I recently had an interesting discussion with a smart friend of mine about the outlook for Chinese equities. His take was that:
1. with expectations of weak Chinese growth overdone, (whisper expectations for a sub 7% GDP figure this week were sorely disappointed)
2. economic reforms in train and supported by the leadership,
3. PBoC easing (chart of 1y IRS below)
4. and with Chinese equities cheap, (2nd chart below shows that, on a P/E basis, the Hang Seng China Index is trading at the steepest discount to the S&P 500 since 2003)
there is substantial room for upside.
Now, for old macro hands, usually this is a pretty juicy setup. It combines elements of variant perception, a clear catalyst, changing fundamentals, and attractive entry prices. When those items align, there is a good prospect of making the year. So what’s not to like?
My answer is that the Chinese equity market is simply NOT like equity markets elsewhere. In particular,
· the relationship between Chinese share prices and economic growth is different
· the way Chinese investors view the equity market is different
As a result, while it may be right to play a pro-growth view in China, Chinese equities may not be the way to do it.
Let me elaborate on that a bit. Usually, the equity markets of most rise over time as long as growth is positive. In other words, even if growth decelerates, equity prices tend to continue rising. This makes sense because earnings are strongly correlated to economic growth, so even if growth slows, as long as it is positive, earnings grow also, and share prices rise. Here is a chart of the S&P vs US GDP growth. Note the 2004-2005 and 2010-2014 periods, where growth decelerated or remained flat, but share prices continued rising:
This is a phenomenon that is not unique to developed markets. Here is a chart of India GDP vs the NIFTY index:
Now take a look at the same chart for the Shanghai A-share market and Chinese GDP:
Note in particular the 2002-2005 period when GDP growth flew yet share prices DECLINED. And in the most recent few years, share price performance has not been correlated to whether growth rates were positive, but to the growth rate of growth. This reflects two things:
1. There is no historically reliable relationship between Chinese economic growth and Chinese share prices
2. One driver of Chinese share prices is LIQUIDTY (hence why share prices are related to the second derivative of GDP rather than the first)
The second item segues nicely into how domestic Chinese residents view the Chinese A-share market, which is that it is NOT a place to put investments. If you ask the typical upper and middle class Chinese about their investments, most will describe their real estate holdings or the interest they are earning at their bank. Very few will mention their holdings of equities. Which means that for the relationship between the Chinese economy and the stock market to strengthen, investor paradigms will need to change. And that, unfortunately, is something that takes a very long time.
Moving on, here are my interpretations of some charts:
After bouncing off its 1.5yr uptrend, the SPX looks to be forming a bullish triangle. And with the Philly Fed beat today,(highest print since last Sept) growth prospects may be picking up, which could provide a catalyst for more upside:
I noted on April 4th that
“In terms of yields breaking higher, the third time wasn’t the charm. The 4th time looks more likely. But we could potentially see a 1.55% print on 5y treasuries before then.”
As it happens, 5y yields touched a low of 1.548% on Monday before turning higher. It appears the fixed income short squeeze is over, and with the potential upturn in growth, (the Philly Fed has a history of being an early indicator, and the Citi US Economic Surprise Index has made its first higher high since Jan) conditions are supportive of higher yields. At the risk of jinxing myself, (gulp) we may finally get a substantive break of the 1.75% level that has been resistance since Sept:
On the other hand, 30y yields continue to print lower highs and lows. As a result 5s30s have broken to new lows. A notable quote on the 30y from Patrick Perret-Green @ ANZ: “Many have said that a 30y UST at 3.5% is expensive but 30y BTPs are now just above 4%.”
I’ll close with a few interesting links for your weekend reading:
1. FT Alphaville highlighted a very interesting speech by Larry Summers. You should read it in its entirety, but here is an interesting paragraph that stood out to me:
I think, that is, it is my best judgment about where the industrial world as a whole is, that absent structural changes in our economy it will be very difficult for monetary polices to simultaneously achieve full employment and maintain financial stability. It seems to me that that is supported by the last time that the US was anywhere near full employment. The period from 2003-2007, when we were manifestly not pursuing sustainable financial policies. And the profound difficulty monetary policy has had in Japan in generating levels of output that are consistent with full employment.
2. Google has developed an algo that can solve CAPATCHAs. Essentially, this means that computers can now read signs and recognize images. This is big. The reason why CAPTCHAs were created was because it was difficult for algorithms to decipher them – hence their use in setup processes for new accounts at many websites. This is likely to mean that driving robots & flying drones will be much better able to identify visual information without human intervention. In other words, another barrier between humans and machines has fallen:
3. An illustration of how the FISC system circumvents checks and balances in our political system:
4. The safest speeds to drive is +5 to -10 mph relative to the median speed of other cars. A follow up study found that “crashes involving turning vehicles accounted for 44 percent of all crashes observed in the study and that excluding these crashes from the analysis greatly attenuated the factors that created the U-shape of the Solomon curve”
5. 538 put out a piece that maybe should’ve been obvious to me but I found interesting. They found a clear correlation between the length of unemployment with the level of national unemployment at the time of job loss. To me, the take away is that one of the most important aspects of a stable career path is keeping your job during recessions!
- Jobless Claims was stable at 304k vs 315k exp and 300k prev.
- Philly Fed improved to 16.6 vs 10 exp and 9.0
- Canada Core CPI improved to 1.3% as exp vs 1.2% prev
- Fri: Good Friday,
- Mon: Europe Holiday,
- Tue: US Existing Home Sales, EU Consumer Confidence, Australia CPI, China HSBC Mfg
- Wed: EU PMI, BoE Minutes, Canada Retail Sales, UK Markit PMI, New Home Sales