In this post, we continue to discuss themes to understand before investing in Chinese stocks in the 2020s.
Investing Amidst the U.S. China Cold War
If the current trajectory continues (steady growth at 6% per year) while the Chinese economy continues to decouple from the U.S., there may end up being positive returns even as the S&P eventually corrects.
Global assets have historically moved together. Emerging markets were a risk-on entity – if the S&P 500 was doing well and investors were bullish in general, they poured money into emerging market funds. Chinese exposure received the most inflows.
This made sense because if the U.S. was doing well, global growth was generally booming everywhere. In an increasingly connected world with shared supply chains and economies of scale across sectors, a hot U.S. economy was enough to carry the rest of the planet.
This pattern may come to an end. Developed markets have seen anaemic growth for some time now with 2.5% GDP growth being seen as quite good.
A new Cold War is beginning with the U.S. and China. The general distrust between the two nations may not be something that can be reconciled, with the likely result being that key technologies that will lead the world in the 21st Century such as 5G/6G, autonomous driving, semiconductor research, operating systems and the telecommunications being bifurcated. Countries will have to choose between the two camps in terms of compatibility – we are already seeing a pseudo-war with countries having politicized the decision to use Huawei as a supplier or not.
Right now, it seems like the camps are China and the U.S. proclaimed axis of evil with North Korea, Iran and Russia onside while the U.S. has the Five Eyes Alliance, India, South Korea, Japan and Western Europe.
However, given the direction that U.S. foreign policy is taking under the Trump Administration and the Chinese method for bilateral diplomacy based on mutual benefit, many developing and middle income nations are subscribing to Chinese trade and infrastructure through initiatives such as the Belt and Road program. Even the U.S.’ traditional allies in the UK, Canada, Australia and New Zealand are having difficulties rejecting Huawei and Chinese investment outright.
If supply chains are split and the détente in Sino-U.S. relations does not come for a while, expect for the correlation between the two markets to decline.
Chinese Bond Defaults and Excess Capacity
China is awash in high yield debt and investment grade debt that should be high yield. This is primarily corporate debt – where in corporate we include State Owned Enterprises and pseudo-provincial backed entities.
Historically, Chinese corporates have had a reputation for having murky financials and a tangled web of subsidiaries and unknown management interests. For bondholders, this is especially scary because there are large structural subordination elements. As a continuing moral hazard, rating agencies such as Fitch or Moody’s are paid by issuers.
Firms did not have right sized balance sheets for a variety of reasons. There could be too much debt because they expanded too aggressively given the availability of debt capital markets and investors looking for yield, they borrowed fraudulently and funnelled money out to vested interests or the industry fell out of favour and the creditor interest in refinancing at similar rates was limited.
For some corporates, the availability of cheap debt from large state owned banks or through loosely regulated financial instruments sold to retail investors meant that they operated outside of their mandates and went on acquisition sprees. Prominent examples of this included Anbang Insurance and HNA Group.
Nonetheless, to protect defaults, financially distressed companies had historically been bailed out repeatedly by larger corporate entities or a last minute savior with or without a connection to the firm.
This was inefficient. Market participants are not stupid – accordingly, the risk was priced so that the firms would fail under any sort of normal credit scenario would be priced to fail with a probability of being bailed out entirely baked in. This resulted in questionable companies trading at interest rates well above similarly rated U.S. peers. Asset managers should have known that the party was not going to last forever – however, many of them will end up taking large losses now.
The Chinese government does not want to experience a balance sheet recession like Japan or the U.S. by taking on too much debt. Real estate prices and speculation are regulated so that borrowing against asset value cannot be too high where if asset prices crash there is too much debt that is onerous to service. China is prepared to let investors take haircuts on their principal in order to make companies that should fail die.
Previously, two major factors staved away defaults. One, for the social stability aspect – failing companies usually means firing workers. For state owned enterprises, low skilled workers who depend on this employment for their livelihood are affected if mines or factories that are suffering from overcapacity close down.
However, China has become much better at retraining and transferring employees to new roles. Sometimes, it makes more sense to just pay people without them doing anything than propping up a failing business.
The other major factor was the protection of vested interests within the state or corrupt management embezzling funds. This would result in fraud with doctored financials that only unravel when a large cash balance is claimed and simple interest payments cannot be met.
The anti-corruption campaign is real – which we will cover in a separate post – and management and government officials who are caught are forced to relinquish gains and face prosecution.
Now this means – if the bonds are in trouble, the stock is almost certainly in trouble. This is obvious to anyone with an understanding of capital structure. Because the Chinese market is not yet mature, bond values may trade at massive discounts to par while there is substantial equity value. This is a huge indication that at least one of the two securities are mispriced – and we would usually wager the stock – don’t buy it! However, if it is actually the bond, there is an incredible investing opportunity.
This new trend of defaults is a good thing. Defaults means that investors, who want to preserve their capital, will demand transparent reporting, higher standards of due diligence and a standardized set of covenants similar to a developed market. What ends up happening is that greater investor comfort leads to more demand (after this initial shake out) and better pricing for corporates, resulting in a cheaper cost of capital.
A wave of defaults also means that if China wants to be a major investable market, an efficient restructuring process must be established similar to the U.S.’ famous Chapter 11 reorganization. This allows for an orderly transition, minimal business disruption and greater investor confidence.