State Of The World

“We have discussed the futility of soothsayers trying to forecast too many times. Attempting to accurately assess complex systems filled with random and interrelated variables, exogenous factors and unknown human behaviour is a fool’s errand. We don’t like to admit it, but nobody knows anything – and that includes me and you.” Barry Ritholtz, Bloomberg.

“We should not overreact to supply shortages or rising energy prices, as our monetary policy cannot directly affect those phenomena.” European Central Bank President, Christine Lagarde.

 

 

State Of The World

“We have discussed the futility of soothsayers trying to forecast too many times. Attempting to accurately assess complex systems filled with random and interrelated variables, exogenous factors and unknown human behaviour is a fool’s errand. We don’t like to admit it, but nobody knows anything – and that includes me and you.” Barry Ritholtz, Bloomberg.

“We should not overreact to supply shortages or rising energy prices, as our monetary policy cannot directly affect those phenomena.” European Central Bank President, Christine Lagarde.

“The headlines don’t look good. China’s largest property developer continues to flirt with bankruptcy and has suspended trading of its shares. And a smaller developer defaulted on an offshore bond (at the start of October), suggesting Evergrande’s woes aren’t idiosyncratic. Meanwhile, power rationing forced factories in at least 20 provinces to close [in the] last week [of September].” ASR Research.

“Contrary to popular claims, mainland China has not been free flowing with easy credit. Real estate developers in China often have to pay 10% to 15% in financing on fully collateralised debt to raise capital for construction projects. The debt is generally short-term in nature – one to two years, with one year notes being the most widespread. Lenders keep a very tight leash and apply tremendous ongoing due diligence as most projects require debt rollover. Importantly, Chinese lenders do not lend based on a developer’s overall balance sheet and income statement. They simply assume that most developers will siphon off money and leave the lender holding an empty bag. In China, credit is not just expensive, it is generally unavailable. You qualify for a loan only if you have hard assets as collateral. The bank doesn’t care about your credit – they only care about the value of the assets you hand over to back the loan.” Jason Hsu, CIO, Rayliant Asset Management.

What does “common prosperity” mean when it is applied with Chinese characteristics? It seems to be to focus attention on the country’s high level of inequality ahead of the 20th Congress of the Chinese Communist Party (CCP) next year. It appears that the CCP are now looking for the private sector in China to be subservient to the Party’s needs. This has had significant consequences on both equity and corporate bond valuations in the country, and on those Chinese company assets listed overseas, particularly on US exchanges. An issue now is whether China is investible for foreign capital, or if unpredictable politics and regulation preclude you from doing so. Since the country was admitted into the World Trade Organisation, investors looking to both diversify away from the US and Europe and capture some of the major opportunities in China have bought assets in the country. The sheer scale of the country, its potential and rapid growth offered the prospect of material returns. As time has passed, outside investors grew more comfortable investing in the country, but exposure in aggregate has been modest, at around 5% being the typical global portfolio allocation, versus the 16% that would match China’s share of World Gross Domestic Product (GDP).

At an entrepreneurs symposium in July 2020, Xi Jinping urged the private sector to align with the Party’s political leadership and cultivate compliance and obedience with its goals. Thereafter, we saw a regulatory overhaul, which resulted in the disappearance of Alibaba founder, Jack Ma, private tuition companies banned and gaming companies told to restrict access and time for certain users.  In the medium-term, the key issue is the sustainability of China’s economic model at a time where Xi Jinping appears to be turning hard left, leaving investors with no recourse to appeal fait accompli changes.

China faces major challenges from demography, indebtedness and shrinking productivity that would benefit from private sector innovation and expansion, but it appears the Party considers its control and oversight as being more important than extending a profound period of economic development.

The indebtedness question concerns itself primarily in China, with the property sector that has long provided revenue for local and provisional Governments across the country. Evergrande is by most accounts the largest corporate junk bond issuer in the country, and is currently under severe distress. This has prompted external observers to ask if Evergrande is “China’s Lehman Bros?”

According to Allianz China, the answer is probably not: “We see this scenario as extremely unlikely. For starters, a key point is that US authorities were trying to save Lehman’s. It is actually the other way around in China – the authorities are making an active decision to let highly indebted companies fail. The intention is to prevent a further build-up of leverage in the property sector that has long been viewed as a source of economic risk. Another key difference is that Lehman’s happened at a time when many other large US financial institutions were also facing problems. We see little risk of systemic weakness in the China banking system.” However, the crackdown on property companies will have an economic impact and lead to further downgrades for Chinese GDP.

If China appears to be a headwind to the ongoing pace and trajectory of the post COVID-19 pandemic, recovery is not the only barrier. Oil, natural gas and other sources of non-renewable fuels have begun to rise this year and provide additional succour to those that see high inflation, or even stagflation, as the ultimate consequence of the pandemic. Brent Crude has rallied in excess of 50% through 2021, coal prices have risen 100% in China and natural gas prices in Europe approached a four-fold rise by the end of the third quarter. Given the strength of the initial recovery, it should not be a surprise that demand for resources has risen strongly since the reopening began in earnest. However, the most recent price moves into the quarter-end are more likely explained in part by geopolitics (Russia constraining gas supplies to Europe and China, until very recently, banning the import of Australian coal) and weather impacting renewable supplies, particularly in the UK and Europe.

Central Banks have begun to question their own belief that inflation is transitory. The Bank of England has sounded very hawkish, and interest rate markets have moved to price in three rate increases over the coming year. In the US, the Federal Reserve has all but confirmed it will wind down its Quantitative Easing bond buying programme in the fourth quarter, and then begin to raise interest rates.

In contrast to the headwinds which have been building up through the late Summer, the case for optimism rests substantially on pent-up savings and the spending potential of the private sector, even if in the UK excess savings could end up covering gas and electric bills! Longview Economics estimate that US households have $3.3trillion more cash in bank accounts than they would have if there was no pandemic. Separately, they note that US corporate balance sheets have increased close to $1trillion since the start of the pandemic. If households and companies across the World, with the US leading, have the confidence to release previously held back demand for spending and investment, then the post COVID-19 recovery can extend well into 2022.

In the meantime, it pays well to remember that the legacy of the pandemic, from the initial fiscal and monetary response, to the way the recovery has unfolded to-date remains unprecedented. As a result, economic data, market volatility and Central Bank actions are likely to continue to surprise until at least Spring, when we think assessing the persistency of inflation will be more valuable than jumping to any conclusions now. Although, to echo comments we made at the conclusion of the prior quarter, we are generally positioned across our Strategies to account for inflation concerns, as well as retaining optimism for the continued post-pandemic recovery to unfold.