China’s seductive stock surge
Published on: July 15, 2020 • Duration: 19 minutes
This week we look at how the Chinese equity market is echoing the market of 2015, which eventually reached bubble territory before the inevitable crash back down to earth. Investors should avoid being seduced by a breakout. In the Chatter, we look at the build-up in government and corporate debt that makes it almost impossible for central banks to extract themselves from the markets. In the Whisper, we highlight a few technical indicators which together may now warrant some caution on equities in general.
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[00:00:05] The Chinese equity market has recently been making headlines because of its very strong performance. The price action has echoes of 2014 to 2015, when the market entered bubble territory during a period of weak economic performance. The price action today has many parallels with that of five years ago, and with that comes a number of risks. That's The Big Conversation.
[00:00:31] China's equity market has been surging over the last couple of weeks, with the Shanghai Composite Index gaining 16 percent in seven trading days on surging volumes from retail investors who have been spurred on by the national press, keeping the 15 year trend intact and adding over one trillion dollars in valuation. If the index can break above the highs around three thousand six hundred from a couple of years ago, then we can anticipate further gains. Although the size of the move is still dwarfed by the breakouts of 2007 and 2014, there are a number of features that this breakout has in common with those, especially the breakout five years ago. As with 2014, today's breakout in the equity market is not backed by strong fundamentals. In 2014, the equity market started to soar just after the US dollar had started to rally. The dollar rally anticipated an expansion of the European Central Bank balance sheet and the Bank of Japan doubling down on their quantitative easing programs, with the U.S. Federal Reserve about to wind down its own QE operations. The dollar surge led to a rapid decline in commodity prices and a slowdown in global manufacturing. Emerging market currencies were under pressure, especially nations with sizable U.S. dollar denominated debts within the corporate sector. China's FX reserves, which have been building for years, peaked and reversed from both the effects of a weaker currency and the outflows, eventually forcing China to adopt some capital controls to limit the losses. The Chinese authorities also experimented with a mini devaluation in August 2015, which briefly sent shockwaves through financial markets, forcing the U.S. Fed to step back from its pursuit of higher rates. Most observers agree that the equity rally in 2014 to 2015 was manufactured to try and help steady the ship. If the equity market was strengthening, then hopefully this would attract foreign inflows, especially into some of the IPO's that were being undertaken at that time. There was and still is this debate about Chinese equities receiving a higher weighting within the MSCI indices, though foreign interest remained limited back then because of restrictions on ownership and uncertainty about how open China's capital markets would become, and nothing's really changed. As a result the 2015 rally was dominated by domestic retail traders using margin accounts for leverage. When the bubble burst, as they always do, there was very little that the authorities could do to stem the declines. The prime lending rate was cut further and the economy was given a massive credit boost at the beginning of 2016. This may have helped stabilize the equity market, but this was at much, much lower levels. Today, the Chinese economy continues to grapple with the numerous headwinds, obviously, like the rest of the world, recovery from the Covid pandemic has been uneven, particularly in areas which can't be as easily influenced by the government. Even before the pandemic, China was faced with an aging population that had seen the dependency ratio bottom out and start to tick higher in the last five years. This ratio will continue to rise, and Japan has discovered over the last few decades that this is a significant economic headwind. And many parts of Europe, incidentally, are also suffering from similar demographic patterns. Although China's official urban unemployment rate has been relatively static at just under five percent, Refinitiv's research partner Fathom Consulting, have calculated that urban underemployment has been steadily rising over the last decade and may now be approaching 25 percent. China's GDP per employee remains relatively weak, and this often gets lost when we look at the absolute numbers from a country like China with a huge population. Growth has been heavily dependent on leverage, as can be seen in this chart of M2 money supply, which dwarfs the FX reserves which have been static around three trillion U.S. dollars for the last few years. Although in terms of percentage change, M2 growth has been falling or had been falling, at least until the Covid crisis took hold. Although China has attempted to recover again with the help of significant credit injections, it's clear that the external picture in terms of trade remains very sluggish. The new export orders are the one component to the PMI that remains very subdued. Unlike the PMIs indicators within major sentiment, sectors such as real estate have so far failed to regain anything close to their pre-Covid levels. A couple of weeks ago, we saw the gaming revenues in Macao were still close to their lows. The surge in interest in the Chinese stock market does, however, echo the pickup in retail interest that we've seen in the US and other parts of the world, including Brazil. China has seen millions of new accounts opened in the first five months of 2020, along with a surge in new investment funds which have been dominated by the equity variety. Margin has started to surge, particularly on the Shenzhen exchange, though both Shenzhen and Shanghai have some way to go before they match the effort of 2015. And the majority of accounts that had been added are added by retail investors who are earning less than 1,000 dollars per month. Recall earlier the chart of income per employee - so this does look like another attempt to get rich quick - though the government has already started clamping down on some of the lenders, well aware of the issues that the deflating bubble caused five years ago. The Chinese currency has, like many others, been enjoying a period of strength versus the U.S. dollar, with the Yuan having moved back under the key psychological seven level in recent sessions. This has also been reflected in emerging market equities outperforming the U.S. market for a sustained period for the first time since 2018. And as we've noted before, copper and emerging market equities have moved in lockstep for the last few years. Copper has recently been surging, assisted by the weakness in the U.S. dollar. So all this does point to more than just a domestic tailwind for Chinese equities. But the move in Chinese equities could be another siren call. Chinese interest rates and yields have offered a premium to most other regions for some time. The Chinese 10 -year yield is over double that of most large trading blocs. The difference in policy rates is even wider. There are already numerous reasons to invest in China's capital markets without the equity market building a head of steam. The old uncertainties, however, remain. Relations with the U.S. Are still stretched, and the U.S. Is imposing additional restrictions on many U.S. Investors looking towards China. Trade negotiations are expected to turn south and become increasingly politicized into the U.S. election. For many institutional investors, uncertainty with regard long term capital flows and restrictions into and out of China will limit the appetite for exposure. As a result, an equity rally in China may peak the interest of a few individual investors, but it's unlikely to engage the attention of global institutional investors while so much political and economic global uncertainty remains in place.
[00:07:19] Global debts are piling up at the government and corporate level and this has helped create a false economy in which households appear to be relatively buoyant even though many furloughed workers expect that their jobs will disappear once support schemes are dismantled. Already, governments have taken extreme action, are realizing how hard it will be to come off these schemes. Global bond markets are reflecting this outlook rooted close to the lows in yield. Most equity markets, outside of a handful in the U.S. and Asia are also reflecting a weaker outlook. One of the key questions for investors over the long term is what can government do to extricate themselves from the spending sprees that they've unleashed? Can government's keep the game going long enough for corporate balance sheets to recover sufficiently to maintain payrolls so that household balance sheets don't suffer a hit? Government's have already stepped into the breach, but very few have an exit strategy. So firstly, let's take a look at some of the debt levels that have started to build up. Starting with government debt, we can see that issuance has exploded. So far year to date the US, the Eurozone and the U.K. have combined issued four trillion dollars worth of debt at a pace that is around four times greater than each of the last six years and double that of 2009 during a recovery period of the great financial crash. As an aside, in Europe, an increasingly large proportion of the debt issuance has taken the form of syndicated deals underwritten by banks rather than via the auction process that is more typically used by government treasurers. Syndicated deals allow a bit more control over who purchases the bonds. The ratio of public debt to GDP is exploding higher. The U.K. has moved back through 100 percent. The Financial Times estimated that eurozone debt would also move through 100 percent from 84 percent at the beginning of 2019. In a scenario in which GDP falls by 10 percent and budget deficits worsen by 10 percent. Of course, the debt to GDP ratios would not be evenly spread across Europe. Italian debt to GDP could be close to 170 percent by 2022, rising from its current level of around 150 percent on a gross basis. These paterns are being repeated globally, from South America to Asia as governments grapple with the depth of the slowdown and the speed of the recovery, which again remains sluggish in areas of the economy that are not directly receiving government support. Corporate debt levels have also been rising. The industries that had the most at the end of 2019, such as consumer discretionary sectors with nearly one point four trillion dollars, according to fund manager Janus Henderson, have continued to pile on those debt levels. The oil and gas industry had over one trillion U.S. dollars of debt at the end of 2019. Five companies in this sector accounted for over 300 billion of the debt and were adding to their debt levels in Q1 of this year, pushing their debt as a percentage of total capital to new highs in some cases. U.S. corporate debt to GDP has made a new record level, with over one trillion U.S. dollars worth of new issuance in the first five months of 2020. But unlike in previous years, the majority of this debt was to keep operations going. Previously, much of it was issued to buy back shares as the only game in town because the outlook for economic growth remained extremely sluggish even before the pandemic hit. Global net debt, that's the completely new debt versus obviously new issuance against old debt that's expiring, this is expected to rise by one trillion to nearly nine point five trillion U.S. dollars, according to Janus Henderson. U.S. corporate profits will have their worst quarterly return since the financial crisis. However, these didn't really come out of the blue. Profits been sluggish throughout 2019, highlighting the disconnect between the equity market as a play on economic fundamentals versus a play on corporate and central bank flows. And if capex would normally be one of the drivers of growth and productivity, this part of the equation is also taking an additional hit, which obviously will travel along the supply chain. The sector expected to implement the largest percentage cuts to capex is the energy sector, where cuts will almost be 25 percent. Consumer discretionary, the most indebted in absolute terms, is also expected to cut back on capex by over 20 percent. Only the utilities sector is expected to keep capex growing. At a country level, capex cuts are expected to be around 20 percent for the US, with cuts of 10 percent or more expected for a large number of industrial countries. The combination of high debts, lower revenues and therefore a cut in capex will keep the long term pressure on jobs and growth. Households have adjusted by increasing their savings rate to record levels -recently it touched 33 percent in the depths of the crisis. And your savings rates are expected to fall, though the ability to save is again spread unevenly. Those households with ammunition to increase savings are already in a better financial situation than those that weren't. Credit card delinquency rates are at record levels, though this was achieved at the end of 2019 before the crisis struck home. U.S. household consumption quarter on quarter obviously dropped precipitously. But again, we have seen some very uneven distributions. Some sectors and regions have seen a rapid bounce back. Denmark and Switzerland have returned back to something close to normalcy, while the U.K., Italy and Spain are still recovering. Even more economies are reopening, attitudes are very different in different regions. Walking through the center of London's financial district last week was still a shock to the system. The area near the Bank of England, right at the heart of the city, was almost deserted. We had an almost free run of Millennium Bridge between St Paul's and the Tate Modern. Usually two of London's busiest tourist attractions. Out in the countryside where I live, the outlook is very different, most shops have reopened and activity feels like it's about 90 percent of normal, though the restaurants are clearly running at a much lower volume. This remains one of the key issues for the governments that have thrown capital at the issue. Has the money stimulated or merely supported the economy? A stimulus should take growth beyond where it was. Remember, most of the V shape recoveries that people are seeing are simply a function of how deep the declines in data were in the first place. Almost everything looks like a V, but what matters is how quickly will the data returned to its original levels rather than simply recover off the lows? Clearly, where volumes remain below the pre-Covid levels or least the equivalent of where they should be at this time of year, then we have to assume that demand will drop again once the schemes have rolled off. That might encourage policymakers to keep rolling the packages, especially if inflation remains subdued at this present moment. But if they continue to throw capital at the economy that is still experiencing outages within the supply chains, then inflationary bottlenecks, which are damaging to consumers, will continue to flare up, as they did briefly within the U.S. meat processing industry. And if they let the packages roll off, then we've all seen the chart of unemployment rates versus Chapter 11 bankruptcy filings, and what this implies. Support has been readily available for many companies that could already support themselves through the crisis, but much harder to obtain for companies that couldn't. Policymakers are caught between a rock and a hard place. Althopugh measures of volatility have been suppressed by central bank intervention, the currency markets are freer than the bond markets to move in line with fundamentals. Once the global support schemes roll off over the next few months, some of these FX fault lines will rapidly start to reassert themselves.
[00:14:47] We've been so used to the relentless march of equity markets, particularly in the US, that we've become a bit blasé about some of the warning signs that have recently been thrown up. Partly, this is also because expectations that if risk assets wobble, then the US Federal Reserve will crank up its balance sheet again. On Monday, the Nasdaq made another intraday all time high. But on this occasion, it was also accompanied by a number of warning flags. These may again be false warnings, but the number of signals is definitely worth bearing in mind. Firstly, whilst the Nasdaq 100 initially rallied two percent, it then reversed to finish the day, closing down more than two percent. Apparently it's done this on 26 previous occasions. There's not a clear pattern in the subsequent performance of the index. However, it is only once before rallied two percent to a new all time high intraday before reversing to close down more than one percent. Monday of this week was the second such event. The first was March the 7th, 2000. That was not quite the all time high, the dot com bubble, but it was only just a few days before it. The candle pattern was also a classic reversal pattern. Now, these don't have 100 percent reliability, they're merely a guide, but this outside day occurred with an uptick in volume as the market rolled over having seen volumes generally on the decline during the rally before it. Technical analyst Peter Brandt called Monday's move 'a sweeping key reversal that was reminiscent of the pattern on February 20th of this year'. Just as the market was rolling over from what was then an all time high, the U.S. equity market also returned to its all time high ratio of market cap to GDP of one hundred and fifty four percent. And that's according to Sven Henrich of the Northman Trader, and it's a level that was also reached in February of this year, again just prior to the highs. We also saw a repeat of February's parabolic move in Tesla. In fact, the recent move has considerably outstripped that of February in terms of size. Based on the expectations of the stock being added to the S&P 500 index. On Monday during one four hour period, forty thousand new Tesla buyers appeared on the Robin Hood platform. Monday's reversal was 18 percent from its high to low, having initially rallied 15 percent of the open. Volume surged during this period. It was also notable that the VIX was edging higher for the previous few days, even as the S&P 500 was grinding slightly higher, too. And this sort of divergence is relatively uncommon, it was most notable in early 2018, just before the volmageddon pullback that we saw in that period. Volatility of volatility is still near the bottom of its five month range, but it also had a significant uptick on Monday's move. In other asset classes, we've seen some risk assets approach key resistance, having filled the gap created by the oil price war, West Texas crude oil futures have been flat lining. Copper has now rallied to its 10 year resistance, which it tested on Monday before falling back. A weaker US dollar has been an impetus for many of these risk assets, but positioning is now getting slightly stretched. With CFTC speculative shorts having increased significantly in recent weeks, and euro longs are now the second highest that they've been in 10 years. The Australian dollar, which has been one of the leaders in the rebound in risk since late March, has also lost momentum since reaching the 70 cents mark versus the US dollar. Now, none of this necessarily means that equity markets should reverse, but there are sufficient cautionary signs. The entry of retail investors means that many of the technical and psychological indicators that have been of little use when the market was dominated by the rules-based funds pre-Covid, well these will now have relevance again. And ultimately, it will probably depend on what the Fed does. The Fed has allowed its balance sheet to decline, and this has coincided with a loss of momentum in the S&P 500, though not the Nasdaq, unless Monday's price action turns out to be pivotal. We don't know the Fed's tolerance limits, but it seems unlikely that they will step off the gas now, but there will still be a few days lag between any risk off price action and response from policymakers.
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