Opening the ‘blind eye’…
August 1, 2021
Short Term Uncertainties
As Equities and Commodities moved higher, western investors in Chinese VIE structures got a shock as one of the hitherto ignored risks to the sector (change in Chinese policy) suddenly appeared. The other risks – taxation and general corporate governance – should also now be reviewed and investors are increasingly going to have to accept that investing in China will be done on Chinese terms.
After the Delta Variant wobble last week, the S&P 500 has been steadily bought on the dips, pushing through to yet another new 52 week high. Interesting (and importantly) the equal weighted S&P500 has also broken to new highs, suggesting that this is a broader move than just the index trackers and min volatility Quant funds at work. Meanwhile, commodities – as represented by the BB Commodity Index – are also breaking out to hit new highs. suggesting that the two or three month consolidation in the reflation/inflation trade may be setting up for moves higher. Oil in particular is looking to break higher and analysts and commentators are focussing on the US inventory data for their guidance. There are certainly some very aggressive drawdown forecasts out there and if they come even close to being met then oil could head above $80 by late summer
Chart 1. Equities and Commodities hitting New Highs
Covid Variants seem to have been embraced by FX Traders as a new High Frequency Data point
Watching the relative economic stagflation, at least partly Covid Policy induced, and with even less prospect of higher interest rates, capital market flows have been buying $s over Euros. Moreover, as we suggested earlier this week , the particular weakness on the Euro/$ cross was also probably a reflection of medium term concerns about whether the EuroZone was going to take the best or the worst of the two competing economic systems on offer (The non Zero Risk of Zero Risk policies) with the current outlook looking worryingly like a combination of Chinese style bio-security authoritarianism and Green Crony Capitalism. Meanwhile. on a shorter term basis, FX traders appear to have taken ‘relative Covid policy performance’ as some new type of metric to trade currencies. Thus, Europe ‘struggling to cope’ = sell the Euro, or “US concerns about the Delta Variant’ = buy Euro sell $. Such noise trading needs little in the way of logic (which is a good job, since there is little on offer) and longer term investors would be sensible to essentially ignire it.
From a technical viewpoint, the bounce in the Euro over the last few days as Europe saw some relatively positive economic data and the US worried (in our view unnecessarily) about the Delta variant of Covid completed a neat 23.6% Fibonacci retracement recovery of the post May weakness. As such it is too early to call any sort of trends reversal. Indeed, we would suspect the balance of risks suggest the weakness will resume.
Euro weakness – looks like a bounce rather than a trend reversal
Source: Bloomberg, Market Thinking
The fact that the Euro appears to have bounced off near term technical support does not alter the medium term risk to the EuroZone from policy induced stagflation, although it does mean that the heavily-watched trade weighted US$ (DXY) remains stuck in its trading range.
Medium Term Risk
The biggest story of the week however was China, where a leaked memo about moves by the authorities to limit the profitability in the Education sector caused widespread selling across not only Education but a lot of the China tech and consumer stocks as western investors took fright and leveraged locals followed suit. While we would expect things to stabilise in the near term, this raises a lot of medium and long term questions around investing in China for western investors, as much about the ‘How’ as the ‘Why”. A lot of the problem stems from the use of VIE structures by western investors to circumvent foreign ownership restrictions on Chinese companies. As this report from the Council of Institutional Investors pointed out over three years ago, these structures act to simultaneously tell the Chinese regulator that the company is under Chinese ownership and control while telling western shareholders the exact opposite. In doing so they expose investors to risk from regulators, corporate governance and potential changes in returns due to taxation. For years both sides have ‘turned a blind eye’ to these potential problems, the Chinese demonstrating the Deng doctrine of pragmatism (“It doesn’t matter if a cat is black or white as long as it catches mice”), while the western investors (and Brokers) were simply chasing attractive returns. It looks like the Blind eyes have snapped open.
By changing its policy towards education stocks, the Chinese government illustrated one very important feature of the Chinese notion of Capitalism with Chinese Characteristics, namely that public goods – in this case Education – should not be seen as a source of (excessive) private profit. This of course is the polar opposite to the Financial Insurance and Real Estate (FIRE) model in the US, which has been heavily focussed on financialisation; taking assets, many of them in fact what would normally be regarded as public goods, loading them up with debt, extracting significant fees and carry for the FIRE sector and then pushing through monopoly or Oligopoly style price rises. This has come to be seen as so ‘normal’ in the west that the Chinese decision to make Education ‘non profit’ has been greeted as a massive shock by western ‘owners’ of the capital. The (self serving) argument now goes that by acting this way China has severely damaged its ability to raise external capital and thus this is bad for China. However, as with much to do with China, this risks viewing China through a western (principally globalist) mindset and expecting them to follow western norms. We need to consider that, far from making a mistake, the Chinese government know exactly what they are doing and it is the west that now need to ‘open their blind eye’ and adapt.
First, with a huge current account surplus and equally large pool of excess savings, it’s important to recognise that China doesn’t need the west for the supply of capital. As we have argued for many years now, what it has relied on the west for over the last decade has been the ‘wisdom of crowds’ in setting prices at the margin. There is a case then to be made, that by acting in this way, China perhaps now thinks that it is able to do this job itself with obvious implications for the western financial sector in Chia. Second, whereas in the west ‘public goods‘ are handed over to be financialised by the private sector, in China this is not the model, as the Party has a wider remit of social stability and social policy. Education is a classic example of this, with the legacy of the one child policy becoming clear in terms of demographics (a flip from 6 adults supporting one child to one child supporting 4 or more adults), there is a need to encourage more children. This in turn requires education to be getting cheaper, not more expensive. Here again, it is difficult to see a role for the western banks in Chinese infrastructure. A third factor not always understood by the west is that, unlike the US, money and politics are not allowed to mix. Nobody is allowed to become more important than the Party, as Jack Ma and others have found out recently. You can become rich, even very rich, but you can’t become President. That is simply not the way it works. As the saying goes – China has State Owned Enterprises while the US has Entreprise Owned States. Not least corporate tax-haven state Delaware “The Luxembourg of the US” where the long-standing Senator, formerly referred to as “The Senator for (Credit Card giant) MBNA” has just become…President of the United States. Investors need to recognise that the excess returns to big corporates they are used to in the west, especially in lobby-savvy near-monopoly tech space, are not going to be tolerated in China – and indeed probably not in the Rest of the West either going forward.
Fourth, that this is less about China punishing western investors in retaliation for US sanctions (as some are suggesting) and more part of a wider policy of financial and industrial self-sufficiency. Following the Global Financial Crisis (GFC), China recognised that, just as the west had effectively outsourced much of its industrial production to China, so China had, in turn, outsourced much of its financial infrastructure to the west. When the western financial infrastructure threatened to collapse, China focussed on building its own, steadily reducing the amount it relied on the west to the point where it is now largely independent. Hence point one. However, the other key area that China has outsourced is the chip manufacturer aspect of its supply chain and obviously that is very much in the sights of the US attempts to slow China’s economy. In response, China is dedicating increasing amounts of resource to becoming self sufficient not only in Chip manufacturing, but in all aspects of the tech supply chain. From a global perspective this is obviously non optimal, but from a China perspective it makes sense – the Ricardian concept of ‘specialisation and trade’ only works if the other party aren’t trying to slow down your economy as a deliberate policy measure. As such, we would expect to see a lot more focus on high tech manufacturing, quantum computing ad supply chain self sufficiency and a lot less focus on video games, crypto-mining and cat videos.
Long Term Trends
The challenge to the FIRE financialisation model that has arisen this week also highlights some longer term issues. The rentier economy, with its associated expansion of Private Capital markets has really arisen since the GFC and the provision of seemingly limitless amounts of low cost capital with ‘QE-forever’. Rather than creating inflation in the real economy – as many feared – it has instead driven significant asset price inflation in financial markets and while China’s moves this week can be seen to have impeded its path to expand in China, in the west this liquidity now looks to be leaking into the real economy, not only through the excess consumption of the rentiers themselves (where are the customers’ yachts) but also through the cost push inflation arising from monopoly rent increases. As such we risk inflation coming through from too much money finally chasing too few goods. In addition, we are seeing the ‘fruition’ of the Private Equity/Private Debt binge of the last decade as otherwise profitable companies are pushed to the edge of negative cash flow due to heavy debt servicing costs. The Pandemic has hit trading volumes in many cases such that bankruptcy looks inevitable once government support is withdrawn. The subsequent reduction in supply/competition will likely be a major driver to higher prices – and likely inflation. Thus we risk both cost push and demand pull inflation occurring at the same time.The household sector can’t cope with balance sheet deflation or higher rates and the public sector is expanding not contracting so the best (only?) policy tool left to avoid inflation is to deflate the FIRE sector through policy rather than price. Just as Chinese policy makers closed a blind eye to VIEs, so western governments have so far turned a blind eye to the privations of Wall Street. This will be a fascinating area to watch.