new lending to non-financial corporations was RMB358.8bn in July, down from RMB644bn in June of which only RMB92bn was in medium/long-term loans likely to result in real economic activity, while RMB152.6bn came from bill financing.

I covered the complex mechanics of Chinese monetary policy in a monthly note last November, and noted that a key element of money creation arose from weak FX sterilisation of sustained current account inflows via the RRR, which leaked into the real economy via the shadow banking sector; recent outflows imply that this money creation process has gone into reverse, tightening liquidity. What I underestimated then was just how fast reserve accumulation would slow in H1, as capital flight became a significant factor. RRR reductions and repo operations do not necessarily represent net easing when the capital account is seeing accelerating outflows and the RMB is declining in nominal (if not real effective) terms. From a stance of buying dollars and selling RMB sterilised via the bill market back to exporters over the past decade, the PBoC now has to sell USD to the market amid a domestic shortage, and surging demand for foreign currency deposits. That changes the liquidity dynamics within the economy fundamentally.

China’s trade surplus and FDI inflows mean pretty constant inflows of foreign funds into the economy, but the pace of growth has slowed dramatically. In the past, expectations that the RMB would rise meant those funds were rapidly exchanged. Purchases of foreign exchange that fall below monthly inflows from trade and investment suggest either hot-money outflows, or a decision by firms to hold their foreign earnings in dollars. The country’s banks were net sellers of 3.8bn RMB in July, from net buyers of RMB 200-400bn a month for most of 2011 i.e. local bank foreign exchange purchases are lower than the monthly trade/investment inflows, and it confirms anecdotal evidence that exporters are reluctant to settle in RMB. China’s banks have been sellers of dollars in five of the past 10 months, purchasing just RMB 145bn in FX over that combined period, compared to the RMB 905bn that flowed into the country via its cumulative trade surplus. To put that in context, in Jan-Oct 2008, China’s banks were net purchasers of RMB 3.6trn in FX and massive inflows of capital were a key factor behind China’s soaring bank lending, property prices and consistent RMB appreciation. The balance of payments deficit in Q2, the first since 1998, reflected these new and potentially structural trends.

The capital outflows so far represent only a minor reversal viewed against the over $3trn in FX reserves, and SAFE won’t be a forced seller of its vast stock of US Treasuries just yet. The flow trend has been negative since September 2011, but the overall FX position hasn’t changed much in the past year, standing at RMB25trn, ex FDI flows (which are down almost 9% y/y). Inflows of foreign money into China have slowed this year, despite the QFII scheme being more than doubled to $80bn but the key issue is that Chinese investors seem to be increasingly evading the country’s strict capital controls to send money offshore. The interesting question is whether those controls are tightened in response, or alternatively this ‘leakage’ accelerates capital account liberalisation.

Although the RMB’s real effective exchange rate index dropped only slightly in July on BIS calculations, from a record high of 106.49 in June, a significant nominal (say 2-3%) depreciation of the RMB in H2 would imply a degree of desperation, as well as complicating the US relationship and RMB internationalisation efforts. The PBoC will be attempting to manage a very gentle downward glide path for the currency, having struggled to stem its natural rise until recent months. As much as momentum in real estate prices and food inflation, the radical and on-going shift in China’s capital flows and consequently monetary environment will be a critical constraint on policy options. And it’s not great for the Baccarat tables either.