Thursday, July 30, 2015

Chinese burn

The speed of the Chinese A share market reversal has been almost as nose-bleed inducing as was the case on the way up. With the Shanghai index having topped out at 5,166 on June 12th (for a then year to date gain of nearly 60%, following on from its rise of 53% in 2014), the index has now fallen by 28% from that level. As of July 30th it's still up by 14.6% year to date, but the speed of the reversal over 6 weeks has been brutal. 

However, given that foreigners are heavily restricted in their access to the A share market and given that they tend to avoid the types of shares that Chinese retail punters like to buy so heavily on margin, and which have been sold off so aggressively, does it really matter?

The Hong Kong markets has behaved as though it does, but maybe that's understandable: the Hang Seng Index topped out at 28,433 on April 27th, whilst the H share index reached its peak of 14,812 on May 25th. The former is now down 14% and the latter by 25%. Broader non-Japan Asian markets are now also down for the year.

The background to the Chinese market's travails lie mainly with restrictions on margin lending that were introduced, somewhat heavy handedly, in May and early June. Since then, the government has been doing all it can to reverse much of these, in the interests of offsetting incipient panic. The jury is still out as to whether or not its efforts will work: the PBOC has trotted out the now well-used global central banker's mantra of being prepared to do "whatever it takes", and we note that a stable stockmarket is an important factor behind China's efforts to promote further market based reforms. Alternatively, are they just postponing an inevitable further sell-off?

It is clear that investing in China brings both risks and opportunities. 


The risks lie in the relatively short experience of Chinese investors with stockmarkets, the lack of any focus on (or indeed interest in) "fundamentals", the focus only on short-term leveraged driven trading, and the shortage of a well developed institutional investor base. All of these cause market movements to be unduly magnified. It's all about momentum. 

It's for this reason that most foreign investors focus on the bigger picture and focus on investing in those companies that give access to that bigger picture. For them, the current sell-off provides the proverbial buying opportunity.

Andy Rothman, the well respected strategist at Matthews Asia, notes that the market did not fall because of macro problems (and indeed the correlation - globally - between GDP growth and stockmarket performance is pretty low), even with GDP growth likely to fall to between 5% and 6% by 2020. Although corporate debts in China have been rising, these are concentrated among state-owned firms, whilst - according to Matthews - "the private firms that generate most of China's new jobs and investment have already deleveraged. China's foreign debt... is less than 10% of GDP". 

Andy also notes that the rise in residential property prices and property supply that many investors fret so  much about (with all those vacant units in secondary cities) occurred at the same time as a 12% rise in average annual urban income growth. He notes also that Chinese buyers are not over leveraged - in contrast to the position in the US and elsewhere in the run-up to 2008/9 - since they all need to put down a deposit of 30%.

We then come down to value: note that the H share market in Hong Kong is now trading at a forward PE of around 8x, vs. 15-16x for the comparable A shares in Shanghai. H shares underperformed the A's on the way up, and now that dynamic is reversed on the way down. UBS certainly feels that the market has been oversold: they have a floor for the H share index of 10,800 (3% below current) and one of 2,600 for the SSE (30% below current). They also note that with the central bank pledging liquidity support, the CSFC has theoretically unlimited buying power (it's just that this has not been fully unleashed).

So - we therefore have a gap between steady fundamentals in the H share market and market sentiment driven by the A share collapse. At the moment, the risks are essentially binary... either the government delivers on its "whatever it takes" commitment, and the market recovers, or it doesn't, and margin related selling takes it further down. 

This is not a great environment for making objective investment decisions.

However, in principle, we like the H share story, feel that valuations are even more attractive and like managers that focus on good companies that will participate in China's structural and consumer led growth over the next decade. These would include insurance companies that cater to the rise in demand for basic life insurance and health care products in China, and some consumer goods businesses.

Bear in mind that in our portfolios, though, China accounts for about a 3-5% weighting, and we're comfortable with maintaining that at present. This is what a sensibly diversified portfolio strategy is all about. 


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Tuesday, June 16, 2015

What if Greece defaults...?

The Wikipedia entry for a Pyrrhic victory is "a victory that inflicts such a devastating toll on the victor that it is tantamount to defeat". The collision of opposing interests between a Greek government (which possesses a popular mandate to push back against more austerity), and its creditors (who want to assurances that their loans will be repaid) seem likely to result in just such an outcome. 

It's obvious that without substantial debt relief, there is no way that Greece will be able to repay any of its debts, with the current debt to GDP ratio at 175% and rising. Without such relief, the nuclear option of default almost looks like common sense. 

Conversely, it is equally obvious that without the Greeks agreeing to significant cuts in spending and changes to their tax system, there is no way that any self respecting lender should or would agree to throwing more money at their government: doing so without such a program in place would merely guarantee a repetition of the current arguments in the next 6 - 12 months when the next loan repayments come due.

Logic suggests that a compromise of some debt relief and some spending cuts should produce a deal that results in equal amounts of satisfaction or dissatisfaction for both sides.

However, a collision of this type between politics and logic was never going to be pretty: both sides seem to view the current negotiations as a zero sum game in which one side or the other has to achieve total victory even at the cost of actual disaster.

If we then assume that the Greeks' least worst option is to default: what next?

A huge mess.
Default by Eurozone member was never envisaged when the brains behind the Euro project dreamt it up originally. Such grubby practicalities would have got in the way of the grand dream. That lack of foresight is now proving costly for all concerned. The Greeks seem keen to remain within the Euro, but without the painful restructuring that has to go with that. However, it also seems that there is no mechanism to force them out against their will. But - if they don't exit the Euro, they will be stuck in a currency that is too expensive for their own good and will have been cut off from all sources of debt financing for a decade. The cuts in spending that the lenders have been asking for would be inevitable and probably more brutal. Greece would sit within the Eurozone as a failed state.

If Greece did exit the Euro and reinstated the Drachma, they would devalue and gain some competitiveness benefits. Unfortunately, these would be limited given Greece's fairly small export base. Tourism might benefit significantly, but the offset to that would be whether or not tourists would want to visit a country which would be facing social melt-down. The further downside of re-instituting the Drachma  would be that debt to GDP would rise even further (because the loans in Euros would compare with a significantly devalued Drachma priced economy), unless the Greeks declared a unilateral write-down to more manageable levels(probably by something like 75%).

From the lenders' perspective, it becomes a question of whether or not you agree to a partial write-off and extended repayment terms on the rest, or force Greece to default on everything. That would be painful for the various Eurozone governments who between them have provided Greece with about half of its total loans. Even Angela Merkel might have trouble explaining how she managed to lose EUR56bn...

 In this instance, we would assume that Mario Draghi will charge in with the ECB and print money like its going out of fashion to underpin the European bond markets, which otherwise would be in turmoil. The Euro would have been proved to be a two way street, so Greece would be cut loose and left to swing in the wind but with its (Drachma based) pension intact. The remaining Euro members would want to ensure that life for Greece outside the Euro was so painful that no country would ever contemplate exit again. What this would mean for the EU project of "ever closer union", and ahead of a UK referendum in 2016/17 is unclear.

So, common sense would suggest a deal between Greece and its creditors is the most logical course. However, whether or not politics and egos get in the way and result in a "Victory" that creates more damage than a "Defeat" is another issue entirely. Over to you Angela.


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Javelin Wealth Management supports the global microfinance philanthropy initiative, the education charity,, and the Singapore Children's Cancer Foundation, New clients to the firm can nominate any or all of these charities for a donation we make on their behalf.