China’s seemingly modest 2% devaluation against the dollar in August has drawn attention to the immense challenges of rebalancing their unwieldy economy. This is crucially important to investors as it has over the past 20 years led to a “super cycle” run-up in commodity prices (China was once consuming 65% of the world’s iron ore) as well as a deflating finished good prices.
But this devaluation has spilled over directly into commodity markets, with oil prices in particular collapsing more than 50% peak to trough. August saw a violent pullback in global equity markets. September so far has been slightly less severe though most asset prices are lower, with the MSCI AC World Index down around 5% at time of writing. The perceived culprits for this panic, and smaller ones seen earlier this year, have been listed as China slowing down and the expectation that the Federal Reserve may finally raise interest rates. They did not, and yet markets continue to plunge.
The crash in mainland Chinese equities, and the mini-crashes elsewhere, are essentially attributed to macroeconomic risks. Indeed, corporate debts in emerging markets, China in particular, are worrying. Especially as that country tries to rebalance its economy. On top of that, Fed policy has tightened significantly already, according to the latest IMF Global Financial Stability Report.
The Fed has not raised rates for nearly 10 years and again backed away in September. The current Fed Funds Rate is lower than headline inflation (excluding food and energy), while the economy is growing, but policy may have tightened more than we realise since the end of QE (Chart – Shadow Rate). The IMF has calculated a “shadow rate” to estimate the policy effects of QE. Since tapering started, policy may have tightened by the equivalent of a 5 percentage point increase in Fed Funds. This is on par with previous cycles, and so too it would seem is the effect on asset prices.
Ultra-loose policy failed to spark a surge in capital expenditures, but has pumped-up real estate and asset prices in general, as well as a large scale share buy-backs. While these do reduce share count, this return of capital is done at high share prices and may not therefore be ideal capital allocation.
This tightening round has already seen a US dollar rally and a simultaneous crash in commodity prices. That EM and Chinese demand had driven a so-called super cycle over the preceding decade suggests this has much farther to go. These economies are slowing now with significant knock on effects in developed markets. But even problems this obvious are difficult to trade.
EM Corporate debt has quadrupled over the past 10 years, from around $4 trillion to $18 trillion, which the biggest issuer is China (Chart – EM Corporate Debt). While this has added to productive assets, the concern is that previous crises has been brought on by rising leverage, now vastly exceeding equity market capitalisation. Today’s strengthening US dollar raises the risk profile even more.
The flip-side is that the global economy throws off immense excess-savings, a term coined by former Fed Chairman Bernanke in 2005, describing how desired savings exceed investments in many countries. In the past, China has been a major contributor and more recently the EU, principally Germany. These funds slosh around global capital markets looking for returns, but often find only risk.
The US usually soaks up most of it, though it can frequently be misallocated, as the subprime crisis brutally demonstrated, and today’s EM debts seem to foreshadow. In any case, current German excess savings are having a depressive effect, particularly in peripheral Europe, where Greece is stuck in a debt trap. Shorting Greek debt often looks interesting but the trouble is expressing the trade.
In March 2012 those buying CDS protection on Greek debt did reportedly receive a $2.5bn pay-out. But since November 2012 there have been restrictions on short sales and CDS for sovereign debt in Europe. So enterprising investors would like to short Greek equities, but one large manager we monitor, who has a huge number of counterparty relationships for sourcing borrow, told us he could not find any back in March.
In fact some hedge funds did manage to locate borrow, for shorting Greek bank stocks, with George Soros’s Quantum Fund, Toscafund and Abbeville Capital amongst those publicly named.
We would think these trades have been profitable, but Greece’s financial regulator is seeking to impose fines on the hedge funds, and Paris-based over-arching agency ESMA will act as umpire to decide if the fines are paid. One of the distressed debt funds that we monitor has also found borrow in the debt of Greek banks, but again this is not always easy to source.
Leading up to the 2008 crisis, China generated vast excess-savings which usually ended up in US Treasuries. Not any longer. A massive post-crisis stimulus programme generated a robust recovery but also drove investment spending there to nearly half of GDP. The OECD average is more like 20%. Hence the pressing need to shift China’s economy towards consumption.
But this investment spending has been funded mainly with debt, as China deployed its huge savings domestically (Chart – EM Bond Issuance). So this shift is doubly tricky, as a small decrease in investment requires a relatively large increase in consumption to maintain growth. And growth must be maintained to support accumulated debts. It is hard to imagine such a large economy managing this change easily.
One of the macro funds that we monitor has periodically been short of mainland China stocks this year, but got stopped out of the short at least once before re-establishing it. Chinese equities are now well below where the manager originally initiated the short, but any manager with disciplined risk management would have run the risk of being stopped out. At the climax of a bubble, markets tend to go straight up, so it is not easy to pick the peak. As implied volatility often reaches elevated levels, purchasing put options can be prohibitively expensive at these times.
The other problem is regulatory intervention, as in Greece. For some years China, and other Asian countries, have been making it easier to short stocks, and expanding the universe of short-able stocks to acknowledge the benefits of shorting in terms of market efficiency and liquidity. But in July and August 2015, China seems to have made a backward step with a phalanx of measures including suspensions of stocks, and some brokerages banning short selling.
Index futures or exchange traded funds listed outside China should not be impacted, but these types of regulatory interventions are a risk for short sellers. In contrast the Chinese Renminbi currency can be shorted, and indeed one of the macro funds we monitor did have a contrarian short in it. But so far its drop of approximately 3% will have offset only a small part of the losses incurred by those owning mainland Chinese equities.
While hedge funds have the versatility to take steps against macro risks, in ways which traditional long only funds cannot, it is still not easy to substantially mitigate the impact of macro panics. That said, nearly all of the funds we monitor have lost substantially less than long only equity indices, and some of them have made a profit from relative value trades. Some trend-following CTAs were up by a double digit percentage in late August, partly from shorting oil and commodity related currencies.
Experience is sometimes another name for our mistakes. Many investors coming into the 2008 crisis probably were taking more risk than they should, often in levered, complex or poorly understood investments. Today’s low yields and vast debts suggest investors should aim for capital preservation rather than prospective returns.
Hamlin Lovell, CFA & Keith Tomlinson, CFA
DISCLAIMER: This material is for information only; it shall not be regarded as advertising any services within the relevant jurisdiction. Tomlinson Research Limited and/or its affiliates, consultants, directors, partners and employees, including those preparing and issuing this material, do not give any representations or warranties in relation to the accuracy, validity or completeness or compliance of this material, including without limitation the factual information obtained from publicly available sources considered by the Tomlinson Research Limited to be reliable; and do not accept any liability for any consequences of using the information contained in this material, and for the applicability of this material for the specific purposes and objectives of the recipients.Download as PDF