Investors take heed of the tale of two Chinas
China’s stock market cannot be taken at face value and the
quadruple-whammy events of January 2016 are a case in point. The CSI 300 index
ended 21 per cent down for January!
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WONG KOK HOI
25 February 2016
China’s stock market cannot be taken at face value and the quadruple-whammy events of January 2016 are a case in point. The CSI 300 index ended 21 per cent down for January!
The market selloff, coupled with fears of a sharp yuan depreciation, George Soros's and several other major hedge funds' declaration that they are shorting the yuan big time, news of huge capital outflows (as large as US$1 trillion in 2015 by some measures) and news that China's GDP (gross domestic product) growth slowed from 6.9 per cent in Q3 2015 to 6.8 per cent in Q4 all came into play. It can look like investors were pulling out en masse and that China's currency, economy and stock market are in dire straits.
The underlying reality is starkly different and is seldom discussed in public forums. Two events were at the heart of the sell down in January and both are unrelated to the state of the economy, the yuan or corporate fundamentals.
The first event is connected to the anti-corruption investigations into insider trading, market manipulation and front running, which I wrote about in an earlier Note from the CIO. Several months have passed since the first high-profile arrests in the summer, including that of the notorious Xu Xiang of Zexi Investment Management. Market players knew that these initial arrests had recently yielded 300 names for further investigation and that the anti-corruption chief, Wang Qishan, almost never does a half-baked job; this means many more industry players will be probed.
Several founders/CIOs of sunshine asset managers are reported to have already left the country and are operating from abroad; those who did not manage to leave have had their passports impounded. To prevent portfolio assets from being frozen indefinitely and to distance themselves from the web of insider trading (although too late), many fund managers closed their positions in the stock market, which was a major contribution to the slide. Other retail investors joined in the selling as manifested by the drop in total margin financing balance to a 14-month low of 898 billion yuan (S$193 billion) as at end-January.
Mutual funds have also joined the selling and some hold about 30 per cent cash. The biggest sellers have been the sunshine asset managers (China's equivalent to hedge funds), and their cash level is even higher, at 60-80 per cent, which brings me to the second event.
Many sunshine funds had entered into arrangements with banks and other intermediaries on "first-loss-capital funds". In such structures, the sunshine funds take the first loss, often set at 10 per cent. Like in last summer's crash, many funds hit the 10 per cent loss limit, at which point the funds must be liquidated; however, some hedge funds cut their losses at 7-8 per cent to avoid liquidation. Such selling and acts of self-preservation have little to do with fundamentals.
Some investors believe that the yuan will soon see a 20 per cent devaluation partly because the Chinese economy is weakening and partly due to large capital outflows. Let's put these two perceptions into perspective.
I have often said that stocks' performance and GDP have no link. But I must comment on China's GDP as misperceptions about its growth speed is one major cause of investors' anxiety. As mentioned earlier, investors were concerned about China's GDP growing slower in Q4 than in Q3. But Capital Economics discovered that Q4 GDP growth actually "picked up markedly" if you strip away the financial sector. If you look even closer at the data, you will see that New China sectors such as services, which now account for more than half of GDP, are growing faster while Old China sectors such as steel manufacturing and coal mining are losing momentum.
For the whole of 2015, the primary industries (agriculture, forestry, etc) grew only 3.9 per cent while the secondary industries (mining, manufacturing, electricity production, construction, etc) expanded 6.0 per cent and the tertiary industries (all others) advanced 8.3 per cent.
This dichotomy is also evident in corporate profitability. Iron and steel companies in the CSI 300 have markedly weaker ROE (return on equity) and ROA (return on assets) than services and software companies. Even if the economic slowdown is more severe than the data is showing, a slower economy is known and priced in by the market. This old concern could not reasonably have caused the market to drop 21 per cent in January!
Capital outflows are another scaremonger. In December 2015 alone, forex reserves fell by US$107.9 billion, followed by another US$99.5 billion in January 2016. For the full year of 2015, the reserves declined by US$500 billion to US$1 trillion, depending on which methodology is used. But contrary to popular belief, global investors are not abandoning Chinese assets in droves.
If you exclude trade surpluses and inbound investment, the outflows are closer to the lower end and a large proportion of that was due to corporates repaying foreign-currency debt that they had taken when US interest rates were near zero. Now, with the US Fed rate hike and a weaker yuan, Chinese companies are borrowing onshore to pay down US dollar debt. As a consequence, onshore foreign-currency loans have fallen about 10 per cent year on year in January.
What is less often discussed is that ill-gotten gains are leaving the country and their "emigration" is one major reason for the decline in forex reserves. Seeing hundreds of billions of dollars reportedly confiscated from mostly party cadres and government officials found guilty of corruption, the remaining illicitly earned gains sought safety outside China. The argument that capital is leaving China for higher returns is complete nonsense.
Chinese are now infamous for buying properties in Sydney, Toronto, Singapore, London, New York and Hong Kong at inflated prices and are not even bothering to seek tenants. Such behaviour can be hardly described as return or income-seeking investments.
There is now a pervasive view that the yuan must depreciate significantly. Mr Soros has declared at the Davos Forum that the Chinese economy is heading for a hard landing. His message to the world and the People's Bank of China (PBOC) was that he shorted yuan big time. But in this instance, he has probably made a miscalculation. He may have made more than US$1 billion from shorting the British pound sterling in the early 1990s on a bet that the Bank of England (BOE) would not be able to maintain an artificially high exchange rate. But the PBOC in 2016 is a very different ecosystem from the BOE in 1992.
Having said that, the yuan may still depreciate moderately in the longer term, but not until the shorts have been shot. Neither will future depreciation be steep. Fang Xinghai, vice-chairman at the securities regulator who spoke on a Davos panel in January, said that there is no basis or reason for a deep depreciation because a steep decline would not benefit China as it will not encourage consumption. Neither will it force manufacturers to upgrade. Dr Fang's view was stressed once again this week by Zhou Xiaochuan, governor of the PBOC, during an interview with Caixin.
Investors are so distracted by the recent meltdown that they are disinterested in the positives. China has been a major beneficiary of depressed commodity prices, which would mean savings of US$500 billion a year!
It has also helped to keep inflation at bay which will prompt the PBOC to cut rates again. With ample liquidity, it is not difficult to see part of this excess liquidity find its way into the stock market. CSRC (China Securities Regulatory Commission) has recently eased the conditions for QFII (Qualified Foreign Institutional Investor) quotas and has also granted sizable QFII quotas to a few investors. This is a crucial measure to facilitate MSCI's decision to include A shares in the GEM index. This announcement looks certain to take place in June 2016.
Given that all mainstream asset classes have been sold off as we ushered in 2016, it is easy for any investor to join the bear chorus. At APS, we believe that investors should be discerning in this kind of environment. On China, while we have been negative on the Old China stocks including banks for more than two years, we are sanguine about the New China sectors and stocks. Even here, we discern because not all New China stocks are attractive. We are certainly worried about the exuberance seen in the e-commerce sector. Our research and analysis show that many will fail and can fail pretty soon.
Consumption is the engine of the New China, as the younger generation - who are more self-indulgent than their forebears because the former grew up in an era of prosperity - form a greater proportion of the population. Those born in the 1980s, after Deng Xiaoping's reforms began, form 57 per cent of the population in 2015 and their ranks will grow to 64 per cent in 2020. Their desires, aspirations and habits are the driving force behind the success of e-commerce marvels such as Alibaba, and purveyors of entertainment such as Wanda Cinema Line.
In the technology sector, Internet security providers such as Venustech and data managers such as Wangsu Science and Technology are growing in excess of 40 per cent per annum. While the focus in the past year had been on the challenges faced by the economy, Shenzhen, a high-tech hub with a population of 20 million people, had seen property prices rise by 50 per cent on average. When markets are sold off indiscriminately across the board, stock pickers such as APS should do well because it provides opportunities for us to pick up gems at discounted prices.
On the other hand, Old China companies and sectors will generally fall behind in competitiveness, profitability and efficiency. Many are state-owned enterprises (SOEs) or companies with close state links that played important roles in China's transition from a Soviet-era economy into the more market-oriented economy it is today.
These Old China companies are rooted in a different dynamic because they were started for a different reason and under different circumstances. Many were established to kick-start China's economy in the late 1970s and early 1980s during Mr Deng's efforts to transform China. It was a time when China had fallen behind other nations in technology, personal and national wealth as well as industrial capacity, all of which Mr Deng sought to rebuild.
In the biography Deng Xiaoping and the Transformation of China, he was portrayed as saddened when he discovered that his co-workers in a Jiangxi factory, to which he was banished during the Cultural Revolution, could not even afford a radio. So when he succeeded Chairman Mao in 1978, the only way to jump-start the economy was to mobilise the most capable party officials to import equipment and technology, and execute much-needed projects to generate cash flow. These were the first enterprises. Today, this breed of companies still generally operate under the auspices of national objectives - quite different from the new crop of businesses mentioned above, driven by purely entrepreneurial DNA.
Our consistently positive view is largely driven by our bottom-up research, shaped and coloured particularly by the growth prospects of our portfolio stocks, while at the same time recognising that the economy's slowdown is being engineered by President Xi Jinping starting three years ago. It may seem preposterous that we could build a portfolio of seemingly undervalued stocks in this market environment, but one can argue that it is investors' risk aversion and the market's volatility that have provided us with the opportunity.
The writer is founder & CIO of APS Asset Management