The sharp spike in the Chinese Stock Markets in late September caught a lot of people by surprise and triggered the usual round of self-serving advice focusing on the need to ‘stimulate’ the economy - followed by the (equally usual) round of disappointment. We said at the time that we saw this as a potential dip to be bought, not a rally to be chased, so with a near textbook rally, retracement and consolidation appearing, the ball in now in the Asset Allocators’ court. In our view we think both that they should and that they will start to pay attention.
The key thing is that, up until now, the Chinese Government has paid little heed to the Chinese Capital Markets. We think that this is about to change. And THAT is the real story.
Is China now a dip to be bought?
In our October monthly we noted that we didn’t trust the spike in the Chinese stock markets and that, while we believed that there may now be a long term base forming, we saw this as a potential dip to be bought rather than a rally to be chased. So with a near perfect 50% Fibonacci retracement of the rally, should we be buying?
Well - and with the all important caveat that this is not to be considered investment advice, please speak to a financial advisor - the answer is, to quote Oasis, Definitely Maybe.
The Fibonacci shape tells us that traders are certainly thinking that way - and if we zoom out a little we can see the longer term chart suggesting that the traders got out around 75 , close to recent trading tops, but also that the medium and long term investors aren’t going to feel any FOMO until around 55.
This suggests to us that the views on China will remain ‘uncertain’ in the near term - with traders dominating and the supposed long term narrative shifting to support the short term technicals. Should the market form a more stable ‘bottom’, we suspect that the asset allocation might start to shift, perhaps in the New Year. But, more important we suspect will be the role of the Chinese authorities and the domestic markets as the ‘New Buyer’.
It’s not about me. Or you. Or the stock market (yet).
The Western commentators are all talking about how the stimulus is ‘risking disappointment’, but this is to once again believe that that the Chinese authorities care about us, or what we think. Or indeed, the Chinese Stock Market. As we noted in ‘Not a Bazooka’ this is not a western-style policy response because the Chinese do not have a western-style mindset. Nor, for that matter, a western-style problem. As such, they will pay no attention to the ‘advice’ from western economists and commentators. Far from bailing out those that supply too much - be they property developers or manufacturers of excess goods - they are taking, perhaps ironically, an Austrian approach to the economics, one of creative destruction.
As the old saying goes (and to steal from my friend Louis at Gavekal in his recent note) “the tragedy of Asia is that Japan is a profoundly socialist country on which capitalism was imposed, while China is a profoundly capitalist country on which socialism was imposed. But each will naturally drift back to its natural state.”
As we look and listen to the policies being imposed on the west by the Globalist governments it begins to feel that it is now they who are finding themselves having Socialism imposed, just as China is reverting to its ‘natural state’.
Capital Markets; the missing piece for China
Which brings us to the role of the stock market and capital markets in general. In the US these are central, while in China they are nowhere, indeed, they are the missing piece of the jigsaw. We believe that this latest round of so-called stimulus in China is actually all about building ‘proper’ capital markets, with the key point that they are as much about the ‘saver’ as the ‘borrower’. Because of this, we think that we need to go beyond thinking about China as a trade and start thinking about it as a long term investment.
The Stock Market is central to US culture as the Billionaire Class that run the country would quite literally not exist without it. China, not so much.
The stock market is extremely important in the US, it is, quite literally, the foundation of the wealth of the richest people in the country - and thus by extension those that run it. Without it, they would be ‘merely’ rich industrialists and the centi-millionaire CEO class merely well compensated managers. It’s the wonders of options and stock based compensation that have delivered us the ‘top’ end of the wealth distribution. (As well as Private Equity, but that is a whole different post).
Meanwhile, the long term investments of much of middle class America are also heavily tied into the US stock market making for a powerful wealth effect, while financial services, including the financial media that talk about China, also view Wall Street as the centre of the world. And finally the US Stock market is important for the US Government finances as it benefits from the Capital Gains Tax received - which is an often overlooked reason why the Bond markets are correlating with equities - lower equities means lower taxes, which means more debt issuance.
Capital Gains Taxes an important source of US tax receipts
Source Congressional Budget office
None of this is (currently) true in China. The Chinese population currently have less than 5% of their wealth in the stock market and the people that run the country are self evidently not the billionaires. The Government is not dependent on capital gains taxes, nor is the market used much for raising investment capital. Currently most investment is funded from internal cash or bank lending. Perhaps most importantly for our argument, there is not yet a proper savings and investment system that can recycle domestic saving into domestic investment and it is this missing piece that we think the latest initiatives are actually focused upon.
What is wrong with the Chart is not that the Chinese own too much property, but that they have too much cash and they do not (yet) participate in Capital Markets
The chart, from Allianz via Reuters, highlights the current dominance of property in the Chinese household balance sheets and while this sort of chart is often used on hyperbolic YouTube channels to show how badly the economy will be affected by a ‘property crash’, in our view it actually misses the point, not once but twice. First, there has not been a property crash - there has been a bursting of a speculative bubble by property developers. Second, high levels of property assets is a function of houses that are lived in - China has close to 100% ownership of housing and as a ‘store of value’. The real takeaway from the chart is the trillions of RMb held in cash.
To take these points a bit further. As we have previously noted, the collapse of the Chinese property developers (not the property market itself) post 2021 was a deliberate policy in China that western 'investors' (speculators) didn't understand, since in their mental model, the investors are always bailed out. When Xi reminded us all of the concept of Common Prosperity and the fact that “Houses are for living in, not speculation”, Chinese banks took note and as the Chart from Gavekal shows, there was a quite deliberate switch in Bank Lending. From Real Estate to the Industrial Sector.
It was around this time of course that US Covid stimulus cheques were being pumped into Robin Hood accounts and Wall Street Bets were pushing effectively bankrupt companies like Gamestop up fortyfold. Meanwhile, as the Magnificent 7 MegaCap tech stocks and crypto first swooned and then soared, bank lending in China poured into the industrial sector, ultimately delivering the new Chips from Huawei, the new EVs from BYD and Xiaomi and innovations across the board in AI, robotics and automation, intelligent manufacturing and low-altitude aviation. No need for IPOs (or NFTs), Chinese investment capital was sourced domestically from cash and the banks.
Chinese economic growth has been fuelled by cap-ex funded by cash, not equity
Meanwhile, Chinese listed companies currently have around Rmb18trn ($2.5trn) in cash, while almost half the stock market are State Owned Enterprises. GS calculated that a 10% increase in dividends would deliver $32bn to the government - a more reliable source of revenue than trying to tax capital gains.
However the point is not just about raising capital, or even about allocating it efficiently - where arguably capital markets are more efficient than banks - but about providing the assets on the other side of the balance sheet to savers and investors. Filling in the missing piece of the economic structure.
As noted, because the people who run China are (quite clearly) not the billionaire donor class, they also think and behave differently and have no desire to 'stimulate the economy' to ensure excess supply clears at a higher price, essentially bailing out producers by encouraging consumers to go into debt. Indeed, it is the very opposite. The latest moves, in our view are really about providing sufficient liquidity for the property market to clear at lower prices - while at the same time effectively delivering more social housing.
Meanwhile, we believe that these latest moves are also about building a savings and investment system for long term social provision. China undoubtedly wants a set of 'capital markets with Chinese characteristics' which means that in the same way he said houses are for living in not speculation, stocks are for long term growth not speculation and thus likely to focus on cash flow, quality and income, rather like the old UK market in fact - before Gordon Brown and the Treasury got involved.
This latest ‘stimulus’ looks to us therefore to be the start of a long term story that is building. If as we believe the so called weak hands have moved to strong hands (see the note we wrote back this time last year ) then long term investors should definitely start to get involved ahead of what we suspect will be the asset allocators starting to move in the New Year.
So, to bring back to the original question, should we buy this dip? Well, it depends on your time horizon - and you ability to ride the waves. For a parallel, consider a stock we know well, Netflix, having bought and sold it multiple times in the early years as it transitioned from CDs in the post to streaming. Ultimately, while that activity seemed very necessary at the time, in the long term the lows are so far away from today’s price as to be a rounding error.
PS: A Quirky Parallel; Netflix.
Thus a final point. Consider a somewhat quirky parallel to China, that of Netflix. The first chart shows how the stock went through a double and a halving in the run up to the GFC. As an investor in the stock (as part of the Axa Framlington Global Opportunities Fund) we believed in the long term story, but were forced to actively manage the position (to put it mildly) on account of how we were being monitored for ‘alpha’ and ‘risk’. Note that it was January 2007 that Netflix first announced its streaming model. After a year, we were flat, after two years, not much better. But thankfully we traded it OK.
Phase 1: Early adopter, great long term prospects, poor medium term returns. Good for trading
The second chart shows how it was ‘easier’ to manage the long term trend - until September 2011 (!) and while we did get out above 30, it was still a painful 25% off the top. This might perhaps be compared to China running up in 2015.
Phase 2: Early adopters, trending until it wasn’t.
The same happened again - buying back at around 10 - having ‘missed’ the low of 8, but then seeing a run up to 70 in 2014, before dropping to 50, and then doubling in 2015. Suddenly it was hard work again.
Which brings us to the real long term chart on Netflix.
Chart 3: In the long run, buying the absolute low doesn’t matter much compared to being in the game
Ultimately everything we see and hear about China makes us positive on the long term thesis. It doesn’t mean we are buyers without reference to the existing valuations, sentiment, likely flows etc, but our underlying thesis is the opposite of much of the YouTube catastrophists.
