Category Archives: China

The positive spin on China

30 Wednesday Nov 2022

Posted by in Asset Allocation, China

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It is not surprising that the comments and analysis on the recent protests in China have been overwhelmingly negative. Even Goldman Sachs which said China may end zero-Covid earlier than expected in Q1’23 put a negative spin (“disorderly exit”) and projected a lower-than-expected GDP in Q4’22.

There is no question that Chinese authorities are almost literally pressed to the wall with no easy options here. But what if there is a positive way out? It is no secret to anyone, including Chinese leaders, that there is a need to re-balance the economy towards domestic consumption and the best way to do that is to shift sectoral incomes towards Chinese households. For whatever reasons though Chinese authorities have not done that over the years, with the bulk of any extra income still going to the corporate (both private but mostly state) sector and local governments.

  • The Covid pandemic has however accelerated their work on DCEP, their version of CBDC, which allows for targeted transfers directly into people’s accounts. I believe, this is an avenue which will be much more explored as China gradually eases off from its zero-Covid policy.
  • Over the years Chinese authorities have been particularly slow in building the institutional infrastructure of pension and insurance vehicles and social security as a whole. But there has been substantial progress on that front this year.
  • Chinese assets, and in particular equities, have had two consecutive years of underperformance and under an extreme case scenario a third one is a distant possibility. However, the current set-up favours the establishment of a small exposure.

The Chinese household balance sheet

Chinese households’ balance sheet looks very different to US households’ balance sheet. In the US more than 2/3 of household assets are in the financial sector, the rest is in real estate (this is on average; it varies a lot depending on the income percentile though). In China, the split is more 50/50.

Within financial assets, Chinese households hold almost twice more Cash and its equivalents than US households (in % terms of the total household assets). But, on the other hand, they hold six times less Bonds and other Fixed Income equivalents and ten times less pension and insurance assets (all vehicles which come under social security). Equity allocations are very similar for both Chinese and US households, at around 1/3 of all household assets (this is direct ownership of equities; US households’ overall equity exposure is much larger as they own financial assets through their pension schemes, for example). A snapshot of Chinese household balance sheet can be seen here and of US household balance sheet here.

Basically, Chinese households have too much real estate and cash, too little exposure to bonds, and pretty much zero ‘social security’ cover. The protest against zero-Covid come at an opportune moment when the authorities have also been trying to contain the implosion in the real estate market. With Chinese households using real estate as the main source for pension coverage, creating a genuine viable alternative has become the top priority for Chinese leadership (the topic got extended coverage in China’s 14th Five-Year Plan).

The Chinese social security system

China’s pension industry framework consists of tree pillars. The first one is the basic state pension comprising of the Public Pension Fund and the National Social Security Fund. The second one is the voluntary employee pension plan in which the employer and employee make monthly contributions. And the third one is the private pension.

In April this year, China’ State Council released a document which stated that building the private pension system infrastructure is where their priorities now stand. This was followed by an announcement at a State Council meeting in September of new tax incentives to spur the development of private pensions.

The point is that a combination of an aging population, inadequate tax base and very early retirement age (60 for men and 55 for women) would eventually put the state pension system into deficit. At the same time, the employee-sponsored pension scheme is extremely inadequate covering only a tiny proportion of the population. So, the development of the private pension system has indeed taken centre stage.

DCEP can be used to top up household income

Part and parcel of that is ensuring the growth in household incomes. The authorities have been extremely slow in shifting national income more towards the private household sector. It is not clear to me why, especially given their goal of inclusive growth and the recent heavy regulations on the corporate sector in that direction. But these protests could speed up that process. For example, PBOC has been at the forefront globally in developing their CBDC (the Chinese equivalent is called DCEP – Digital Currency Electronic Payment). They have already successfully employed that in several cities on experimental basis.

In the present environment the authorities can use DCEP to help them ease out of their zero-Covid policy by directing payments to households in specific cities, neighbourhoods, even apartment buildings, which are affected by lockdowns. This kind of real-time, targeted fiscal policy can be extremely beneficial – much more so than the blanket free-for-all fiscal policy the US did during the Covid pandemic.   

Chinese assets offer an opportunity

Where does this leave your exposure to Chinese assets? If you are an institutional Fixed Income investor, you should consider the possibility of large flows into Chinese government bonds by both domestic retail as well as private pension providers, based on the analysis above (to a smaller extent, the same holds true for Chinese equities). Otherwise, it is easy to find reasons (see below) to not have any exposure to Chinese equities, but selling now here on the back of (zero) Covid does not make sense to me. In fact, the opposite is a better option.

Case in point, there was a lot of positive signalling at the latest weekly Covid briefing yesterday. For example, the authorities plan to increase vaccinations among the elderly, a move which could mean intentions to start reopening earlier. Some local governments were criticised for implementing severe lockdowns and were urged to adhere to ‘reasonable’ requests from residents. It is even possible, though I doubt it, that Beijing even decides to fully open up.

But there are two main risks to Chinese equities. The first one is regulatory and it is well known. The developments there are still in progress but if you are long CQQQ or KWEB (these are/were the popular China ETFs among foreign retail investors) and still worried US ADR delisting risk, you should know that only a small percentage of these ETFs holdings is still in ADRs. For example, CQQQ has 131 holdings worth about $767m. Of those only 8% (of the holdings and 15% of the market value) are still US ADRs.

Basically, the ETF providers have converted most of their US ADRs to equivalent HK/China listings, so the risk of substantial loss from US delisting for the whole portfolio has substantially diminished. There are though still regulatory risks. For example, the Chinese authorities can ban foreign entities from owning any China/HK listed stocks. I think the probability of this is small.

It could be also the case that US regulators ban US entities from investing in China/HK listed companies. I think the probability of that is also small but bigger than the former above. But, anyway, both of these are possible in a full-on US-China confrontation ala US-Russia now, which is the second risk to Chinese investments, and which is of truly existential nature. If this is your view, either you should not be touching any China-related investments, or, if you are a probability investor, you should appropriately scale your China exposure.

What explains the spectacular bounce in risk?

16 Wednesday Nov 2022

Posted by in Asset Allocation, China, Debt, Equity, Monetary Policy

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The prevailing sentiment among the people I speak to (predominantly hedge fund managers) is to sell this rally. The reasons given are (also see below for a complete list): 1) One CPI is unlikely to change the Fed’s interest rate trajectory (basically we are data dependent), 2) China has not changed its zero-Covid strategy in earnest, 3) There is still a risk of a winter energy crisis in Europe, 4) JPY weakness will not reverse before YCC is over.

All these are valid, but I will stick with a risk-on attitude a bit longer. In any case, what caused this drastic change in sentiment?

Positioning was really lopsided. See this article citing research from GS which believes CTAs were forced to buy $150Bn in equities and $75Bn in bonds. Real money is also very light risk after being forced to reduce exposures throughout the year. But what were the main drivers which changed sentiment to begin with?


It was weird to see markets actually not really selling off after Powell’s hawkish FOMC press conference. Perhaps the fact that we had a bunch of FOMC members (see here and here, for example), calling for a slowing down of the pace of Fed Fund Rate (FFR) increases, may explain to some extent the positive reaction at the time. And of course, the catalyst came when the US CPI was released lower than expected.


FFR actually does not give anymore a precise indication of the stance of US monetary policy – this is the conclusion of a new paper by FRBSF. If all data such as forward guidance and central bank balances sheet effect are taken into account, the FFR is more likely already above 6% vs the current target of 3.75-4% (the paper puts the FFR at 5.25% for September and I add the 75 bps of hikes since then).

This means monetary policy today is even more restrictive than at the peak before the 2008 financial crisis and approaching levels last seen during the tech bust in 2000. The findings in the paper make intuitive sense. Quoting from the paper:

“[W]hen only one tool was being used before the 200s, the stance of monetary policy was directly related to the federal funds rate. However, the use of additional tools and increased policy transparency by FOMC participants has made it more complicated to measure the stance of policy.”

The new tools the authors refer to are mainly forward guidance, which started to be actively used after 2003, and central bank balance sheet management, which started after 2008. The proxy FFR (see chart above) actually includes a lot more, a total of 12 market variables, including UST yields, mortgage rates, borrowing spreads, etc. It is perhaps intuitively easier to see that monetary policy was much looser at times when the FFR was at the zero-low bound and QE was in full use than it is a lot tighter today when FFR is firmly in positive territory and QT is in order, but the logic is the same.


So, I think somehow or other, the market now believes that we have seen the peak in FFR (forward) – that provided the foundation of the risk bounce.

China provided the other pillar of support for risk. Ironically, in a similar fashion to how it played out after FOMC, i.e., the consensus was that the 20th CCP Politburo meeting was an overwhelming negative for Chinses assets. And even though they sold off, there was no immediate follow through. In fact, we started hearing that Chinese authorities are looking into taking the first steps to pivot from the Zero-Covid policy, and are very serious about providing a floor for property prices. Finally, there was a genuine improvement on the US-China relations side as US regulators finished their inspection of Chinese companies in HK ahead of schedule and US President Biden and Chinese leader Xi Jinping met at the Group of 20 summit in Bali.

The third pillar of support came from Europe. First, European energy prices (see a chart of TTF) have come a long way down from their peak in the summer (almost full inventories and mild weather helped). Second, the UK pension crisis was short-lived after the change in government and did not have any spill-over effects on other markets. And third, there is genuine hope of a negotiated solution of the war in Ukraine after the Ukrainian army made some sizable advances in reclaiming back lost territory, with both the US and Russia urging now for possible talks. My personal view is that the quick withdrawal of Russia from these territories is a deliberate act to incentivize Ukraine to come to the negotiating table – even though the latter does not seem eager too . Yesterday’s missile incident, and Ukraine’s quick claim that it is Russia’s fault, which is contrary to what preliminary investigation has led to so far, might be a testament to that.

Finally, and that falls under positioning, there is the unwind of USDJPY longs spurred by heavy intervention by Japanese authorities. If there is any proof that policy makers are taking the plunge in the Yen seriously it is in the details of Japan’s Q3 GDP which shrunk unexpectedly by 1.2% (consensus was for a 1.2% increase). The bad news came almost entirely from the negative contribution of net trade. Net trade has been a drag on GDP for the last four quarters primarily from the rise in imports, i.e., the weakness in the Yen. The good news is that the economy otherwise is doing fine: private demand had a big bounce from the previous quarter and has been a net positive overall (all data can be found here): in other words, the problem is the Yen, and YCC makes that worse.

Another piece of data, released last week, which caught our attention, is Japan FX Reserves. The decline from the high in July 2020 is $241Bn, about 18% – that is a substantial amount. The interesting thing, and we kind of know this from the TIC data is that the decline is coming entirely from the sale of foreign securities; deposits actually went up marginally (some of the decline is also valuation). But we know now that when Japan was intervening in USDJPY in September/October, it was selling securities, not depos – most analysts thought Japan would first reduce depos, while intervening, before selling their security portfolio. All data is here.

In summary, CTAs’ sizable wrong way bets long USD and short equities and bonds and real money light risk exposure overall coincided with dovish economic data, reopening China and improving geopolitics (all of these happening on the margin).

The Apple of my eye

09 Wednesday Nov 2022

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After a nearly two-year hiatus due to compliance requirements (I was consulting a hedge fund start-up), I will attempt to continue writing on this blog in a more frequent format until further notice.

The Apple of my eye

One of the most enduring questions I have encountered lately is, “How come Apple is still ‘standing’ when not only other big techs are falling apart but also given that Apple is one of the most heavily exposed, amongst them, on China?”. The best answer to this was given this week by Scott Galloway here.

At the core of Apple’s recent outperformance (the stock is down only 20% from peak vs 40-50% for the other big tech and even more for the smaller tech) is a decision the company made a year ago to the effect that the upgraded Apple iOS “forced apps, including Facebook… to ask users for permission to track their data”. Here is the story on this from October 22, 2021.  

As it turns out, only about 16% of users agree to such tracking which is a big problem for companies using sophisticated data to direct ads to potential customers. As Prof. Galloway succinctly says in his note, ”[W]ithout data, the digital ad ecosystem doesn’t work”.

Here is a chart of Meta’s global ad revenue growth rates YoY until 2021. Unfortunately, in Q3’22 the company reported its first ever annual decline on a quarterly basis in ad revenues ever. Needless to say, when ad revenues make up more than 95% of the total, this development is a big problem going forward.

What about Apple? The company’s share price performance is perhaps a better indication of the drawdown one would expect stemming from all macro forces for a leading monopoly-like big tech. Yet, its overreliance on revenues from Greater China and Europe (the two combined are bigger than revenues from Americas), two regions which are grappling with idiosyncratic issues such as zero-Covid and an energy-crisis, is probably a reason to be cautions on the stock, nevertheless.

Alibaba and the 40 risks

China tech (CQQQ) trades at a record ‘discount’ to US tech (QQQ): the underperformance of the former from a year ago is staggering.

This underperformance is primarily due to regulatory issues which first started in the beginning of 2021 in China. Then at the end of that same year, US regulators independently added further pressure on Chinese companies listed on US bourses. Some of the big China tech ADRs, like Alibaba, are not only trading below IPO price, but also are down 80% from their highs.

I have no idea where this is going to end. However, I do believe that there is legitimate progress in easing of the regulatory burden from both the Chinese side as well as the US one. In any case, given that Chinese ADR positioning is now much cleaner, the regulatory risk from the US side can be easily avoided if one buys the HK-listed shares.  I do not know if this is the right time to do that, but I do know that, given their extreme undervaluation, it makes little sense to sell Chinese tech stocks on the risk of a continuation of the zero-Covid policy.

On the other hand, a China pivot on this policy would provide a massive boost to their share prices. From such an angle, the risk-return profile favours some exposure to HK-listed China tech. Still, for any investor in China, the risk of an (almost) ‘total ruin’ is quite real in the extreme scenario of a China-Taiwan conflict which leads to the freezing of Chinese external assets as well as closing access for foreigners to China/HK-listed company shares – something akin to what happened in Russia.

Ultimately, it is this unquantifiable risk which probably holds foreign investors off from dipping their feet in the China market. But, as always, the risk to any trade is not in whether one has the exposure or not, but rather what size it is and how it is timed.

Chinese ADRs Delisting Risk

08 Tuesday Feb 2022

Posted by in China, Equity, Politics

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After SEC finalized the rules relating to the Holding Foreign Companies Accountable Act (HFCA) in December last year, the next shoe to drop would be the Public Company Accounting Board (PCAOB) to identify which ADRs become ineligible for US listing. That latter would very much depend on which accounting firm does the ADR company audits – is there adequate disclosure primarily on foreign government ownership and the use of VIE structures. After that the companies have three years to comply with the rule (regulators may shorten that to 2 years). If the authorities are still not happy with the disclosures, the ADRs get delisted. So, the earliest delisting is 2024 at the moment.

This paper analyses case studies on Chinese companies that delisted from US exchanges in the past. There have been 80 such companies between 2001 and 2019 of which 29 are still operating, 26 are out of business, 14 relisted in HK/China, 11 were acquired. About Âź of those companies actually had a positive performance (IPO price minus stock delisting price). Moreover, companies that relist themselves on Chinese stock exchanges (including Hong Kong) or get acquired by private equities have already shown positive returns before delisting, on average.

In 2015 alone, 29 Chinese ADRs announced their decisions to delist and go private. A similar wave of Chinese ADRs announcing to delist and go private also occurred during the 2011-2014 period. This paper suggests that the wave of Chinese ADRs announcing to delist and go private in 2015 was mainly motivated by the Chinese government’s economic policies and regulatory changes. In that sense, it is different from the wave of going private during 2011-14, which was more likely motivated by undervaluation. It looks like the potential 2024 delisting would be caused by US regulators.

One option after delisting from US exchanges is an equivalent listing in HK. This is the default assumption of many foreign investors who have been switching to a HK listing already. But for those that don’t have a HK listing already, a listing on the A-share market either directly – an extremely cumbersome process as it would require the unwinding of the VIE structure, in most cases – or indirectly, via a CDR is a real possibility. CDRs are akin to ADRs and allow foreign-incorporated Chinese companies to list at home (the VIE structure remains intact – Ninebot a small scooter maker became the first such company to issue CDRs in September 2020). This could work well for Chinese internet ADRs which generally trade at a discount compared now to similar names in the A-share market.

Could forced delisting be averted? Possibly, if the US and China find a way to resolve their differences before the period of non-compliance is enforced. For example, in Europe, China was able to negotiate an arrangement known as “regulatory equivalence” whereby EU regulators accepted the auditing work done by the foreign accounting firm. This is extremely unlikely in the US given the current tensions between the two countries and the example of recent Chinese accounting irregularities (Luckin Coffee).

Another option is for Chinese companies listed in the US start to start complying with the necessary regulatory requirements. That is also extremely unlikely because it would require Chinese companies to hand over data and materials viewed as critical to national security by the Chinese government.

Will the US pull the plug on investing in China?

14 Thursday May 2020

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It has been going on now for a year, at least: after stopping Chinese companies on several occasions from buying specific US assets, the US administration has been also looking into banning outward US investments in Chinese assets.

The fund in the spotlight is the Federal Government Thrift Savings Plan Fund (TSPF) – the largest defined contribution plan in the world with assets of about $558Bn. The assets are split in five core funds and one additional overlapping fund as following:

Of those above, it is the I Fund that is now in the spotlight. For the moment, it has no exposure to China as it is invested in MSCI ex US EAFE.

TSPF is an outlier amongst most large retirement plans that it still has no EM exposure. In June 2017, external consultants, Aon Hewitt, made a recommendation to the board to switch to MSCI ex US All Country which is a much broader index followed by all large retirement plans. One characteristic of this index is that it includes many EMs (and yes China). The board studied the proposal and made the decision to switch in November 2017 with a target for that sometime in 2019*.

As the US-China trade war was going in full swing, the threats of possible ramifications on US investments in China started coming in, and the I Fund never made that switch.

How big is this potential US investment?

The MSCI ex US All Country is still about 75% developed markets (DM). But China is about 11% weight (second largest now), which is rather big given the recent index inclusion (the weightings have increased progressively in the last two years). That means the I Fund would have between $6Bn exposure to Chinese equities.

Adding the L Fund exposure. The L Fund will have 9% in the I Fund (from 8% currently). Therefore, given the AUMs in each above, it will have between $1-2Bn Chinese equities exposure. So, total TSPF exposure will be max $8Bn. Note, however, the L Fund’s expected exposure going forward: projections are for a substantial reduction in the G Fund weights at the expense of all others. So, potentially the future Chinese exposure can grow substantially as also China’s weight in the MSCI ex US All Country index also grows.

What is that in the context of the big flow picture?

China is in the cross hairs of deglobalization which started before the Covid crisis, but now, that process is accelerating in direct proportion to the anger towards China amongst some of the major global players, especially the USA. In the USA, globalization coincided with financialization which promoted major capital inflows to offset the trade account outflows. Financialization is now on the wane in the USA (as per the regulations post 2008, and accelerated further post the Covid crisis), while on the rise in China (see flows below).

As the Chinese economy has been catching up to the US (and possibly the Covid crisis also accelerated this process as well), it is likely that we may see a reversal of some of these past flows, namely, a reduction in China’s current account surplus at the expense of net foreign inflows.

Equities

  • Last year passive index inflows in China A shares were $14Bn; total inflows were about $34Bn
  • Total foreign investment in Chinese A shares is about $284bn
  • Foreign equity inflows this year are still a positive $5Bn despite the Covid crisis: according to HSBC data, March recorded an outflow (largest ever) but all other months were inflows, with April inflow more or less cancelling the March outflow.

Fixed Income

  • Total foreign holdings are also around $283Bn, 70% of which are in GGBs.
  • Inflows into GGBs have been consistently positive since the index inclusion announcements last year and the year before.
  • According to Barclays, YTD net Inflows are at $17Bn (5x more than at same time last year) despite a net outflow in March (but that was only because of selling in NCDs).
  • Average monthly inflows in Chinese FI is about twice that in equities.

Domestic Flows

  • March registered the largest domestic outflow ($35Bn) of any month since the 2016 CNY crisis (largely due to southbound stock connect flow (mainland residents bought the largest amount of HK stocks on record).
  • According to HSBC, FX settlement data shows that, most likely, domestic corporates have actually been net sellers of foreign currency in Q1 this year. 

Economics

While Chinese exports are expected to decline going forward, in the short term, so are imports, especially after the collapse in oil prices. However, it is inevitable that if globalization does indeed start reversing, China’s current account will shrink and possibly go into a deficit. 

Conclusion

What happens to the overall flow dynamics then, really depends on whether foreigners continue to invest in Chinese assets (and expecting that domestic residents might look to diversify their portfolios abroad once the capital account is fully liberalized, if ever). A potential ban on US Federal Government investments in China might indeed be driven by short-term considerations and emotions following the Covid-19 pandemic developments, however, unless it is followed by also a ban encompassing all US private investment, it is unlikely to amount to anything positive for the US. Moreover, it could actually give the wrong signal to foreign investments in the US, that the administration is becoming not so ‘friendly’. That could spur an outflow of foreign money from US assets, something that I discussed at length here.

*See the memo from that meeting here: https://www.frtib.gov/MeetingMinutes/2017/2017Nov.pdf

Keep Calm and Stay at Home

11 Wednesday Mar 2020

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China went through three main changes to stem the spread of the Coronavirus:

  • Quarantine
  • Lockdown
  • Rationing

In the ‘West’, we’ve added ‘Self-quarantine’ first, in some countries. Others are in the delusional phase of ‘Delay’, because, apparently, they are worried that ‘people will get bored and break out of self-isolation if it last too long’. In fairness, there is a logical reason to delay because as China and Italy will find out, the economic costs of going through those stages above are enormous. That reason is that scientists could be able to find vaccine in time. That is a very dangerous bet for the infections grow exponentially, and if a vaccine does not come soon enough, the health care system of the country will be overwhelmed (and no, the coming warm weather in the Northern Hemisphere is unlikely to slow down the infections, like in the normal flu, because this is not the normal flu, and infections have shown to grow also in hot weather like Singapore or Iran). Then, not only the economic costs but also the societal costs will be unspeakable.

Finally, one other country’s leader still thinks this virus could be ‘fake’…

WHO went on a fact-finding mission to China and released a report on February 28. The report is unequivocal:

“China’s bold approach to contain the rapid spread of this new respiratory pathogen has changed the course of a rapidly escalating and deadly epidemic.”

There are also stories about two different strains of the virus, apparently stemming from the desire to explain higher number of infections/deaths in some countries and lower in others. I don’t know. To me this is simply a function of testing more people and proper reporting. It also makes sense to run with that story in countries which have chosen to be in the ‘Delay’ stage. Occam’s razor: even if there were two strains, I don’t see how they can be country-specific.

“Everywhere you went, anyone you spoke to, there was a sense of responsibility and collective action, and there’s war footing to get things done”

~Bruce Aylward, the epidemiologist who led the WHO mission to China 

There is no doubt that even in the best cases in the ‘West’, the ones which added ‘Self-quarantine’, it will take longer to get through this also because of culture, different societal structure and more liberal thinking. For example, the talk in Italy is that if things don’t start improving in a couple of weeks the country might have to go to the next stage, ‘Rationing’ (only one person per household can leave the house to replenish supplies).

After decades of general peace, no major natural disasters in the ‘West’, and used to thinking only in financial terms, we cannot comprehend what is happening to us and are unable to quickly make the right decision how to proceed forward. For almost everybody, understandably, limiting our movement is at minimum uncomfortable and for a lot of people, unacceptable. To go through rationing is unimaginable (even though for some of us, who grew up behind the Iron Curtain, this was a feature of daily life). But seriously, it’s not like we have been asked to go to war, like our grandparents; we are just told to sit on the couch at home and play video games!

It can’t be that bad, can it?

Toto, I’ve a feeling we’re not in Kansas anymore

03 Tuesday Mar 2020

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This worked out quite well. Too well given the G7 “strong and coordinated response”. Let’s not kid ourselves, unless they can build a hospital in six days, this is going to be highly inadequate.

As if rates going negative was not enough of a wake-up call that what we are dealing with is something else, something which no one alive has experienced: a build-up of private debt and inequality of extraordinary proportions which completely clogs the monetary transmission as well as the income generation mechanism. And no, classical fiscal policy is not going to be a solution either – as if years of Japan trying and failing was not obvious enough either.

But the most pathetic thing is that we are now going to fight a pandemic virus with the same tools which have so far totally failed to revive our economies. If the latter was indeed a failure, this virus episode is going to be a fiasco. If no growth could be ‘forgiven’, ‘dead bodies’ borders on criminal.

Here is why. The narrative that we are soon going to reach a peak in infections in the West following a similar pattern in China is based on the wrong interpretation of the data, and if we do not change our attitude, the virus will overwhelm us. China managed to contain the infectious spread precisely and exclusively because of the hyper-restrictive measures that were applied there. Not because of the (warm) weather, and not because of any intrinsic features of the virus itself, and not because it provided any extraordinary liquidity (it did not), and not because it cut rates (it actually did, but only by 10bps). In short, the R0 in China was dragged down by force. Only Italy in the West is actually taking such draconian measures to fight the virus.

Any comparisons to any other known viruses, present or past, is futile. We simply don’t know. What if we loosen the measures (watch out China here) and the R0 jumps back up? Until we have a vaccine or at least we get the number of infected people below some kind of threshold, anything is possible. So, don’t be fooled by the complacency of the 0.00whatever number of ‘deaths to infected’. It does not matter because the number you need to be worried about is the hospital beds per population: look at those numbers in US/UK (around 3 per 1,000 people), and compare to Japan/Korea (around 12 per 1,000 people). What happens if the infection rate speeds up and the hospitalization rate jumps up? Our health system will collapse.

UK released its Coronavirus action plan today. It’s a grim reading. Widespread transmission, which is highly likely, could take two or three months to peak. Up to one fifth of the workforce could be off work at the same time. These are not just numbers pulled out of a hat but based on actual math because scientist can monitor these things just as they can monitor the weather (and they have become quite good at the latter). And here, again, China is ahead of us because it already has at its disposal a vast reservoir of all kinds of public data, available for immediate analysis and to people in power who can make decisions and act fast, vert fast. Compare to the situation in the West where data is mostly scattered and in private companies’ hands. US seems to be the most vulnerable country in the West, not just because of its questionable leadership in general and Trump’s chaotic response to the virus so far, but also because of its public health system set-up, limiting testing and treating of patients.

Which really brings me to the issue at hand when it comes to the reaction in the markets.

The Coronavirus only reinforces what is primarily shaping to be a US equity crisis, at its worst, because of the forces (high valuation, passive, ETF, short vol., etc.) which were in place even before. This is unlikely to morph into a credit crisis because of policy support. 

Therefore, if you have to place your bet on a short, it would be equities over credit. My point is not that credit will be immune but that if the crisis evolves further, it will be more like dotcom than GFC. Credit and equity crises follow each other: dotcom was preceded by S&L and followed by GFC.

And from an economics standpoint, the corona virus is, equally, only reinforcing the de-globalization trend which, one could say, started with the decision to brexit in 2016. The two decades of globalization, beginning with China’s WTO acceptance in 2001, were beneficial to the USD especially against EM, and US equities overall. Ironically, globalization has not been that kind to commodity prices partially because of the strong dollar post 2008, but also because of the strong disinflationary trend which has persisted throughout.

So, if all this is about to reverse and the Coronavirus was just the feather that finally broke globalization’s back, then it stands to reason to bet on the next cycle being the opposite of what we had so far: weaker USD, higher inflation, higher commodities, US equities underperformance.

That’s my playbook.

Corona Virus market implications

29 Saturday Feb 2020

Posted by in Asset Allocation, China, EM, Equity, Monetary Policy, Politics, UBI

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Following up on the ‘easy’ question of what to expect the effect of the Corona Virus will be in the long term, here is trying to answer the more difficult question what will happen to the markets in the short-to-medium term.

Coming up from the fact that this was the steepest 6-day stock market decline of this magnitude ever (and notwithstanding that this was preceded by a quite unprecedented market rise), there are two options for what is likely to happen next week:

  1. During the weekend, the number of Corona Virus (CV) cases in the West shoots up (situation starts to deteriorate rapidly) which causes central banks (CB) to react (as per ECB, Fed comments on Friday) -> markets bounce.
  2. CV news over the weekend is calm, which further reinforces the narrative of ‘this too shall pass’: It took China a month or so, but now it is recovering -> markets rally. 

While it is probably obvious that one should sell into the bounce under Option 1, I would argue that one should sell also under Option 2 because the policy response, we have seen so far from authorities in the West, and especially in the US, is largely inferior to that in China in terms of testing, quarantining and treating CV patients. So, either the situation in the US will take much longer than China to improve with obviously bigger economic and, probably more importantly, political consequences, or to get out of hand with devastating consequences. 

It will take longer for investors to see how hollow the narrative under Option 2 is than how desperately inadequate the CB action under Option 1 is. Therefore, markets will stay bid for longer under Option 2.

The first caveat is that if under Option 1 CBs do nothing, markets may continue to sell off next week but I don’t think the price action will be anything that bad as this week as the narrative under Option 2 is developing independently. 

The second caveat is that I will start to believe the Option 2 narrative as well but only if the US starts testing, quarantining, treating people in earnest. However, the window of opportunity for that is narrowing rapidly.

What’s the medium-term game plan?

I am coming from the point of view that economically we are about to experience primarily a ‘permanent-ish’ supply shock, and, only secondary, a temporary demand shock. From a market point of view, I believe this is largely an equity worry first, and, perhaps, a credit worry second.

Even if we Option 2 above plays out and the whole world recovers from CV within the next month, this virus scare would only reinforce the ongoing trend of deglobalization which started probably with Brexit and then Trump. The US-China trade war already got the ball rolling on companies starting to rethink their China operations. The shifting of global supply chains now will accelerate. But that takes time, there isn’t simply an ON/OFF switch which can be simply flicked. What this means is that global supply chains will stay clogged for a lot longer while that shift is being executed. 

It’s been quite some since the global economy experienced a supply shock of such magnitude. Perhaps the 1970s oil crises, but they were temporary: the 1973 oil embargo also lasted about 6 months but the world was much less global back then. If it wasn’t for the reckless Fed response to the second oil crisis in 1979 on the back of the Iranian revolution (Volcker’s disastrous monetary experiment), there would have been perhaps less damage to economic growth.  Indeed, while CBs can claim to know how to unclog monetary transmission lines, they do not have the tools to deal with supply shocks: all the Fed did in the early 1980s, when it allowed rates to rise to almost 20%, was kill demand.

CBs have learnt those lessons and are unlikely to repeat them. In fact, as discussed above, their reaction function is now the polar opposite. This is good news as it assures that demand does not crater, however, it sadly does not mean that it allows it to grow. That is why I think we could get the temporary demand pullback. But that holds mostly for the US, and perhaps UK, where more orthodox economic thinking and rigid political structures still prevail. 

In Asia, and to a certain extent in Europe, I suspect the CV crisis to finally usher in some unorthodox fiscal policy in supporting directly households’ purchasing power in the form of government monetary handouts. We have already seen that in Hong Kong and Singapore. Though temporary at the moment, not really qualifying as helicopter money, I would not be surprised if they become more permanent if the situation requires (and to eventually morph into UBI). I fully expect China to follow that same path.

In Europe, such direct fiscal policy action is less likely but I would not be surprised if the ECB comes up with an equivalent plan under its own monetary policy rules using tiered negative rates and the banking system as the transmission mechanism – a kind of stealth fiscal transfer to EU households similar in spirit to Target2 which is the equivalent for EU governments (Eric Lonergan has done some excellent work on this idea).

That is where my belief that, at worst, we experience only a temporary demand drop globally, comes from, although a much more ‘permanent’ in US than anywhere else. If that indeed plays out like that, one is supposed to stay underweight US equities against RoW equities – but especially against China – basically a reversal of the decades long trend we have had until now.  Also, a general equity underweight vs commodities. Within the commodities sector, I would focus on longs in WTI (shale and Middle East disruptions) and softs (food essentials, looming crop failures across Central Asia, Middle East and Africa on the back of the looming locust invasion). 

Finally, on the FX side, stay underweight the USD against the EUR on narrowing rate differentials and against commodity currencies as per above.

The more medium outlook really has to do with whether the specialness of US equities will persist and whether the passive investing trend will continue. Despite, in fact, perhaps because of the selloff last week, market commentators have continued to reinforce the idea of the futility of trying to time market gyrations and the superiority of staying always invested (there are too many examples, but see here, here, and here). This all makes sense and we have the data historically, on a long enough time frame, to prove it. However, this holds mostly for US stocks which have outperformed all other major stocks markets around the world. And that is despite lower (and negative) rates in Europe and Japan where, in addition, CBs have also been buying corporate assets direct (bonds by ECB, bonds and equities by BOJ).

Which begs the question what makes US stocks so special? Is it the preeminent position the US holds in the world as a whole? The largest economy in the world? The most innovative companies? The shareholders’ primacy doctrine and the share buybacks which it enshrines? One of the lowest corporate tax rates for the largest market cap companies, net of tax havens?… 

I don’t know what is the exact reason for this occurrence but in the spirit of ‘past performance is not guarantee for future success’s it is prudent when we invest to keep in mind that there are a lot of shifting sands at the moment which may invalidate any of the reasons cited above: from China’s advance in both economic size, geopolitical (and military) importance, and technological prowess (5G, digitalization) to potential regulatory changes (started with banking – Basel, possibly moving to technology – monopoly, data ownership, privacy, market access – share buybacks, and taxation – larger US government budgets bring corporate tax havens into the focus).

The same holds true for the passive investing trend. History (again, in the US mostly) is on its side in terms of superiority of returns. Low volatility and low rates, have been an essential part of reinforcing this trend. Will the CV and US probably inadequate response to it change that? For the moment, the market still believes in V-shaped recoveries because even the dotcom bust and the 2008 financial crisis, to a certain extent, have been such. But markets don’t always go up. In the past it had taken decades for even the US stock market to better its previous peaks. In other countries, like Japan, for example, the stock market is still below its previous set in 1990.

While the Fed has indeed said it stands ready to lower rates if the situation with the CV deteriorates, it is not certain how central bankers will respond if an unexpected burst of inflation comes about on the back of the supply shock (and if the 1980s is any sign, not too well indeed). Even without a spike in US interest rates, a 20-30 VIX investing environment, instead of the prevailing 10-20 for most of the post 2009 period, brought about by pulling some of the foundational reasons for the specialness of US equities out, may cause a rethink of the passive trend.  

Planning vs trial and error

13 Monday Jan 2020

Posted by in AI, China, Decentralization, Politics

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What’s the best model of resource optimization?

The market has been predicting the coming collapse of China ever since it joined the WTO in the early 2000s and people started paying attention to it*. The logic being, with the collapse of the Soviet Union in 1989, China would be next: the free market must surely assure the best societal outcome. But with the re-emergence of China thereafter, and, especially, that it is still ‘going strong’ now, on top of the slowdown (‘secular stagnation’ or whatever you want to call it) of the developed world, I think the verdict of what the best model of resource optimization is, is still out. 

The Soviet models of resource optimization in the 1960s and 1970s were very sophisticated for their time (and even ours): In the late 1950s, Kitov proposed the first ever national computer network for civilians; in the early 1960s, Kantorovich invented linear programming (and got the Nobel prize in Economics); shortly after Glushkov introduced cybernetics. 

Kitov’s idea was for civilian organizations to use functioning military computer ‘complexes’ for economic planning (whenever the latter are idle, for example during the night). Kantorovich brought in linear programming which substantially improved the efficiency of some industries (he is the central character in a very well written book about the Soviet planning system called ‘Red Plenty’). Glushkov combined these two ideas and his OGAS (The All-State Automated System for the Gathering and Processing of Information for the Accounting, Planning and Governance of the National Economy) was intended to become a real-time, decentralized, computer network of Soviet factories. The idea was very similar to a version of today’s permissioned blockchain: the central computer in Moscow would grant authorizations but users could then contact each other without going through Moscow.

The Soviet planning system failed not necessarily because it would not work (limited, though, as it was in terms of computational power and availability of data) but because of politics: Khruschev, who had taken over after WW2 and denounced the brutality of Stalin, was ousted by Brezhnev. The early researchers were pushed aside (in fact, those Brezhnev years were characterized by fierce competition among scientists for preferential political treatment). One could say, the Soviets’ model of resource optimization failed because it was not socialist enough (compared to how the Internet took root in the US on the back of well-regulated state funding and collaboration amongst researchers). In other words, the 1970s Soviet Union was a political rather than a technical failure. 

I should know, I guess. I grew up in one of the Soviet satellites. My father was in charge of a Glushkov-style information data centre within a large fertilizer factory. When we were kids, we used to build paper houses with the square punched cards he would sometimes bring home from work. Later on, when I became a teenager, my father would teach computer programming as an extracurricular activity in my local school (I never learned how to program – I preferred to spend my time playing Pacman instead!). At that time, Bulgaria used to produce the PC, Pravetz (a clone of Apple II), which was instrumental in the economy of all the countries within the Soviet sphere of influence.

By the time I was graduating from high school, though, things had begun deteriorating significantly: even though everyone had a job, ‘no one was working’ and there was not much to buy as the shops lacked even the essentials. Upon graduation and shortly after the ‘Iron Curtain’ fell down, I left to study in America. 

Eventually, I ended up spending much more time in the ‘trial and error’ economy of the developed world, working at the heart of the ‘free market’ in New York and London. I am certainly not unique in that sense as many people have done this exact same thing, but it does allow me to make an observation about the merits of the planned economy vs the free market.

My point is the following. The problem of the planned economy was not so much technical misallocation of resources, but, ironically, one of proper distribution of the surplus. The Soviet system did not exactly create an extreme inequality, like the one there is now in America (even though some people at the top of the Party did get exorbitantly rich) but instead of using the production surplus for the betterment of the life of the population NOW, politicians continued to be obsessed with further re-investment for the future. There was perhaps a justification for that but it was purely ideological, a military industrial competition with America, nothing to do with reality on the ground.

So, while the Soviets were perhaps winning that competition (Sputnik, Gagarin, Mir, etc.), the plight of the common people was not getting better. And while they ‘couldn’t’ simply go in the street and protest or vote the ruling party out, they expressed their anger by simply pretending to work. Of course, that eventually hurt them more as the surplus naturally started dwindling, productivity collapsed and the quality of the finished products deteriorated. The question is, given a chance, would the planned optimization process have worked? If Glushkov’s decentralized network with minimum input from humans had been developed further, would the outcome now be different?

There is a lesson here somewhere not just for China but also America. Both have created massive surpluses using the two opposing optimization solutions. And both are running the risk of squandering that surplus, in a similar fashion to the Soviet Union of the 1980s, if they don’t start distributing it to the population at large for general consumption. In both cases this means transferring more income to ‘labour’: in China away from the state (corporates), in America away from the capital (owners). But because the differences at the core of the two systems, it is easier for China to do this consciously; in America, the optimization process of the free market, unfortunately, ensures that the capital vs labour inequality goes further to the extreme.

So, can China then pull it off? 

While I am not privy to the intricacies of their ‘planned’ resource optimization model, just like in the Soviet Union, the risks there seem more political. But after an additional 50 years of Moore’s law providing computational power and after digitalization has allowed access to data the Soviets could never even dream of, China stands a much better chance of making it than the Soviet Union ever did.

*I actually use “The Coming Collapse of China”, Gordon Chang, 2001 as a reference point

China issues in hard currency!?

05 Tuesday Nov 2019

Posted by in Asset Allocation, China, Debt

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Why do smart people do obviously ‘irrational’ things? It must be the incentive structure, so for them they do not seem irrational. So, I am wrecking my brain over China’s decision to issue EUR-denominated bonds (and a few weeks ago USD-denominated ones), in light of its goal of CNY and CGBs internationalization, 40-50bps over the CGB curve (swapped in EUR).

The rationale China is putting forward is that enables it to diversify its investor base on the back of the trade tensions! Seriously? Do they really mean that or are they getting a really bad advice? Wasn’t the intention to actually go the other way as a result of the trade war? Didn’t China want to be become more self-reliant? In any case, China does not need foreign currency funding given its large, positive NIIP. China has the opposite problem. It has too much idle domestic savings and not enough domestic financial assets. This, among other things, creates a huge incentive for capital flight which, despite its closed capital account, China is desperately trying to prevent.

In that sense, China does need foreign investor but to invest in CGBs (and other local, CNY-denominated bonds) to act as a buffer to the potential domestic capital outflow as the capital accounts gates slowly open up. It is for this reason that BBGAI and JPM have started including CGBs into their indices this year.

It is for this reason SAFE decided to scrap the quota restrictions on both QFII and RQFII in September. It is for this reason that Euroclear signed a memorandum of understanding with the China Central Depository & Clearing to provide cross-border services to further support the evolution of CIBM. That opens up the path for Chinese bonds to be used as collateral in international markets (eventually to become euro-clearable), even as part of banks’ HQLA.

All these efforts are done to make access to the local fixed income market easier for foreign investors. And now, what does China do after? Ahh, you don’t need to go through all this, here is a China government bond in EUR, 50bps cheaper (than if you go through the hassle of opening a Bond Connect account and hedging your CNY back in EUR).

This not only goes against China’s own goals regarding financial market liberalization but also against the recent trend of other (EM) markets preferring to issue in domestic currency than in hard currency. And while other EMs may not have had the choice to issue in hard currency from time to time, China does. And while the investor base for other EMs between the domestic and the hard currency market is indeed different, and the markets are very distinctive, China does not have much of an international investor base. Issuing in the hard currency market may indeed ‘crowd out’ the domestic market. Especially when you come offering gifts of 50bps in a negative interest rate environment.