A better way to play a China rebound

It should be obvious that China's economy has turned the corner. While we may not necessarily see gang buster growth, the risks of a hard landing are diminishing fast (see my previous posts China dodges a bullet? and Is the World Bank's downgrade of China's growth the nadir?).

The chart below of Chinese stocks (as represented by FXI) compared to the MSCI All-Country World Index (ACWI) shows that FXI rallied through a relative downtrend line in October, indicating that the worst is over for Chinese stocks. Moreover, FXI has retreated to test the downtrend line, which is now relative support, and this represents a good entry point for China bulls.

Given the volatility of Chinese stocks due to the uncertainty in political climate and weak corporate governance, a better way to play a rebound in Chinese growth may be through the markets of China's regional trading partners. The chart below of MSCI Pacific Ex-Japan (EPP) relative to ACWI shows that EPP is in a more robust relative uptrend. There is a short dated relative uptrend (dotted line) that began in October, which is supported by a longer dated relative uptrend (solid line) that began in May when EPP bottomed on a relative basis.

Another way is to play a China rebound is through Australian equities, such as EWA. A glance at top 10 stocks in EPP shows that nine of them are Australian, which indicates that the Aussie market has the heaviest influence in EPP.

Another way to get exposure is through the Hong Kong ETF (EWH). The chart of EWH vs. ACWI below shows that Hong Kong equities staged a relative breakout in late September and have been in a well=defined relative uptrend since. EWH does appear to be a tad overextended in the short-term, though.

One way to diversify your exposure is to buy both Australia and Hong Kong. The bottom panel of the above chart shows the correlation between EWA and EWH, which currently stands at 0.62. While that is an elevated reading, keep in mind that is roughly the long-term correlation between stocks and bonds and therefore positions in those two ETFs should provide an adequate level of diversification while maintaining an exposure to the China bull story.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Buy Canada, sell Australia

I read with some interest the report by Jonathan Tepper of Variant Perception, highlighted by John Mauldin and Isabella Kaminska at FT Alphaville, about the likely long term path for Australia. The report is entitled Australia: The Unlucky Country.

In a nutshell, Tepper believes that Australia's problems has two components. The first component consists of too much financial leverage and an over-reliance on external financing, i.e. the kindness of others, which makes its economy an accident waiting to happen. The second component, or the likely trigger of the pending accident, are "a domestic housing market that is one of the most overvalued in the world and a reliance on the Chinese fixed asset investment craze". Should China's growth, in particular its infrastructure growth, slow significantly, then the effects on the Australian economy could be ugly.

Here are a few selected highlights from the report that makes Australia particularly vulnerable to a devastating downturn:

Australia net external debt levels resemble those seen in the European periphery; the currency is fundamentally vulnerable. Australia has been running a persistent current account deficit since 1980 and the country's negative net international investment position is one of the largest in the world. On this background, the strong currency makes no sense and fundamentally the currency is very vulnerable to capital flight from the banking system.

Australian banks and corporates rely heavily on foreign funding; the RBA will have to provide liquidity through LTROs. Structural global deleveraging and stop-go flows add volatility for Australian banks. As the housing market continues to correct, it may be difficult for Australian banks to fund themselves. Lowering interest rates will hurt the margins of the banks, and the RBA will likely be forced into domestic liquidity operations to prop up its banks.

Australia's commodity sector is tied to a structurally slowing Chinese economy. The commodity sector remains a force to be reckoned with in Australia and will remain cyclically tied to China. Still, the Chinese economy is structurally slowing down and this will impact the growth rate of mining and resource related activities in China. Australia is likely sitting on significant overcapacity in the mining sector which will be difficult to transfer to other sectors.

What's next for China?
If the economy Down Under is so tied to China, then the obvious question is, "What's next for the Chinese economy?" As I wrote before, it appears that the Chinese authorities are determined to stimulate their economy with the same old formula of infrastructure and export growth, instead of re-balancing economic growth toward their household sector as called for by their latest five year plan (see Why is Shanghai falling?)

Premier Wen Jiabao's recent statement about the urgency to boost export growth is a sign of that desperation determination:

China’s Premier Wen Jiabao urged extra measures to support exports and help meet economic targets as a decline in industrial companies’ profits added to evidence that the nation’s slowdown is deepening.

“The third quarter is a crucial period for realizing full-year targets on export growth,” Wen said during an inspection tour of Guangdong, the nation’s biggest exporting province, the official Xinhua News Agency said Aug. 25. Industrial profits fell 5.4 percent in July from a year earlier, the statistics bureau said today.

As a consequence, I wrote that while top-line revenue growth for Chinese companies have remained relatively healthy, bottom-line profits have fallen - that's why we see the divergence between commodity prices, which have been stable, and the Shanghai Composite, which has been in a downtrend. Also Spracht Analyst confirms my observation by pointing out that Chinese corporate earnings have collapsed:

The chart below from Goldman Sachs illustrates the point perfectly. It shows that for A-share companies (CSI 300) which have reported their second quarter earnings, earnings growth on a year-on-year basis for second quarter of 2012 is now hugely negative if we exclude the financials. Meanwhile, profits for MSCI China in the first half increased by a mere 1% yoy, or –5% yoy when financials are excluded.

(Click to enlarge)

A better way to play Australia
If investors are so worried about Australia, but want to have exposure to the global sectors that it represents, there is a better way - Canada. The equity markets of both countries are structurally similar, with similar degrees of weighting in resources (though Canada is more energy heavy and Australia is more tilted towards mining).

The chart below of the relative performance of the US-listed Australian (EWA) and Canadian (EWC) equity market ETFs show that EWA at the top of the trading range against EWC. Moreover, we have see a recent turnaround in the relationship in favor of Canadian equities.

A glance at the AUDCAD cross-rate shows a similar level of turnaround in favor of the Canadian Dollar against the Australian Dollar:

Moreover, the Variant Perception report highlighted Australia's vulnerability to external financing and compared its position to eurozone peripheral countries. By contrast, Canada's net international investment position (NIIP) is far better than Australia's and makes it less sensitive to foreign funding needs [the chart annotation is mine]:

The crisis-stricken economies along the eurozone periphery share one key characteristic: their external debt is too high and their net international investment position (NIIP) - measuring the difference in stock value between assets held abroad and asset held domestically by foreigners - is deeply negative.

Yet, a closer look and you will find Australia and its neighbour New Zealand in the same company, with negative NIIPs well above countries such as Turkey and Brazil.

Australia sounds like it may be an accident waiting to happen. As for the timing of a downturn, I have no idea when China's economy will hit a serious air pocket, but when it does the Australian economy is going to be toast. For investors looking to get exposure to those global sectors represented by the Australian stock market, Canada is a better bet given the their recent relative performance and risk profiles.

In short, it's may be time to buy Canada and sell Australia and, for the adventurous, buy Canada and short Australia.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Cheap way to get Aussie exposure

I have written about the Australia/Canada pair trade before. Both economies and their stock markets are structurally similar. The major difference is that while Australian resource exposure is tilted towards mining, Canadian resource exposure is more heavily weighted in energy.


Buy Canada/Sell Australia
The chart below shows the relative performance of the iShare Canada ETF (EWC) compared to the iShare Australia ETF (EWA), both measured in USD. As you can see, Canada is near the bottom of a relative trading range.

The Canadian election held Monday gave the Conservatives a rare majority government. These results should take some of the political uncertainty out of the Canadian market.

Given the relative performance of the two markets, traders may want to consider going long Canada and shorting Australia. More risk averse investors can think of the Canadian market as a cheap way of gaining exposure to an Aussie-like stock market.

As always, pairs trading is not for the faint of heart and any trade should be entered with well-defined risk limits in mind.

Time to sell Australia

Back in late May I suggested that a cheap way to buy Canadian-like equity exposure would be to buy the Australian market, as both markets and economies are fairly similar. The chart below shows the relative returns of the iShares Australia ETF (EWA) relative to iShares Canada (EWC) and what the pair has done since the call:

Since my post, the Australian market has beaten the Canadian market by about 8%. The maximum outperformance of this trade was about 11%. The pair trade has reached parity. It's time to take profits.

Buy Australia, sell Canada

Recently Bill Hester of Hussman Funds did some analysis of average country valuation based on a composite of cyclically adjusted P/E ratios and dividend yields and concluded that US equities remains overvalued compared to its own historical average.

What fascinated me about the chart was the degree of overvaluation exhibited by Canada, compared to Australia, which is trading at roughly its own historical average. The economies of Australia and Canada are similar in character. Both are resource based economies and about the same size. There is a minor difference as Australian resource industries tend to be more tilted toward the bulk commodities (i.e. coal and iron ore) whereas Canada has a higher weight in energy.


Long Australia/Short Canada
The chart below shows the relative total performance in USD, which takes out any currency effects, of the iShares Australia ETF (EWA) and the iShares Canada ETF (EWC). This chart suggests that Australian and Canadian markets have tracked each other relatively closely since late 2002 and Australia is now at the bottom of a trading range relative to Canada.

Hester’s analysis, combined with the above chart, screams out for a trade of going long Australia and shorting Canada.

The risk in the trade is seen in the recent steep selloff in the Australian market, attributable to the news of a super-tax of up to 40% being imposed on resource companies. Nevertheless, the trading range is indicative that the risk-reward ratio is positive for this pair trade and that most of the bad news is already in the Aussie market.

Here are some of the things that could go right for the trade:

• Australia took the lead, but the super-tax contagion could spread. How long would it take for budget constrained countries like Canada or Brazil to consider a form of super-tax on resource extraction companies? The 40% tax rate is awfully tempting and forms a very high ceiling rate from which to impose a new tax. Sympathy for resource extraction companies is low, especially in offshore oil extraction given BP’s environmental and public relations nightmare.
• The Australian government has indicated that the door is open in changes to the tax regime. While the news is bad right now, the Aussie market could rally should the government step back and ease up its tax proposal.
• The Reserve Bank of Australia is ahead of the curve in its monetary policy, as it has moved into tightening mode. By contrast, the Bank of Canada remains behind the curve in its monetary policy. What would happen to the Australia/Canada spread if and when the BoC tightens?

A long Australia/short Canada trade is a highly speculative position. As such, I would be entering into such a trade with a target and pre-defined stop loss levels.