- Switzer Report - https://switzerreport.com.au -

Don’t fight Beijing

Posted By Charlie Aitken On In Economy,Shares | No Comments

Key points

Clearly, there has been a complete investor capitulation in all things China facing. From Chinese equities, through to Macau casinos, luxury goods stocks, commodities, commodity currencies and commodity equities, it has been a complete wipe out. There has been absolutely nowhere to hide.

Investors have shoulders slumped and losses have been large. The financial press and analyst community have become universally bearish, while hedge fund short positions are now very crowded. It seems even people who once liked China now hate it because they have lost money.

From Chinese mainland equity investors through to BHP Billiton shareholders, everyone has lost money. It is an absolutely textbook capitulation and reminds me of the peak of the European sovereign debt crisis back in 2011.

Back to the future

Remember back then when EVERYONE was an expert on Europe? Remember all those emails you got about the Eurozone breaking up when Spanish and Italian 10yr bonds were 9%? Well, fast-forward to today and the gains in EU equities and EU sovereign debt are between 80% and plus 120%. If you’d shut your eyes and bought the nadir of the “crisis” you would have made serious positive total returns.

We operate in an extremely instant world as I have written many, many times. The present is extremely efficiently priced, the future is not. The world analyses the present, not the future, and therein lies the investment edge for anyone with more than a one-day investment horizon.

This week I have never ever seen more written on China. Not even at the peak of the growth boom. China headlines and associated price action in a wide variety of China facing assets have absolutely dominated the press, research and trading screens.

Capitulation, forced selling (margin calls) and universally negative sentiment almost always turns out to be a value buying opportunity. It’s been the hardest thing in the world to buy anything China facing this week, but I have done it for my fund as I believe there is genuine deep value and the potential to make positive total returns in the months and years ahead, as the consensus China negativity eases.

I am not looking for instant returns in the China facing instruments I have bought. I expect further volatility and sentiment swings. But if I look out 12 to 18 months, which is my investment horizon, I feel comfortable I will generate solid total returns.

We all forget it’s actually easier to do that off a low base. There is now a very low (aka value) base in all things China facing. Even a slight recovery in absolute terms will generate solid percentage gain returns.

Bargain basement

While Australian investors look at resource stocks, my first move due to my global mandate has been Hong Kong listed China H shares. The Hang Seng China Enterprises Index or HSCEI Index, if you believe the earnings forecasts, trades on 7.5x FY16 and a dividend yield of 4.2%. This index includes mostly massive cap state owned enterprises (SOE’s) and now trades on a record -42% discount to exactly the same bunch of stocks listed in Shanghai.

My thinking about buying the HSCEI index is firstly it appears to have double bottomed technically, secondly there is clear and present value, and thirdly I expect through time the -42% discount to A shares to narrow to -30% in the future. There was actually a period last year when H shares traded at a premium to A shares, so to forecast the discount to narrow to -30% is not a major call.

Obviously, Chinese GDP growth isn’t “7%”. My forecast is Chinese GDP is growing at plus 4% per annum. Yet let’s put that in context: it’s still the fastest GDP growth rate in the world and the GDP base in China expands each year.

It’s somewhat stunning that the cheapest equity valuations in the world are now in the fastest growing major economy. Sure, China is an emerging economy as such, and we need to expect volatility in Chinese asset classes, but the value is clear in my view.

Commodity fog

Australia’s view on China is clouded by commodity prices. Commodity prices have collapsed due to over-supply and the resurgent US dollar. If you look at Chinese demand for iron ore and oil, it’s actually rising. The problem is supply has risen faster and all commodities are denominated in US dollars. I actually don’t think commodity prices tell you ANYTHING about the Chinese economy. I think they tell you about an over-supply issue that won’t be fixed in the short-term.

Australian resource stocks will probably remain volatile trading instruments in the months and years ahead. I will approach them as trading stocks inside well-established lower trading ranges. BHP seems to consistently hold the $25.00 level for example.

Fundamentally, I am interested in Chinese financials, Chinese consumer stocks and Chinese technology stocks. These are the major weightings in the HSCEI Index. The funny thing is lower commodity prices are fundamentally helpful to the commodity intense Chinese economy, which should retain inflationary pressures and allow further PBOC interest rate cuts and bank reserve ratio cuts.

What I also find amusing is the allegation Beijing is “rigging” the Chinese equity market. No doubt Beijing is trying to bring stability to domestic equities. That has been partially successful. However, is Beijing’s behaviour any different to what the Bank of Japan (BOJ), Bank of England (BOE), Federal Reserve (FED) and European Central Bank (ECB) do in terms of quantitative easing (QE) and competitive currency devaluation? It’s no different.

Intervention everywhere

In hindsight, the ECB’s euro 1.1 trillion quantitative easing policy provided the platform to stabilise bond yields and, ultimately, support European equity markets. In fact, central bank policy is widely regarded as providing the major stimulus for asset prices generally since the GFC. So it’s very surprising to read the almost universal criticism of the government support for Chinese equities with internal stabilisation polices. It’s either indirect government support for asset prices through the central bank or direct government support for equities through a stabilisation fund. I just don’t see the difference. Either way, looking back in a year’s time I believe government intervention will be viewed as the inflection point for the Chinese equity market.

Let’s face it, markets globally have NEVER seen more central bank and government intervention. China is just another market experiencing this global trend as every government plays a home-biased game.

You know I’ve said for years: don’t fight the Fed. That was the right advice. Today I am telling you don’t fight Beijing. I believe they will win this fight with the domestic equity market and their drive to get economic growth driven by consumer spending rather than fixed asset investment. Just like the Fed, Beijing has very deep pockets and I believe they will eventually generate the same returns in risk assets by their policies.

My core investment philosophy is to place my biggest bets where value and central bank/government policy support collide. I think that’s right now in Chinese equities and that’s why I will continue to increase my bet inside what will be volatile short-term trading.

Remember, the idea is to “buy in gloom”. Right now there is textbook “gloom” towards all things China facing. I think there’s a clear contrarian opportunity in this gloom.

As Lord Rothschild said “buy on cannons, sell on victory trumpets”. I tend to feel the cannons were firing in China this week.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.