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Interesting Times | Ed's Rant
INTERESTING TIMES
Despite appearances, the Year of the Pig is off to a good start, says Michael Wilson. Can it last?
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Oh dear, this isn’t shaping up very well, is it? With hindsight, perhaps it wasn’t such a great idea to let Huawei, a Chinese technology company with firm links to Beijing’s ruling Communist Party, become the dominant force in the western world’s 5G telephone networks?
Not so much because the evil reds have finally moved out from under the beds and installed their listening ears in your bedside telephone instead - but simply because they might?
Please feel free to take that observation with a large pinch of salt. But over the last couple of months the issue of Huawei Technologies’ insidious global reach has become something of a political bellwether cause in the Trump administration’s struggle against China’s wider trade ambitions. It might have started out as a loud burst of presidential namecalling against China’s premier telecoms company, but the issue has been gaining traction in its own right. And in other ways.
ECHO CHORUS
First it was Australia that heeded the US President’s call by banning
Huawei from the rollout of its national 5G networks, and New Zealand and Japan quickly followed. Then
came Japan, and then Germany, Italy and Canada started debating their own bans, while the Czech Republic barred the Chinese company from tendering for a contract, apparently in response to pressure from US secretary of state Mike Pompeo. In Britain, where we’ve had more things to think about recently, the response has been less strident but BT is reported to be removing Huawei equipment, especially from its emergency response infrastructure.
Should we be worried about a creeping Chinese advance into our secret lives? It depends on how much you trust your ever-listening Amazon Echo Dot, which is also made in China, or your new Huawei AI Cube, which contains an Alexa voice assistant. Can you see where all that paranoia is coming from?
THE INVESTMENT TIDE TURNS
But here’s a funny thing. As we were preparing for press, the Financial Times reported that foreign investors are turning back to Chinese equities in their millions, apparently unfazed by all the political dust that’s been blowing around. During January, the FT said, foreigners had pumped $9 billion of net new money into Chinese equities, the largest inflow in history.
Thus neatly reversing the massive slowdown during 2018 which had lopped 25% off the value of Shanghai and Shenzhen blue chips. And almost trebling the average net inflow of the previous thirteen months. And why?
Firstly, the industry reckons, because there are rising hopes that President Trump can make progress in his trade tariff negotiations with Beijing, which if successful
would take much of the pressure off China’s exporters – while also making it easier for China to drop its reciprocal import tariffs on much-needed staples such as pork, maize and soya beans.
Secondly, because the US Federal Reserve has dampened the dollar recently by backing down from the tight monetary policy that seemed intent on raising US interest rates this year. The expectation of higher rates had been sucking cash out of the developing world for most of 2018, much to the detriment of China, whose own currency, the renminbi yuan, had been weakening significantly. By reversing its tight money policy – apparently in recognition that America’s impressive economic growth was a bit of a one-off fuelled by tax breaks, rather than a truly fundamental paradigm shift! – the Fed appears to have made Chinese equities more attractive. That’s a topic which we’ll revisit in a minute or two.
But thirdly, because Beijing is moving actively to improve the flexibility and ease of access for foreign investors in its stock markets. At a time when China’s economic growth seems to be slowing to a still-impressive 6.6% a year, the government securities regulator has proposed widening the range of investments permitted under a scheme whereby approved foreign institutions will be able to buy technology stocks on an over-the-counter exchange in Beijing.
According to the FT, the new rules would also let foreigners buy Chinese hedge funds and futures, and conduct margin trading and short selling. A fair proportion will continue to come from passives that track the Chinese elements of various MSCI indices, but the general loosening will be helpful.
LOOPY VALUATIONS NO MORE
Before we go on, it’s important to stress that Chinese stock valuations have a long record of being utterly decoupled from economic growth. Wind the clock back to the heady days of 2001, and you’ll find that Chinese shares were trading on price/earnings multiples of 60 and more. (As quoted by Hong Kong’s CEIC Data.) Whereas these days a more viable (and sensible) ratio of 15 or thereabouts is more normal.
Not that you can ever really expect to be completely safe from volatility – back in 2007 the Shanghai p/e skyrocketed to 72 before crashing back to the high teens in 2011 as the global economic crisis struck. By 2014 it was below 10, but last spring it once again approached 20 before being driven down in the mid-year rout that followed Washington’s trade sanctions and the ensuing threat or trade war.
All of which serves to underline one crucial point – namely, that for all the country’s economic robustness, China’s financial markets are very much subject to the whims of whatever the western world throws at them. If it isn’t a commodity crisis (China has very little high-grade oil of its own, and precious little copper), or a trade war or a currency war, it might be something else -such as the current row over Huawei – that tips the balance.
I’m not an analyst by training, but I’ve been in and out of China for the last 25 years, and there seem to be two distinct ways of coping with the volatility that is the People’s Republic. One is to stock-pick with all the local expertise you can muster – an approach which cost Fidelity’s superstar Anthony Bolton a lot of kudos from his highly-geared China Special Situations portfolio in the aftermath of the steep 2010 correction, but which has been somewhat kinder to the new team who took over in 2014. (Declaration – I hold FCSS.)
And the other way, of course, is simply to buy and hold. Which, in the light of today’s relatively subdued p/e levels, seems a relatively simple proposition. Just as long as you know where the obvious rocks in the water are…
PIG YEAR QUALITIES
If you think it doesn’t matter that this is the year of the pig, rather than the rabbit or the dog, there’s a chance that you might be wrong. The Chinese are pretty superstitious, and they gamble with great dedication and a lot of lucky charms, and they tend to pay a lot of attention to what their horoscopes say. Which can be either good news or bad news. Most of the horoscopes I’ve seen say that pig
years are good for careers but potentially iffy for financial returns. Don’t bet unconditionally on a pig that’s still in the poke, they say. Who would I be to disagree?
The pig is the twelfth sign in the twelve-member Chinese zodiac. Legend has it that, when the zodiac animals were summoned by the gods, the pig turned up last because it was too lazy to get a proper move on. Pig people are positive, loyal, brave and honest, but they can also be stubborn, stroppy, self-indulgent - and somewhat inclined to use their considerable bulk and strength to have things their own way. Good luck with that one, Mr Trump.
DOES SIZE MATTER?
As the zodiac reaches its final year, it’s reasonable to ask ourselves whether there are any sectors that have reached the top of their cycle, or any which are waiting their moment to shine at last? I’m asking this question in the spirit of progress-checking, rather than from any particularly superstitious tendencies; but hey, it never hurts to ask. China is a long way away from Britain, and the cyclical factors may be different from ours.
Consider the startling growth of China’s major companies, for example. Are social networker Tencent (over $500 billion, p/e 30) and retailer/exporter Alibaba (over $450 billion, p/e 42) getting too big to be fanciable as growth prospects? And what about Huawei?
Good question, that. Huawei has just elbowed Apple out of the number two slot for global smartphone production, but you won’t find it easy to buy its listed shares. That’s because it doesn’t have any. Huawei is, apparently, an “employee-owned company”, which (unlike John Lewis) means that its true ownership is anybody’s guess. Hence the CIA’s warning that it’s actually controlled by the Chinese government, and hence the worries that it might be used as a channel for espionage.
Could that be true? Well, certain Chinese companies do have access to special cheap loans from governmentcontrolled banks such as the China Development Bank, and Huawei has certainly had those in the past; and like its tech exporting rival ZTE, it’s been known to offer its customers cheap financing based on state loans – although, to be fair, so have Siemens and Alcatel. The difference is that Huawei’s listening-in technology makes it particularly sensitive internationally. 2019 is likely to show how far Beijing will go to protect its protegé.
PROPERTY AND CONSTRUCTION?
What’s the next thing you know about China’s economy? Right, it’s that the property and construction business is a busted flush. They’ve built all the airports and the motorways and the railways by now, and now that property inflation is cooling and home sales are flagging it’s all going to be downhill for a sector that eats up financial resources that can’t be afforded.
Except that it isn’t. Beijing is about to announce a new round of funding for ‘social projects’, and the infrastructure sector is getting a second wind. Fitch solutions has just forecast 5.9% growth for the industry this year, followed by 6.1% growth next year. The country is set to build 6,800 km of new railway lines, which is 40% more than last year - of which 3,200 km will be for highspeed trains. Shanghai and Wuhan are just two of the cities that will benefit from plans to build new urban and inter-city rail projects to the value of $127 billion.
And if this year’s Trump/Xi trade talks fail, and the threatened US/Chinese tariffs materialise? Although Fitch thinks there’s a chance that this would put some of the new projects on hold, other analysts believe that ways would be found to achieve them. President Xi has a disaffected urban class to keep happy, and I’d say he’s got more sense than to disappoint them.
BANKS?
What about the banks, then? China’s commercial banks are famously tied down by the Beijing government, which still owns chunks of them and which owes them an awful lot of money. They are known to be carrying colossal values of bad debts, which were foisted on them by the government when it needed to finance all the expensive housing projects of the noughties. If the banks had refused to lend to the local authorities, who had then defaulted on their loans, then who knew what might have happened to them?
In return, of course, the central bank and the financial regulators have obligingly turned a blind eye to the mountain of undeclared non-performing loans that somehow don’t make it onto the commercial banks’ returns. Well, not all of them anyway.
Bloomberg reported in mid-January that the China Banking and Insurance Regulatory Commission (CBIRC) had conceded a figure of two trillion yuan (about $300 billion) for the end of December 2018 - which it said would have represented a default rate of 1.89%. But that didn’t include another 3.4 trillion yuan ($510 billion), which it said represented 3.16% of all commercial bank lending.
All of that against the background of a 6.5% increase in lending, which you might suppose was reasonably in line with an economy that grew by 6.6% during 2018. But it wouldn’t account for the fact that the commercial banks upped their loan loss reserves by nearly a quarter, to 3.7 trillion yuan. In the meantime, Bloomberg said, the banks were increasingly turning to unconventional measures such as asset-backed securities and debt-for-equity swaps, in their efforts to fend off the effects of a potential crisis.
In itself, this isn’t an irresponsible approach, let alone a fraudulent one. Japan’s banks couldn’t have divested themselves of their own bad debt mountain in the 1990s without the willing collusion of a government that allowed them to fess up, little by little, until all their non-performing debts had been written down. What will count for China is whether it’s done openly, or at least sensibly. But it will certainly wipe out some small banks – there have been a few rural banks declaring bad loan ratios above 20%.
MINING COMPANIES?
If you’re a commodities nut like me, you won’t have missed the way that the shares of foreign mining companies tend to swoop and soar in synchrony with the fortunes of the Chinese market, and specifically with the trade war between Washington and Beijing. China does, after all, import an awful lot of rock from Australia. With the added bonus of a fundamental uplift, largely from the copper market: my BHP shares put on a heart-warming 22% in the year to February, with a chunky special dividend as well. Sometimes I think that proxy ventures like these are as good a way as any to back the Chinese scene?
Indeed, the government set up a new Ministry of Natural Resources last summer, with the key aim of persuading foreign companies to get involved with Chinese mining. But investing in the Shanghai and Hong Kong mining listings is not particularly difficult for a manager. Vast coal producers such as Shaanxi or China Shenhua, copper miners like Jianxi – or, less contentiously, the China Northern Rare Earth Group, are worth a look if only because some of their assets are very special indeed. (Look up neodymium, yttrium and lanthanum for more details. China has got plenty of them.)
Or take the Chinese companies which own eight of the world’s 14 biggest cobalt mines in the faraway Democratic Republic of Congo. If I say that the DRC produces 68% of the world’s cobalt, and that the world’s electric cars won’t currently run on anything but cobalt-heavy batteries, and that China also has a contract to buy as much as a third of the cobalt output from Glencore, the world’s biggest producer, you’ll see that Beijing has a lot of political bargaining chips that the American president might not have reckoned with.
Which, with the world of trade being increasingly dominated by international political balances, might just prove significant as the year progresses. Watch this space.
