Secular bull or bear?


Author Cam Hui

Posted: 07 May 2013

As US equities have rallied in the last couple of weeks, there has been much discussion about the rotation in sector leadership from defensively oriented sectors to the deep cyclical sectors. Does the rotation mean that this market is truly ready to take off to further new highs? What does it all mean?

I have spent a fair amount of time pondering that question (see my recent post Sell in May?). My conclusion is where you come down on the question of whether this is the start of a new secular bull market where stocks move to new highs or whether we are just seeing the top of a range-bound secular bear.

To explain, consider this long-term chart of the Dow, where the market has seen alternating secular bulls, where stocks rally to multi-decade highs, and secular bears, where the market remains range-bound for years.

Still a secular bear market
My main belief is that we remain in a secular bear for two main reasons: demographics and valuation. I have written about the demographics issue before (see Demographics and stock returns and A stock market bottom at the end of this decade). For stocks to go up, there has to be more buyers than sellers at a given price. The propensity of Baby Boomers, as they move into retirement, is to take money out of stocks. In order for equities to rise, those negative fund flows have to be met by the retirement savings of their children, the Echo Boomers. Two research groups looked into this topic (see papers here and here). Their conclusion – the inflection point at which the fund flows of Echo Boomers moving into stocks start to overwhelm the Baby Boomers taking money out is somewhere between 2017 and 2021.

In addition, long-term valuations don’t appear compelling. I have long considered the market cap to GDP ratio as a proxy for an aggregate Price to Sales ratio for the stock market. The chart below from Bianco Research via Barry Ritholz, shows this metric, whose history goes all they way back to 1925, to be well above its long-term average. In addition, note that instances of falling market cap to GDP ratios correspond with secular range-bound bear markets.

Another reason for the long-term secular bear case comes from John Hussman, an investor for whom I have much respect. His latest 10-year return projections for the SPX is about 3.5% (see My answer to John Hussman). Even with bonds yields at microscope levels, a 3.5% return expectation for US equities is nothing to get overly excited about.

The bull case (and it’s always important for investors to consider opinions contrary to his own) is represented by Ray Dalio’s “beautiful deleveraging” concept (see my post Falling tail risk = new secular bull?). Dalio believes that the United States has undergone a “beautiful deleveraging” process in the wake of the financial crisis of 2008. A “beautiful deleveraging” involves just the right amount of austerity, debt restructuring and money printing. He went on to observe that, by contrast, Europe has gotten it all wrong and that region is likely to be mired in a Lost Decade.

If Dalio is correct, then the rotation that we are observing from defensive to cyclical sectors is another sign of a new upleg in equity prices and therefore the start of a new secular bull.

The intermediate term outlook
While my analysis of the secular bull vs. bear is based on a long-term multi-year investment time frame, what about the intermediate term time frame for the next several weeks to months?

Here’s what’s bothering me about the emergence of the cyclical leadership. First of all, commodities look positively sick. Here is a chart of the industrial metals. Does this look like the basis for a cyclical rebound?

In addition, the Citigroup Surprise Index has been turning down, both in the US and globally. Despite Friday’s NFP upside surprise, the internals of the employment report appeared to be negative and it was before long that there were a cacophony of voices pointing out the weaknesses in the report (for examples, see herehere and here).

I agree with the blogger MicroFundy when he pointed out the divergences between the macro picture and US stocks:

I think we are getting real close to a major inflection point. It seems like every macro-economic data point I come across is saying one thing – the same thing. There is an extremely high correlation between all the varying data points and indicators. Data like the 10yr treasury yields, PMI manufacturing, durable goods orders, copper prices, international (ex Japan) stock markets, inflation expectation, margin levels etc – are all saying that the (global &) US economy is slowing, and that the risks of deflation/contraction/recession are growing.

The only thing diverging from this pattern in all of the charts below is the US equity markets.

His conclusion is “something’s gotta give”:

There are two extreme scenarios that can “correct” the above divergence, although I believe it will be a combination of the two.

1 – We could see a correction of 15-20% that would put the US equity markets back in line with most of the charts above. It would then be priced closer to fair value based on most of the recent economic data.

2 – The economic data can pop back up. Whether it was because of the payroll tax increase, sequestration, or some other seasonal event(s)… maybe this is/was just a blip on the radar these last few months, and the economic data will “catch up” to the US equity markets.

If these scenarios were mutually exclusive, I would bet the farm on #1. A realistic base case assumption though, is a combination of the two. I am anticipating a good 10% correction combined with a small pickup in some of the macro data.

Either way, something’s gotta give. The level of divergence here is bordering historical, and the relative and absolute over-valuation of some of these high-yield names are frightening.

With Europe mired in recession, commodity markets signaling that Chinese growth is stalling, the US is once again holding up the world. If the American economy is holding up the world, then why is US equity performance faltering against global equities? The chart below shows the relative performance of SPY against ACWI (All-Country World Index). If we are indeed seeing a launch of a new secular bull, shouldn’t the US, which has been the beneficiary of the “beautiful deleveraging”, be leading?

A bearish bias
While I have outlined my bias for the bear case, investing is about probabilities and I honestly don’t know how this market is going to resolve itself. While the bear case is compelling, Street earnings and revenue estimates continue to get revised upwards (as per Ed Yardeni).

Until we see some sort of negative macro surprise that cause estimates to get revised downwards, the stock market is likely to grind higher. As I wrote last week, there is no catalyst yet for a bearish impulse for stocks yet.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest. 

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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Wash, rinse, repeat?


Author Cam Hui

Posted: 30 July 2012

Wow! The market’s ups and downs are getting more violent and the time frame of the moves are getting more compressed. When I wrote last Monday that the markets looked a little overbought and that it was maybe time for a little pullback (see Time for one step back?), I never expected the severity and speed of the downdraft.

On Wednesday, I had remarked to a friend that things looked a little overdone in Europe. The sense of panic was evident. 17 leading economists publicly warned that Europe was sleepwalking toward disaster. Tim Duy, who I regarded as relatively level-headed, rhetorically asked if there is even a panic button in Europe. Little did I know Draghi’s pledge to do “whatever it takes” to save the euro was imminent. Nor did I expect that we would move from a short-term oversold condition Wednesday on one of my trading models to a near-overbought reading by the close Friday.

Up, up and away?
The bulls were encouraged Friday when the SPX staged an upside breakout past a key level of technical resistance on decent volume. Does this mean that the bull and bear tug of war is over and the bulls have won?

Not just yet. When I reviewed some of my secondary indicators on the weekend, they hadn’t quite confirmed the bullish breakout staged by the SPX. Consider, for example, the relative returns of SPY vs. TLT (US long Treasury ETF) as an indicator of the risk-on vs. risk-off trade. As of Friday’s close, this relative return ratio remains in a trading range and has not confirmed the bullish equity breakout.

The same non-confirmation can be found in the relative performance of defensive sectors, such as Consumer Staples against the market. As of Friday’s close, Consumer Staples remain above a relative support level and has not broken down, which would indicate that the bulls had taken control of the stock market. Similarly, the relative performance of Utilities (not shown) also shows a similar pattern of holding up above relative support.

Moving across the Atlantic, where ECB chief Mario Draghi sparked the risk-on rally, the chart of the Euro STOXX 50 is still struggling to rise above resistance. In addition, while the yields on Spanish and Italian bonds have fallen, they have not fallen sufficiently for me to wave the all-clear signal.

More of the step-forward, step-back shuffle?
I wrote several weeks ago that we remain in a choppy market and I am waiting for some definitive signs of either strength or weakness before I would want to make a directional call (see Waiting for direction). While the bulls won a battle Thursday and Friday, they haven’t won a decisive victory yet. To be sure, there are good reasons to be relatively sanguine about the outlook. China seems to be turning around, as evidenced by the better than expected HSBC flash PMI last week; Mario Draghi has taken the risk of Eurogeddon off the table, as least for now; and the American economy appears to be stabilizing, or at least it’s not going over a cliff.

Even though I am cautiously optimistic about the stock market, my official vote in the Ticker Sense blogger poll remains neutral. Until I see some signs that the bulls can break through and take control, my base case remains that of a market dancing the step-forward and step-back shuffle, though I may be tactically inclined to either increase or reduce my portfolio beta. Wash, rinse and repeat.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

China, beyond the hard/soft landing debate


Author Cam Hui

Posted: 11 July 2012

Imagine a country where a sector has dominated that nation’s economy and is deemed to be “systemically important” to growth. Insiders of that sector have made obscene profits from the growth. One day, we wake up and find that that sector has gotten in over the heads. The “logical” free-market solution is the let that sector go down and allow the economy to re-balance, but sector insiders have a cozy relationship with the government. If leading companies in that sector goes down, the collapse will surely take many in government down with them. What country am I referring to? What sector? What is the most likely course of action for the government?

One obvious answer to the first two questions is the finance sector in the West (see my last post Another test of the banking lobby’s powers). It’s a good guess, but I am referring to State Owned Enterprises (SOEs) in China.

The roots of China’s growth
The China miracle was fueled mainly by two factors:

  1. Access to a cheap source of labor and the willingness to use it as a source of competitive advantage to grow the economy; and
  2. The CNYUSD currency peg.

While the currency peg allowed Chinese labor to be highly competitive, it also created all sorts of nasty side effects. First and foremost, China was stuck with America’s monetary policy, which was inappropriate for China. As the Chinese economy heated up and inflation rose, Chinese interest rates could not rise with inflation and inflationary expectations because of the currency peg. Thus, real interest rates went negative.

Negative real interest rates created winners and losers. The winners were the companies with easy access to capital, which were mostly the SOEs at the expense of private businesses, which are often referred to as Small and Medium Enterprises (SMEs). An academic paper called A Model of China’s State Capitalism (h/t Michael Pettis) that shows that the dominance of SOEs and their superior growth is largely attributable to their monopolistic or semi-monopolistic positions in the Chinese economy, e.g. telecom, oil refining. etc. John Hempton called this arrangement a kleptocracy because Party insiders have become enormously wealthy at the expense of the ordinary citizen.

Negative interest rates also meant very low or negative cost of capital. As Japanese companies found out in the late 1980’s, it’s easy to make money when your cost of capital is that low. You borrow as much as you can and invest in something, anything with a positive real return. If you are positioned properly, you can make obscene profits – and they did.

Currency peg = Financial repression
The biggest loser in China, on a relative basis, was the household sector. The ordinary Chinese who worked hard and managed to squirrel away savings had few places to put their money other than the banking system. The Chinese bond market is not sufficiently large. The stock market is very small and undeveloped compared to major industrialized countries and is regarded mostly as a casino. The household sector was forced to put money into the banking system at negative interest rates. Carmen Reinhart calls that financial repression. Here is the definition from Wikipedia:

Reinhart and Sbrancia characterise financial repression as consisting of the following key elements:

1.Explicit or indirect capping of, or control over, interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
2.Government ownership or control of domestic banks and financial institutions with simultaneous placing of barriers before other institutions seeking to enter the market.
3.Creation or maintenance of a captive domestic market for government debt, achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
4.Government restrictions on the transfer of assets abroad through the imposition of capital controls.

John Hempton at Bronte Capital outlined the dilemma of the Chinese household well:

The Chinese lower income and middle class people have extremely limited savings options. There are capital controls and they cannot take their money out of the country. So they can’t invest in any foreign assets.

Their local share market is unbelievably corrupt. I have looked at many Chinese stocks listed in Shanghai and corruption levels are similar to Chinese stocks listed in New York. Expect fraud.

What Chinese are left with is bank deposits, life insurance accounts and (maybe) apartments.

For those ordinary Chinese citizens who could afford it, the only logical place for savings is in real estate. Real estate became a form of money and savings poured into it. In effect, the CNYUSD peg was indirectly responsible for China’s property boom.

Where we are today
Fast forward to today. China’s growth has hit a slow patch. One of the objectives in the Party’s latest five-year plan calls for a re-balancing of growth away from heavy infrastructure spending, which has benefited SOEs, to the consumer (read: household sector). Andy Xie described the slowdown and how the authorities have managed to contain the worst effects of the downturn:

There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.

SOEs, the vehicle of wealthy Party insiders, have been hit hard:

State-owned enterprises (SOEs) reported 4.6% net profit margin on sales and 7.4% return on net asset in 2011. Both are very low by international standards. In the first five months of 2012, SOEs reported a 10.4% decline in profits but 11.3% increase in sales.
SOE performance indicators are low and declining. This is despite the fact that SOEs have such favorable access to financing and monopolistic market positions.

Xie also echoed Hempton’s kleptocracy claims, though in a less dramatic fashion:

Closer observation gives clues as to why SOEs are so inefficient. Their fixed investment often costs 20% to 30% more than that for private companies and take about 50% longer to complete. The leakage through overpriced procurement and outsourcing and underpriced sales is enormous. SOE leakage can explain much of the anomalies in China.

In addition to the problems presented by slowing growth, the financial system is teetering because of an over-expansion of the shadow banking system (see my previous comment Ominous signs from China). Left unchecked, it could have the potential for a crash landing, i.e. negative GDP growth, which is not in anybody’s spreadsheet model.

What will the government do?
In the face of the cracks exposed by a slowing economy, what should the Chinese authorities do?

The textbook answer is that growth has been overly unbalanced towards large infrastructure projects and tilt growth toward the household and consumer sector. The Chinese consumer needs to rise. The latest five-year plan specifies this objective in a clear fashion.

The problem with that solution is that it gores the SOE and Party insiders’ ox. For the household sector to rise, household income needs to rise. Wages need to rise. Returns to household savings need to rise. For this to happen, financial repression needs to end.

Ending financial repression would mean that real interest rates would need to rise, which would squeeze the cost of capital of Chinese enterprises – SOEs in particular. Would the Party cadres go along with that? This may be a case of where the leadership dictates a course of action but the bureacracy doesn’t go along.

The good news: A soft landing
Under the circumstances, the most likely course of action is a “more of the same” stimulus program. Already, we have seen a surprise rate cut, which does nothing for the returns of the household sector. We are likely to see more infrastructure stimulus. Already, we have seeing signs of a growth revival and signs of real estate revival.

The good news is that such a policy course will mean a soft landing in China. The bad news is that it will mean more unbalanced growth and it just kicks the can down the road. The next time the economy turns down, it will be that much harder to revive.

Bad news: End of the commodity supercycle
What’s more, such a growth path would mean the end of the commodity supercycle. The principal argument for being long-term bullish on commodities (which I have made before here) is rising household income in emerging market economies like China’s mean rising resource intensity. Greater household income mean that consumers want more stuff, e.g. cars, TVs, etc. This is shown by this analysis from the Council on Foreign Relations.

If financial repression continues and the household sector continues to get repressed, then where is consumer demand coming from? Moreover, there are indications (via FT Alphaville) that resource intensity may not rise despite greater infrastructure spending:

Nomura analysts Matthew Cross and Ivan Lee looked at China’s urbanisation rate and concluded that it can keep progressing at its current pace for years without needing an increased rate of steel consumption. In fact, they argue that China’s annual steel needs won’t increase at all in 2012 and 2013 — and that’s with new government stimulus.

Also see this chart (via FT Alphaville):

This is where I depart from commodity bulls like Jeremy Grantham. Even long-time commodity bull Jim Rogers has become more cautious on China.

More importantly, while the world focuses on the China hard vs. soft landing debate, I am thinking about the longer path for Chinese growth. They will slow down. When the next downturn hits, we could see a classic negative GDP growth recession.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.



None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Don’t lose sight of the medium term


Author Cam Hui

Posted: 18 June 2012

Rather than focus on Greece this weekend, I thought that I would write about the medium term path for equities and the global economy. I came upon this BIS paper entitled Characterising the financial cycle: don’t lose sight of the medium term! The BIS researchers break economic cycles into two components, a shorter business cycle and a longer financial cycle. Here is the abstract:

We characterise empirically the financial cycle using two approaches: analysis of turning points and frequency-based filters. We identify the financial cycle with the medium-term component in the joint fluctuations of credit and property prices; equity prices do not fit this picture well. We show that financial cycle peaks are very closely associated with financial crises and that the length and amplitude of the financial cycle have increased markedly since the mid-1980s. We argue that this reflects, in particular, financial liberalisation and changes in monetary policy frameworks. So defined, the financial cycle is much longer than the traditional business cycle. Business cycle recessions are much deeper when they coincide with the contraction phase of the financial cycle. We also draw attention to the “unfinished recession” phenomenon: policy responses that fail to take into account the length of the financial cycle may help contain recessions in the short run but at the expense of larger recessions down the road.

The financial cycle is turning down. Ray Dalio of Bridgewater explained the financial cycle using the Monopoly® game as an analogy in this note.

If you understand the game of Monopoly®, you can pretty well understand credit and economic cycles. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players give them cash. So as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property with lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So early in the game, “property is king” and later in the game, “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.

Now imagine Monopoly® with financial leverage and you understand what is happening with the financial cycle:

Now, let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it could make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other giving each other credit (i.e., promises to give money and at a later date). If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. There would be more spending on hotels (that would be financed with promises to deliver money at a later date). The amount owed would quickly grow to multiples of the amount of money in existence, hotel prices would be higher, and the cash shortage for the debtors who hold hotels would become greater down the road. So, the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash.

What happened with Lehman in 2008 and in Greece, Spain and the other eurozone peripheral countries today are symptoms of the downturn in the financial cycle.

The business cycle turns down
There is no doubt that the financial cycle has been turning down since 2008. What about the business cycle? It’s turning down as well. Regular readers know that I use commodity prices as the “canaries in the coalmine” of global growth and inflationary expectations. Consider this chart of the negative divergence between US equities and commodities prices.

The market is also telling a similar story of an economic slowdown. Here is the relative performance of the Morgan Stanley Cyclicals Index against the market. It’s in a relative downtrend, indicating cyclical weakness.

Globally, air cargo traffic represents an important real-time indicator of the strength of the global economy (h/t Macronomics). This chart from Nomura shows the correlation of air cargo growth with global industrial production growth. Air cargo growth is headed south as well.

I have written about the Axis of Growth, namely the US, Europe and China and at least two of the three are slowing. Hale Stewart at The Bonddad Blog went around the world and explained why the global economy is slowing:

[T]here are no areas of the world economy that are demonstrating a pure growth environment; everybody is dealing with a fairly serious negative environment. Let’s break the world down into geographic blocks:

1.) China is located at the center of Asian economic activity. Recently, they lowered their lending rate largely as result of weakening internal numbers. While these numbers still appear strong to a western observer (growth just over 8%), remember that China is trying to help over a billion people become middle class. To accomplish that goal, the economy needs to have a strong growth rate. Also consider that the news out of India has become darker over the last few months as well. A recent set of articles in the Economist highlighted the issues: a political system that is more or less unable to lead, thereby preventing the action on structural roadblocks to growth. The fact that two of the Asian tigers are slowing is rippling into other regions of the world, which leads to point number 2.

2.) The countries that supply the raw materials to these regions are now slowing. Australia recently lowered its interest rate by 25 BP in response to the slowing in Asia. A contributing factor to Brazil’s slowdown is the decrease in exports to China. Other Asian economies that have a trade relationship with China are all experiencing a degree of slowdown, but not recession. Some of these countries (such as Brazil) were also experiencing strong price increases. The price increases are are starting to slow, but they are still above comfort levels.

3.) Russia has dropped off the news map of late. However, it emerged from the recession in far worse shape; it’s annual growth rate for the duration of the recovery has been between 3.8% and 5%, which is a full 3% below its growth rate preceding the recession. This slower rate of growth makes Russia a far less impressive member of the BRIC list.

4.) The entire European continent is caught up in the debt story — underneath which we’re seeing some terrible economic numbers emerge. PMIs are now in recession territory, unemployment is increasing and interest rates for less than credit-worthy borrowers are rising. And, the overall credit situation is casting a pall over the continent, freezing expansion plans.

5.) The US economy has experienced 2-3 months of declining numbers. While we’re not in recession territory yet, we are clearly in a slowdown with growth probably hovering around the 0% mark.

In addition, I have documented warning signs of rising tail risk in China (see Focus on China, Not Europe, Ominous signs from China and The ultimate contrarian sell signal for China?)In last week’s analysis, John Hussman said that the US is in recession now and blamed it on the financial cycle:

By our analysis, the U.S. economy is presently entering a recession. Not next year; not later this year; but now. We expect this to become increasingly evident in the coming months, but through a constant process of denial in which every deterioration is dismissed as transitory, and every positive outlier is celebrated as a resumption of growth. To a large extent, this downturn is a “boomerang” from the credit crisis we experienced several years ago.

Regardless of the outcome of the Greek election, my inner investor tells me that the fundamentals of the economic outlook is negative. When the financial cycle and the business cycle both turning down in unison, that’s bad news.

As for how much of the negative news has been discounted by the markets, I don’t know. What can change the trajectory of the outlook in the next few months is intervention, either by the central banks (which was rumored late last week), an announcement of more QE by the FOMC, or the news of some deal cooked up by the European governments, IMF, etc.

My inner trader tells me that fundamentals don’t matter and the markets will react to short term headline news.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The ultimate contrarian sell signal for China?


Author Cam Hui

Posted: 18 June 2012

It’s a sign of the ultimate height of hubris and I have been watching for this for some time, but the Skyscraper Index is flashing a sell signal on China. Here is an explanation of the concept from Wikipedia:

The Skyscraper Index is a concept put forward in January 1999 by Andrew Lawrence, research director at Dresdner Kleinwort Wasserstein, which showed that the world’s tallest buildings have risen on the eve of economic downturns. Business cycles and skyscraper construction correlate in such a way that investment in skyscrapers peaks when cyclical growth is exhausted and the economy is ready for recession. Mark Thornton’s Skyscraper Index Model successfully sent a signal of the Late-2000s financial crisis at the beginning of August 2007.

Now comes the news that China plans to build the world’s tallest building in just three months! It’s a contrarian signal that indicates that an economy is topping out.

The Skyscraper Index is admittedly an imperfect indicator, largely because there are so few data points and the results could be attributable to data fitting. Nevertheless, the ideas are highly intuitive, as Wikipedia explains:

The intuitively simple concept, publicized by business press in 1999, has been cross-checked within the framework of the Austrian Business Cycle Theory, itself borrowing on Richard Cantillon’s eighteenth-century theories. Mark Thornton (2005) listed three Cantillon effects that make skyscraper index valid. First, a decline in interest rates at the onset of a boom drives land prices. Second, a decline in interest rates allows increase in average size of a firm, creating demand for larger office spaces. Third, low interest rates provide investment to construction technologies that enable developers to break earlier records. All three factors peak at the end of growth period

Interestingly, the market peak and financial crisis that follow seems to occur sometime between the planning of the building and its completion. Consider, for example, the Empire State Building, which began in January 1930 – after the stock market crash. The Petronas Towers in Malaysia was completed in 1998, a year after the onset of the Asian Crisis. Here is more about the Skyscraper Index from Barclays (via The Big Picture).

To be sure, a peak indicated by the Skyscraper Index doesn’t mean that the lights have permanently gone out on the country which constructed the world’s tallest building. The United States went on to continue its growth and assume the mantle of global leadership after the Great Depression. The Malaysian economy of today, or the economy of Asia, can’t exactly be characterized today as a black hole either.

For today’s investor, I remain of the belief that, in terms of the effect on markets, China is at center stage and Europe is the sideshow (see Focus on China, not Europe). This latest signal from the Skyscraper Index confirms that view. If Europe were to stabilize itself but China lands hard, what happens in Greece or Spain won’t matter very much.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Ominous signs from China


Author Cam Hui

Posted: 12 June 2012

As I write these words, markets are surging in the wake of the news of a bailout of Spanish banks. I had written before that the principal macro risk wasn’t coming from Europe, but China (see Focus on China, not Europe). I had expected that the eurozone would lurch in a crisis to rescue to crisis cycle and the Spanish banking rescue is more of the same. Already, there is a chorus of voices of why the bailout won’t work (see examples from Goldman Sachs, BoA and Bruce Krasting). For now, it doesn’t matter as the markets have interpreted the move as a stay of execution – as the cycle of crisis and rescue continues.

What is more ominous are the signs coming from China.

Technical outlook negative
First of all, the technical outlook has turned negative as the Shanghai Composite is in a wedge formation that has resolved itself bearishly.

Next door in Hong Kong, the Hang Seng Index is in a downtrend, which confirms the bearish technical outlook for China.

China’s economy is weakening
The signs of weakness in China’s economy are becoming more evident. There was a dump of economic data over the weekend and most of the numbers came in below expectations. The weakness is likely to spill over to the Chinese stock market. Thomson Reuters reports that StarMine expects severe negative earnings surprises out of Chinese stocks [emphasis added]:

StarMine models suggest that it’s still too early to embark on any bargain-hunting expeditions in Asia, where stock prices have underperformed most other regions of the world. In China alone, stock prices are down 16% from their March highs, but the value created by that selloff comes with big risks attached. Now, a new analysis of the most recent data suggests that the picture doesn’t appear likely to change any time soon. The “Predicted Surprise” – for earnings – the percentage difference between StarMine’s SmartEstimate, which puts more weight on recent forecasts and top-ranked analysts, and the mean estimate of all analysts – for emerging Asian markets earnings as a whole, currently stands at -1.6%. Among all markets in the region, China’s Predicted Surprise is -2%, second only to that of Sri Lanka, which comes in with a -2.8% Predicted Surprise.

No wonder we saw the surprise rate cut last week. Dong Tao of Credit Suisse (via Also Sprach Analyst) believes that actions by the PBoC won’t be enough, because the central bank is in a liquidity trap and rate cuts are pushing on a string:

However, we believe that a cut in the lending rate will only have limited impact in stimulating investment. We believe China is in a liquidity trap. With a low interest rate environment, further cuts in interest rates may not get much of an additional impact. Today’s problem in China is not about funding cost or bank liquidity, but demand for loans for real businesses. As companies in the real businesses struggle with surging costs, over-capacity, and weakened demand, the incentive to conduct real investments is low. It would take some structural changes to jump-start the momentum of investments in the private sector, instead of just through easing monetary policy.

As the economic picture deteriorates, expect more cranky commentaries like this one from John Hempton (The Macroeconomics of Chinese kleptocracy):

I start this analysis with China being a kleptocracy – a country ruled by thieves. That is a bold assertion – but I am going to have to assert it. People I know deep in the weeds (that is people who have to deal with the PRC and the children of the PRC elite) accept it. My personal experience is more limited but includes the following:
(a). The children and relatives of CPC Central Committee members are amongst the beneficiaries of the wave of stock fraud in the US,

(b). The response to the wave of stock fraud in the US and Hong Kong has not been to crack down on the perpetrators of the stock fraud (so to make markets work better). It has been to make Chinese statutory accounts less available to make it harder to detect stock fraud.

(c). When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big 4 audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably especially the big four) are co-opted for the benefit of Chinese kleptocrats.

This however is only the beginning of Chinese fraud. China is a mafia state – and Bo Xilai is just a recent public manifestation. If you want a good guide to the Chinese kleptocracy – including the crimes of Bo Xilai well before they made the international press look at this speech by John Garnaut to the US China Institute.

Hempton concluded that Chinese State Owned Enterprises (SOEs) depend on negative interest rates as a source of cheap funding and falling inflation is the real economic threat to the Chinese economy [emphasis added]:

The Chinese kleptocracy – and indeed several major trends in the global economy – depend on copious quantities of savings at negative expected rates of return by middle and lower income Chinese…

The more serious threat is deflation – or even inflation at rates of 1-3 percent. If inflation is too low then the SOEs – the center of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 percent. A positive real funding rate – well that is a completely different story.

The real threat to the Chinese establishment is that the inflation rate is falling – getting very near to the 1-3 percent range.

Low Chinese inflation rates will mean reasonable returns on savings for Chinese lower and middle income savers. Good news for peasants perhaps.

But that changing division of the spoils of economic progress will destroy the Chinese establishment (an establishment that relies on a peculiar and arguably unfair division of the spoils). The SOEs will not be able to pay positive real returns to support that new division of spoils. The peasants can only receive positive real returns if the SOEs can pay them – and paying them is inconsistent with looting.

If the SOEs cannot pay then the banks are in deep trouble too.

If the banking system gets into trouble, then we are not just looking at a hard landing scenario, defined as sub-par economic growth, but a crash landing, which I define as zero or even negative GDP growth.

Ursa Minor romps in China?
For now, the good news is that the risk of a crash landing appears to be off the table. I had written in my previous post that systemic risks in the Chinese shadow banking could result in a crash landing and speculated about the possibility of Chinese capital flight.

Those risks appear to be contained for now. I had written that I was watching the share price of HSBC as a barometer of financial risk in China. A Hong Kong based investment banker informs me that HSBC is not thought of as a good gauge of the risks to the Chinese financial system as the bank had diversified its exposure. Better to watch the Chinese banks listed in Hong Kong, such as:

  1. Agricultural Bank of China (1288.HK)
  2. Bank of China (3988.HK)
  3. China Merchant Bank (3968.HK)
  4. ICBC (1398.HK)

Right now, none of the shares of these banks are falling in a way that suggests market fears of an uncontrolled implosion of the shadow banking system. But watch this space!

Current conditions are suggestive of an attack by Ursa Minor, or a minor bear market, in China. Nevertheless, such a scenario is one that hasn’t largely been discounted by the global financial markets. So watch out.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The NFP coin tossWhat’s the risk of capital flight in China?


Author Cam Hui

Posted: June 3 2012

I wrote before that the likely negative surprise was going to come from China and not Europe (see Focus on China, not Europe). Yes, I am worried about China, but my concerns are longer term oriented.

No, I am not as concerned about the possibility of a slowdown in China, as per Marc Faber on CNBC:

“As an observer of markets – whenever everyone focuses on one thing – like Greece and Europe – maybe they miss issues that are far more important – such as a meaningful slowdown in India and China.”

No, I am not as concerned about the disappointment over the size of the announced stimulus program. The market rallied initially when the news of the stimulus program hit the tape and official media announced that it was RMB 1 trillion [emphasis added]:

In the context of complicated and changed economic situations, the Chinese government has vowed to make some tailored changes to its established macroeconomic policy. At an earlier State Council meeting, a consensus was reached that China will accelerate the approval of some infrastructure projects, promote consumption of energy-saving home appliances and increase tax cuts on enterprises in a bid to ensure steady growth. China’s central bank also announced a 50-basis-point cut for banks’ reserve requirements on May 12, the second such cut this year and a third since December, which will release more liquidity. The stimulus packages are expected to reach 1 trillion yuan ($158 billion).

The markets then sold off the next day when it realized that the size of the program is only one-quarter of the size of the 2008 RMB 4 trillion program. What did you expect? They announced that it would by RMB 1 trillion!

Is China’s business elite losing confidence in China?
Here’s what I am worried about: There are signs that the Chinese business elite is losing confidence in China, which could result in a disastrous run on the RMB.

To set the stage, FT Alphaville highlighted a paper by Victor Shih of Northwestern University that illustrates the vulnerability of China’s vaunted foreign exchange reserves:

And on that note, we found some of the points raised in this 2011 paper by Victor Shih from Northwestern University extremely insightful.

For one thing, did you know that China’s wealthiest 1 per cent could determine everything?

Consider the following points (emphasis ours):

China in fact faces three major structural causes of capital flight.

First, the empirical portion of this paper will conduct three calculations to show that the wealthiest 1% households in China commands wealth that is at least as large as 2/3 of the foreign exchange reserve and possibly as high as nearly twice its size.

Thus, if the top 2.1 million households in a nation of 1.3 billion people decide to move even 30% of their wealth overseas, the foreign exchange reserve will reduce by a trillion dollars or more.

Second, despite official foreign exchange control, numerous channels, especially those through China’s current account, exist to move capital in and out of China.

Third, households, which are net savers, face a negative 3 plus percent in real return from bank deposits and Chinese treasury bonds, forcing them to constantly look for higher returns than inflation rates.

These three conditions combine to create extremely fragile conditions for China’s foreign exchange reserve, which is the backbone of the entire financial system of China.

If the foreign exchange reserve is depleted by capital flight, the central bank will need to resume large scale money creation, as it did in the 1980s and the 1990s, to maintain the solvency of the banking sector (Walter and Howie 2011; Shih 2004).

In other words, the Shih paper says that China’s foreign exchange are highly vulnerable to a loss of confidence by its business elite.

So what? That’s just like saying that a banking system, any banking system, is vulnerable to a loss of confidence. What if all the depositors all rushed to get their money out of the banks at the same time? If you had been predicting doom in the banking system in the last 50 years based on this premise, you would still be waiting for the collapse to occur.

What you need is a catalyst, a loss of confidence, for a catastrophe to occur. There are signs that a loss of confidence by China’s business elite seems to be happening. I wrote on Monday that:

FT Alphaville highlighted a survey by the Committee of 100, an international, non-profit, non-partisan membership organization that brings a Chinese American perspective to issues concerning Asian Americans and U.S.-China relations. The results of this key question asks American and Chinese business leaders their outlook for China. While Americans believe that Chinese growth will continue long into the future, the Chinese are far less optimistic and their outlook has deteriorated rapidly since 2007.

China in 20 years

Capital flight?

OK – so they are starting to lose confidence in China’s long-term growth outlook. What are they doing about it?

Look at this chart from Bianco Research of China’s net purchase of Treasuries. They went NEGATIVE a few months ago and ticked back to positive, but net purchases are still net negative on a rolling 12 month basis.

When I added two and two together, this story of a USD shortage in China now makes sense:

We noted last week that there was a rising tussle over dollars in China, spurred by capital outflows and RMB-denominated selling on signs that the world’s key economic powerhouse may be slowing. A situation which was arguably thrusting China into a dollar short position.

While that might seem counterintuitive given China’s substantial longer-duration dollar assets, it is possible because of China’s substantial short-term dollar liabilities. Essentially, we’re talking about a dollar-denominated duration mismatch on the mainland at a time when China is running one of its largest outstanding external debt positions for 27 years.

When I worked with our emerging market investment team, the team head told me that one of the buy signals for a country is when the locals start to repatriate funds from abroad (and he was referring to Latin America at the time). What we have in China are signs of a loss of confidence, followed by indications of capital flight – all very bad news.

To be sure, I may have just misinterpreted the data and wrongly concluded that capital flight is occurring. Another explanation is that this episode of capital flight is just a momentary flash of panic, created by the uncertainty that accompanies a change in leadership.

Let me make myself clear: A collapse in China’s foreign exchange account is not my base case scenario. Such a loss of confidence would not just mean a hard landing involving sub-par economic growth, but a crash landing involving negative GDP growth, which would totally freak out the markets. Nevertheless, the probability of such an event is small, but non-zero – and definitely not discounted by the markets at all. What worries me is that the markets start to get a whiff of this story and starts to price in this kind of tail risk. That’s when the trouble begins.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Focus on China, not Europe


Author Cam Hui

Posted: 30 May 2012

While everyone is focused and worried about the news flow from Europe, I am less concerned about the prospects for Greece and the eurozone. As I wrote in my last post (see Draghi, the last domino, falls), Germany is becoming increasingly isolated and expect her to start to bend on the issue of eurobonds. While they may not be eurobonds in the strictest sense, we are likely to see some sort of typical European compromise on Pan-European infrastructure bonds.

I am more concerned about the news flow out of China, which is likely to deteriorate over the next few months – and none of the negative news has been discounted by the market.

The consensus on China
Currently, the consensus view on China is that while the economy is weakening, the authorities are aware of the problem and they are taking steps to remedy the situation. Indeed, Bloomberg reported that Premier Wen Jaibao made some remarks on May 20 suggesting that more stimulus was on the way:

Chinese Premier Wen Jiabao said the government will focus more on bolstering economic growth, indicating policies may be loosened further as inflation moderates.

“The country should properly handle the relationship between maintaining growth, adjusting economic structures and managing inflationary expectations,” Wen said during a tour of Wuhan, the capital of China’s Hubei province, from Friday to Sunday.

“We should continue to implement a proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth,” Wen said.

The market interpreted his comments as being growth friendly:

Wen’s remarks cited in the report, which didn’t mention concern about inflation, indicate the government might take more aggressive steps to support the economy after April data showed the slowdown may be sharper than expected. The central bank this month cut banks’ reserve requirement ratio for the third time since November to boost liquidity.

Take a look at the Shanghai Composite, which reflects this ambiguity about China’s near-term growth outlook. The index is currently testing the downside of an unresolved wedge formation, which indicates indecision. A breakout to the upside of the wedge would be interpreted bullishly while a downside breakdown would be bearish.

Turmoil beneath the surface
While the picture of the Shanghai Composite reflects this consensus view, a tour of secondary market indicators suggest that not all is well with the Chinese economy. First of all, the flash PMI release showed contraction.

Signs of economic weakness are everywhere, this analysis shows a a tight correlation between Macau gaming revenues and Chinese growth – and gaming revenues are falling.

Next door in Hong Kong, the Hang Seng Index is not behaving quite as well as the Shanghai Composite. The index rallied in February to fill the downside gap that occurred in August 2011, but the rally couldn’t overcome resistance. The index has now violated an important support zone and weakening rapidly.

Further north from Hong Kong, South Korea is an economy that is highly sensitive to global economic cycle. In particular, the South Koreans export a lot of capital equipment and other goods to China. That country’s stock market isn’t behaving well either. In fact, it’s cratering.

China has been an enormous consumer of commodities. Commodity prices have also been weakening as the CRB Index is in a downtrend and has violated an important support level.

Australia is not only a major commodity exporter, it is highly sensitive to Chinese commodity demand because of its geography. The AUDUSD exchange rate is falling rapidly.

Just to show how bad things are, the Canadian economy is similar in characteristic to Australia’s. Both are industrialized countries that are large commodity exporters. The only difference is that Australia is more levered to China, whereas Canada is more sensitive to US growth. Take a look at the AUDCAD cross rate as a measure of the forward expectations between the level of change in Chinese and American growth.

Is the shadow banking system unraveling?
The story that I have outlined so far is the story of economic deceleration in China. There is another risk that the market doesn’t seem to be focusing on – the risk of a Lehman-like catastrophe in China’s financial system. Patrick Chovanec, a professor at Tsinghua University’s School of Economics and Management in Beijing, writes:

There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate.

He went on to detail an incident of how the shadow banking system is unraveling in China:

In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital. “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system. If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make). In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

OK, so China has a bunch of little AIGs. The story gets better, you have leverage on top of leverage [emphasis added]:

Zhongdan, the company in the Caixin article, took these risks one step further. It persuaded borrowers to take out bank loans based on guarantees from Zhongdan, and then hand some or all of that money back to Zhongdan to invest in Zhongdan’s own “wealth management” products:

Under the arrangement, a participating company would take out a bank loan and give some of the money to Zhongdan for investing in high interest-paying wealth management products for a month or more.

The firm then apparently put those funds to work by buying stakes in small companies such as pawnshops and investment consulting firms, according to the sources. Some of the funds went toward a U.S. consultancy that later failed.

When excesses occurred in the US with subprime lending and “liar loans”, rules were skirted. It’s no different in China.

Since this use of funds completely violated banking rules, Zhongdan forged documents indicating the money was being borrowed to pay fictitious suppliers:

To nail one loan, [an executive for a building materials manufacturer] said, Zhongdan formed a shell building materials supplier and wrote a fake contract between the supplier and his company. The document was presented to the bank, which approved the loan. Zhongdan later de-registered the phony supplier.

It all unraveled in the end.

The whole thing started to unravel in January when banks “reacted to rumors of a liquidity crunch” at Zhongdan:

At that point, regulators stepped in and told everybody to freeze — and to keep all the assets as “good” on everyone’s balance sheets while they figured out what to do next. Zhongdan had over 300 clients, and guaranteed RMB 3.3 billion (US$ 521 million) in loans from at least 18 banks. The only liquid assets that the guarantee company appears to have available to pay banks is RMB 210 million (US$ 33 million) in margin accounts deposited with the banks themselves. Good luck finding the rest:

Several banks that cooperated with Zhongdan smelled trouble and started calling loans they had issued to companies backed by the firm … The next domino fell when the creditor companies, seeking to appease the banks, turned to Zhongdan for help repaying the called loans. But Zhongdan executives balked, and the domino effect accelerated as companies teetered under bank pressure and the city’s business community shuddered with credit freeze fears.

When I hear stories like this, I think of the cockroach theory. If you see one cockroach, there are sure to be more.

Reuters recently reported a story that Chinese buyers were defaulting on coal and iron ore shipments. While this story may be an indication of a slowing economy in China and slackening commodity demand, it might have stopped there. But the story gets worse as it exposes the cracks in the shadow banking system. It turns out that Chinese buyers have been buying commodities and using them as collateral to obtain financing. When the economy and commodity prices turned down, they were caught. This type of financing is highly prevalent in the copper market, as Reuters reported that Chinese warehouse were so full that copper inventory was the red metal was being stored in car parks.

Watching the shadow banking system
I have no idea what all this means. China’s economy is highly opaque and we have no reliable statistics. How big is the shadow banking system and how much leverage is involved? We know that there are problems, but I have no way of quantifying it.

Could this result in a crash landing, i.e. negative GDP growth, in China? I have no idea. Certainly, the unraveling of excessive leverage has seen that kind of result before.

Here is one offbeat way that I am watching for signs of stress in China’s shadow banking system. I am watching the share price of HSBC. While HSBC is a global bank, it has deep roots in Hong Kong and Asia. For newbies, HSBC stands for Hongkong Shanghai Banking Company. It is a bank that was firmly established in Hong Kong. As a child, I can remember driving by the bank’s headquarters in downtown Hong Kong in the 1960’s.

Stresses in the Chinese financial system is likely to show up in the share price of major financials that have exposure to China and Asia, like HSBC. The stock has been falling rapidly in the past couple of weeks, which is not a good sign.

To put the stock performance into context, I charted the performance of the stock relative to the BKX, or the index of US bank stocks. HSBC has been in a relative downtrend, but the lows of 2009 have not been violated. I interpret this as the market signaling that while there may be signs of trouble, it is not panicking.

Chinese elite losing confidence
To add to China’s troubles, the Chinese business elite is starting to lose confidence in China’s long-term outlook. FT Alphaville highlighted a survey by the Committee of 100, an international, non-profit, non-partisan membership organization that brings a Chinese American perspective to issues concerning Asian Americans and U.S.-China relations. The results of this key question asks American and Chinese business leaders their outlook for China. While Americans believe that Chinese growth will continue long into the future, the Chinese are far less optimistic and their outlook has deteriorated rapidly since 2007.

China’s outlook in 20 years

Putting it all together, we have signs of a weakening economy, a shadow banking system that is teetering and a loss of confidence by China’s business elite. While the government is taking steps to address the problems, none of these risks have been discounted by the market.

While I expect the news flow from Europe to improve in the days to come, which is bullish, I also expect further stories of deterioration out of China, which has the potential to be extremely bearish. All this points to further choppiness in stocks and risky assets with a downward bias.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Draghi, the last domino falls


Author Cam Hui

Posted: 25 May 2012

As expected, the Latin quarter of the eurozone ganged up on Germany on the issue of eurobonds, but Angela Merkel stood fast. But Germany is becoming increasingly isolated. The WSJ report that Christine Lagarde of the IMF came out in support of the concept of eurobonds:

International Monetary Fund head Christine Lagarde Tuesday called on euro-zone governments to accept more common liability for each other’s debts, saying that the region urgently needs to take further steps to contain the crisis.

“We consider that more needs to be done, particularly by way of fiscal liability-sharing, and there are multiple ways to do that,” Lagarde told a press conference in London to mark the completion of a regular review of U.K. finances.

So did the OECD:

Her comments came an hour after the Organization for Economic Cooperation and Development had, for the first time, endorsed joint bond issuance in its latest Economic Outlook

Angela Merkel’s staunchest ally has been Mario Draghi of the European Central Bank. Up until now, Draghi had been relatively silent on the Greek crisis. He spoke yesterday at at the Sapienza University in Rome and addressed the latest eurozone crisis in an unusually frank manner [emphasis added]:

We are living at a critical juncture in the history of the Union. The sovereign debt crisis has exposed serious weaknesses in the institutional framework; in this context, the difficulties in finding common solutions are having a negative impact on market valuations. The extraordinary measures taken by the ECB have gained us time; they have preserved the functioning of monetary policy.

But we have now reached a point where European integration, in order to survive, needs a bold leap of political imagination. It is in this sense that I have referred to the need for a “growth compact” alongside the well-known “fiscal compact”.

He went on to explain what he meant by a “growth compact”, namely closer economic integration:

A growth compact rests on three pillars and the most important one, from a structural viewpoint, is political: the economic and financial crisis has challenged the myopic belief that monetary union could remain just that, and not evolve into something closer, more binding, into an arrangement whereby national sovereignty on economic policy is replaced by the Community ruling. If the governments of the Member States of the euro define jointly and irrevocably their vision of what the political and economic construct that supports the single currency will be and what the conditions to reach that goal together should be. This is the most effective answer to the question everyone is asking: “Where will the euro be in ten years’ time?”.

Hmm, sounds sort of like an endorsement of eurobonds to me.

He went on to talk about “structural reforms”, which I wrote about extensively in the past (see Mario Draghi reveals the Grand Plan). It means, in effect, structural reforms at the micro-economic level so that it’s easier to fire people. It also means internal devaluation by the peripheral countries:

The second pillar is that of structural reforms, especially, but not only, in the product and labour markets. The completion of the single market and the strengthening of competition are crucial for growth and employment. Labour market reforms that combine flexibility and mobility with a sense of fairness and social inclusion are essential.

Growth and fairness are closely connected: without growth, and the events of recent months also reflect this, the temptation to “circle our wagons” gains strength, and solidarity weakens. Without fairness, the economy breaks up into multiple interest groups, no common good emerges as a result of social and economic interaction, and there are negative effects on the capacity to grow. Recent Italian history has no shortage of examples.

By fairness, he refers partly to the high level of youth unemployment compared to the entrenched older generation with their job security and gold-plated pension plans:

In the European Union, between 2007 and 2011 the unemployment rate rose by 5.8 percentage points among the 15-24 year olds, by 3.5 points among the 25-34 year olds and by 1.8 points in the 35-64 age range. Qualitatively, the profile is similar almost everywhere; the clear exception is Germany, where the unemployment rate among 15 to 24 year olds in the first quarter of 2012 was 8%; in Italy it was 34.2%, in Spain 50.7% and the euro area average was 21.9%. These trends reflect a fundamental question: they confirm the particular vulnerability of this essential part of our workforce. The unequal sharing of the “cost of flexibility”, only affecting young people, an eternal flexibility with no hope of stabilisation, leads among other things to companies not investing in young people, whose skills and talents often decline in jobs with low added value. The underuse of their resources reduces growth in various ways: it makes the creation of start-ups less likely – and they are on average more innovative than others – it causes a decline in skills in the long run, slowing down the assimilation of new technology and acting as a brake on efficient production processes. In addition to undermining society’s sense of fairness, it is a waste that we cannot afford.

In addition, Draghi endorsed the idea of pan-European infrastructure bonds:

The third pillar is the revival of public investment: the use of public resources to push forward investment in infrastructure and human capital, research and innovation at national and European levels. (The proposed strengthening of the EIB and the reprogramming of Union structural funds in favour of less-developed areas go in this direction).

An endorsement of closer economic integration? A advocate for pan-European infrastructure bonds, which is the first step in the slippery slope to eurobonds?

It sounds like Merkel is losing her last ally in Mario Draghi. Expect the Germans to bend sooner than later.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Not enough panic?


Author Cam Hui

Posted: 25 May 2012

As stocks have descended in the last few weeks, investor sentiment measures have moved into zones indicating excessive fear. As an example, the Citigroup Panic/Euphoria model is in the “panic” territory, which is contrarian bullish.

Numerous other indicators, such as the Ticker Sense Blogger Survey, to which I contribute and voted “bearish” last week, also confirms the observation that there are too many bears.

Watch what they do, not what they say
What’s bothering me is that while all these sentiment surveys point to excessive bearishness, market based indicators such as the VIX Index is not showing very much fear at all.

Remember, what what they do, not what they say. While I have written before that this market is deeply oversold and due for a relief rally, these readings are suggestive that there is more downside before we see an intermediate term bottom.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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