Thursday, December 12, 2013

The Chinese elephant in the room

In my last post (see Is a Fed taper bullish or bearish for stocks?), I outlined a cautiously optimistic growth outlook for the American economy. In another post (see More reasons to buy Europe), I outlined a bullish scenario for Europe. While these two major regions in the world appear to be recovering nicely, the elephant in the room that no one wants to talk about is China.

There is no question that China's rate of growth has been slowing for the past few years. Mr. Market has been showing his concern as well. My framework for analysis is the relative return of the country market ETFs of China and its major trading partners against the MSCI All-Country World Index ETF (ACWI). That way, all returns are denominated in USD and therefore any exchange rate effects are neutralized.

Here is the relative returns of FXI, the China ETF, against ACWI. FXI has been in a multi-year relative downtrend showing a series of lower lows and lower highs on a relative basis:

Here is EWH, or the Hong Kong ETF, against ACWI. While the relative downtrend is less pronounced and EWH is approaching a relative support level, the relative trend nevertheless remains down.

The relative returns of EWT, the Taiwan ETF, tells a similar story of multi-year underperformance.

Here is EWY, or the South Korea ETF, against ACWI. It's not a pretty picture, but you get the idea.

The most alarming relative return chart of the region belongs to EWA, the Australia ETF. It recently violated a major relative support area, with little signs of relative support below. I interpret this as Mr. Market telling us that the era of Chinese infrastructure-led growth, which stimulated outsized commodity demand, is over.

Silver linings
The risk for the global economy is that a slowdown in China, if not properly managed, has the potential to turn into a crash landing. Given the financial linkages that exist around the globe, the financial contagion from a Chinese crash landing would likely spread around the world and create another Lehman or Creditanstalt style event.

Fortunately, silver linings are starting to appear. From a short-term technical viewpoint, the Shanghai Composite managed to stage a rally through a downtrend. This may be the early signs of stabilization.

Political purges ahead?
As well, I had speculated that what China needed is a purge for the new leadership to consolidate power so that it can properly end, or at least lessen, the practice of financial repression in order to re-balance the growth in the economy (see Does China need a "Night of the long knives"?):
In order to achieve its stated goal of re-focusing growth from export and infrastructure to the consumer, the authorities would have to stop, or at least lessen, the financial repression of the household sector with higher wages and interest rates for household savings. All those steps would hurt the interest of the Party insiders who got filthy rich.
I concluded that a purge may be necessary:
If China's top leadership really wanted to signal the seriousness of its intention of re-balancing growth and market based reforms, maybe what it needs is a Night of the Long Knives, which refers to an event in 1934 when Adolf Hitler instituted a purge of his enemies. One of the victims of the purge was the SA, otherwise known as the brown-shirts, because they had outlived their usefulness.

Maybe what China needs is its own purge of Party cadres, because they have outlived their usefulness and become an impediment to stable long-term growth.
Michael Pettis more or less said the same thing in this post that is well worth reading in its entirety. He began with his longstanding warnings about the need to re-balance growth in China and the road ahead is difficult. In particular, the elites will have to suffer, at least on a comparative basis [emphasis added]:
[E]very country that has experienced a growth miracle has also developed imbalances that had to be reversed, and the adjustment process is simply the process by which these imbalances are reversed. China is no exception. In order to rebalance the Chinese economy we must move from a period during which the elite received a disproportionate share of growing Chinese wealth to one in which ordinary households and small businesses receive a disproportionate share. After thirty years during which Chinese households retained an ever smaller share of the rapidly growing Chinese economy, doing nonetheless very well in the process, we must shift to a period during which ordinary Chinese households receive an ever rising share of a more slowly growing Chinese economy, in fact this is almost the very definition of rebalancing in the Chinese context.
Economic adjustments mean political adjustments as well, especially given the type of political system that exists in China. Pettis appears to be cautiously optimistic as the leadership knows what needs to be done:
History has a lot to teach us about this process, and it has a lot to teach us about which countries were able to manage the difficult adjustment in ways that created a basis for long term success and which countries were not able to do so. China’s leaders have already demonstrated sufficient foresight and ability to have managed the growth period successfully, and we have every reason to hope that they will manage the adjustment process equally well. But there should be little doubt that thirty years of astonishing growth was the relatively easier part, and that President Xi Jinping and Premier Li Keqiang face a greater challenge than that faced by their predecessors. And there should also be little doubt that the recent political turmoil in China is not an accident. History makes it very clear that the next ten years will be a political challenge for China even more than it will be an economic one.
He concluded that a purge "political step backwards" may be necessary:
[A] successful adjustment in China actually requires that China move temporarily “backwards” towards greater centralization of power and a tighter grip on decision-making by President Xi and his allies. After all it took Deng Xiaoping to unleash the radical reforms of the 1980s, and it is an open question as to whether he would have been able to do so had political power in China been as dispersed in the 1980s as it is today. In that sense what seems like an attempt by President Xi to consolidate power more tightly within a small group is perhaps not a step “backwards” in political liberalization but more of a temporary retreat in order to ensure a successful adjustment, which itself might be a precondition to further political liberalization some time in the future.
There are signs that the "political step backwards" may be starting to happen. Business Insider recently highlighted the unusual political development of the arrest of former Politburo member Zhou Yongkang:
Zhou Yongkang, China's former security chief, has been placed under house arrest while the government investigates him on charges of corruption and "violating party discipline." He's the most powerful politician to go down since the Communist party took over in 1949, and his arrest is more evidence that President Xi Jinping is embracing authoritarianism in a big way.

Think of Zhou's arrest like the President taking down the retired head of the FBI or the CIA.

The difference in China, though, is that those two security apparatus' are controlled by the party, and within the party, Zhou still had a great deal of influence. He's a former members of the Politburo Standing Committee (the 7 to 9 men that run the country) and in arresting him "Xi has broken with an unwritten understanding that members of the Standing Committee will not be investigated after retirement," writes the South China Morning Post.
This is a key development that suggests that President Xi Jinping is consolidating power. In all likelihood, the purges will spread and the markets may freak out over the prospect of political turmoil in China.

Should the markets sell off because of these political developments, it could be a buying opportunity. I agree with Pettis that some measure of authoritarianism (think Singapore) and power consolidation may be necessary for China to move ahead to the next phase of growth. Such political developments should be viewed in a bullish, rather than bearish, context.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

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 blog 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 I may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

Anonymous said...

Your articles are well thought out and well written. However like many of them you express both sides, starting with the bearish aspect and ending on a bullish note. Good to look at both sides, yes. But where do you stand?

Are you finally a SSEC bull or bear?

Hard to tell (hard to get it wrong to!) when all the articles pitch to both sides