Just how worried should we be about China? John Stepek chairs our Roundtable discussion.
John Stepek: Let’s talk about the world’s most important currency. Will the US dollar bull market continue, or is the Federal Reserve’s decision not to raise interest rates a turning point?
Max King: The dollar bull market’s over – regardless of when the Fed raises.
John: Why do you think that?
Max: Firstly, everyone is bullish on the dollar and expects it to go higher when rates are raised – so that should already be in the price. Also the dollar has gone up a long way. That’s tightened global liquidity, which has squeezed emerging markets and China, as we’ve seen. So we may well see measures to boost liquidity – perhaps in the form of more quantitative easing (QE), maybe something else – even if rates rise. Basically, a stronger dollar is bad news for both the US and the rest of the world, so the US will take measures to prevent it.
Killian Connolly: Being long the dollar does seem a crowded trade, and it doesn’t look as good from a technical analysis point of view as it did. And given the reasons the Fed gave for holding off – high equity volatility and poor economic data, which won’t go away soon – I can’t see why it would raise rates this year at all.
Mark Williams: I look at things from an Asian perspective. I reckon those currencies will keep weakening. China’s cut rates, Korea’s cut, Australia’s cut, and you’ve got decelerating growth, whereas growth in America is continuing, and a rate hike still seems likely in the next six months. I’d also expect China to want the US dollar to continue to rise against the yuan – being pegged to the strongest currency in the world is unhelpful.
Maike Currie: America is in better shape than pretty much any of its rivals. The housing market is picking up and unemployment is falling, which boosts tax receipts, and helps the government balance its books, which means Uncle Sam has to borrow less, which boosts the currency. The prospect of higher rates – if not quite yet – also makes its currency more attractive as a store of value. So the case for a stronger dollar remains.
But it does look as though monetary tightening has been delayed until at least October, possibly next year. What was most interesting was the reaction. Markets didn’t like the Fed’s dovishness. The message seemed to be: “just get on with it”. Whatever the timing of the first hike, it’s becoming clear that rates will be lower for longer, amid what looks like a prolonged slow recovery.
Max: I’m not surprised at the market’s reaction. Either the Fed knows something nasty about the US and the world economy, or it doesn’t know what it’s doing. Either is bad news. Investors have had too much faith in the authorities: from the European Central Bank (ECB) to the Fed to China’s government. Whether rates rise this week or in December makes little difference in economic terms, but it all gives me a sense of déjà vu.
Yet again, the Fed will start too late, raise too slowly, and go too far. Yellen believes it’s riskier to raise too early than too late, as monetary policy can always catch up. But that’s like thinking you can turn up 30 minutes late to a marathon and catch up – you can’t, especially if you’re wearing a donkey costume.
Eric Verleyen: Yes, not hiking just creates more uncertainty.
Killian: But imagine what people would have said ten years ago if they knew the Fed would be vacillating this much over a 0.25% move – and we’re supposed to think this is a normal environment.
John: What about China? Is this an apocalypse, or just a blip on the road to long-term prosperity?
Mark: I don’t think it’s an apocalypse, but it’s more than a blip. They’re trying to manage an incredibly difficult transition. That has to involve parts of the economy failing – you might have to see bankruptcies, for example, and the knock-on impact of those. Until the intervention in the stockmarket – which was wasted money, basically – the authorities were doing a very good job. We would like to see the opening up of certain areas, and changes being made to allow more service-led growth. I think we’ll probably see the yuan weaken gradually too.
John: But you don’t see the yuan collapsing by 10%-20%, say, and China exporting deflation across the world?
Mark: That’s not our base case. The big risk is the outflow of capital. China has an increasingly porous capital account, and that’s what we have to watch. I would hope to see currency reserves stabilising. But this is a very difficult process. That said, many other Asian currencies have fallen by a lot more than the yuan. And if you look at exports, China has actually been gaining market share for the past decade. So the problem is international demand for exports, rather than the value of its currency.
Killian: I’m a bull on China long term. But I wonder whether the market’s just breaking down… because the market’s breaking down. I don’t think there’s anything that can be done to stop a bear market. We have all these narratives about China – “they’re making a transition to a consumer economy” – but I don’t buy them. China is not that different to America – they both have big states, just in different ways. I think these are stories we tell to rationalise the bear market away. In the longer run, the Chinese economy itself will be fine, as long as the authorities don’t respond to economic downturns in a strange way.
Eric: Yes, the market might remain volatile, but we don’t yet think we’ll see a “hard landing”. I know many people don’t trust China’s official economic data. But if you try to recreate those figures, by looking at electricity consumption, or data from export partners, you get something quite close to the official numbers. So we expect Chinese growth next year to stay around 6% – decelerating, but pretty high.
Maike: A Chinese market slowdown was inevitable, given the extent to which it has risen. But our managers are still finding interesting companies on cheap valuations, particularly now that the market is down a third on where it was in the spring.
Max: Freeing up exchange rates is part of becoming a market economy and is a very good thing in the long term, both for China and the rest of the world. If you go back a few years, China’s growth rate was not only fictitious, but clearly unsustainable – it had to come down. But Lombard’s Diana Choyleva reckons growth is likely to pick up next year, from around 4% this year (by her reckoning) to around 4.3%-4.5%. A 4% growth rate for an economy with virtually zero population growth is extremely good.
And the idea that this has any implications for Chinese equities is laughable. Look at the long-term charts – all the time that China’s economy was booming, equities were terrible. There’s very good value in China right now. The market is 80% retail investors, who are all chasing blue-sky, big-theme, never-never growth stocks – so you can have a share trading on a teens multiple, with 20% earnings growth for the next five years, and it won’t get a look in. So there’s tremendous value in the “growth at a reasonable price” category.
John: The other knock-on impact from China has been on commodities. Killian, have they hit bottom yet?
Killian: I wouldn’t like to hazard a guess, but it looks like they’ll go lower still. Commodities have diverged further from equities than at any point since 1994. That’s not sustainable. But I fear equities will fall to close that gap, rather than commodities rising. Long term though, you want to own commodities over bonds – real assets over paper promises.
Max: I like the resource sector. In 1992, BP had just fired its chairman, changed its chief executive, cut its dividends and was in crisis. I bought it. In the next eight years, the oil price did nothing. BP’s share price multiplied six-fold and outperformed the UK market by 150%. All you want is relatively stable prices from here, maybe after a modest bounceback: oil $50-$60 a barrel; iron and copper up a bit – and you could make good money. These companies can cut capital spending and extraction costs are falling too.
John: Emerging markets have been hit hard – which are you keeping an eye on?
Mark: I agree that certain areas of China now stand out. Taiwan too, and Thailand. The risk is that this may be the start of a financial crisis in China, but for now,
I can’t see signs of that.
Maike: Emerging markets generally look to be in a bear market. But the interesting one is India. The demographics look good, it’s not highly exposed to China in terms of exports, and while China’s reforms are all about financial stability, reforms in India are all about the growth.
Max: The trouble is that the reform story’s good at the top-down level, but it doesn’t filter through to the millions or tens of millions of bureaucrats further down the line – apparently, drinks giant Diageo needs to get 250,000 licence agreements each year to do business there.
Maike: Bureaucracy is still a major issue. But India is also benefiting from the falling oil price – it imports about 80% of its oil.
John: Max, the last time you were here you talked about Brazil.
Max: Yes, five years ago I set an exchange-rate target of three reals to the dollar and we got there – in fact, now it’s four. But I think Brazil has now rung the bell. It’s a mess and President Dilma Rousseff should not just be impeached, she should be in prison. But I think things are turning round, and reform is coming. The recession will probably continue, but I think that you want to buy not only Brazil, but also Latin America in general. In fact, you should be overweight emerging markets.
You’ve had a four-and-a-half-year bear market – that’s a pretty long time. Reform is slowing happening, the currencies have fallen, monetary policy has been, or is about to be, relaxed in these countries, and the dollar’s peaking. This is as bright a green light for investing in emerging markets as you’ll ever get.
John: Let’s turn to Europe. We have the Schengen area splintering amid the refugee crisis and Greece fading from the headlines – what do you expect from Europe over the next 18 months or so?
Eric: We’re quite positive – we expect growth to pick up and the ECB is helping. Yes, the situation with Greece isn’t over. But a mechanism is in place to prevent contagion, and it worked during the last crisis. What we need now is confidence. The migrant crisis and division we are seeing between European nations is not helpful for that. But assuming confidence returns, the coming years should be better for the eurozone. Some southern countries, such as Spain, are already doing better and have implemented reforms. The bad guy is France, where reform is slower, but even there, growth is picking up.
Max: About a third of European equities aren’t even listed in the eurozone – there are many good companies in Switzerland or Scandinavia. Eurozone growth will be OK because QE has some benefit and certainly the drop in the currency will help. In any case, a lot of these companies are selling around the world, so they’re not dependent on the eurozone – or even China. And returns on capital in Europe are actually low, whereas in the US they are at the top of the historic range. That says there’s a lot of opportunity for European companies to raise returns, even if the top lines aren’t doing that much.
John: So let’s turn to tips – where are you sticking your money just now?
Mark: I like Wasion (Hong Kong: 3393), which makes energy measurement instruments, such as electricity meters. It’s benefiting from the Chinese government’s push on energy efficiency. It’s on a forward price-to-earnings (p/e) ratio of about ten, with about 20% annual earnings growth expected. Texwinca (HK: 321), a knitted fabrics group, sells to a number of Western brands, such as Uniqlo, Gap and H&M. It’s adding capacity, has decent cash flows, and is on a similar valuation – ten times forward p/e and an 8% dividend yield. Finally, Religare Health Trust (Singapore: RHT) is a business trust which holds a number of Indian hospitals. It’s on a yield of around 7.7% and has low double-digit growth.
Killian: I’ve got three commodity plays. Silver Wheaton (NYSE: SLW) is a precious metals royalties company. A lot of precious metals miners aren’t being run for their shareholders. But Silver Wheaton has a history of strong shareholder returns and excellent capital allocating. For example, it’s launched a share buyback just now when it’s cheap – trading at one times book, down from six at one point.
Similarly, if you want to diversify into oil, try Freehold Royalties (Toronto: FRU). Again you’re getting no operational risk, just a percentage of the revenue from companies drilling on its land. It’s trading now at 1.3 times book value. I’m not too sure where oil’s going to go, but you get royalties from 3.6 million acres across north Canada. It’s got 37,000 wells, so it’s a diversified oil play, and it’s cheap.
Finally, Lukoil (London Int’l: LKOD) trades at 0.3 times book value. For that you get a diversified Russian oil company. It’s again got strong return on equity and a yield of about 8% that’s 24 times covered by cash flow. That’s in rubles too – and you have to ask how much weaker the ruble can get from here. You may get asset writedowns at some point – but the share price is more than compensating for this risk.
Eric: I like Randstad (Amsterdam: RAND), a recruitment company. It makes two-thirds of its revenue in the eurozone and the rest in America. Then there’s the Algebris Financial Credit Fund. Basically it’s invested in debt issued by banks. During the summer when markets were quite stressed, bank debt behaved OK – this fund only lost 0.4% during August, and it’s up 4% year-to-date. It’s a very good way to diversify a bond portfolio. Marshall Wace TOPS is a long-short market neutral fund – it was up in August, and year-to-date it’s up 5.6%. It’s very diversified and again it’s a good way to diversify your portfolio with a fund that’s unlikely to be heavily correlated with your other holdings.
Maike: The slowdown in emerging markets will have a deflationary impact on developed markets, because emerging markets are now much more integrated into the global economy. In that environment, you want to own high-quality companies with strong brands and good pricing power.
Lindsell Train UK Equity is a highly concentrated fund which seeks out these types of companies. Europe looks really interesting. It offers strong global companies, there’s the potential for further QE, good dividend yields – a fund such as Threadneedle European Select, managed by David Dudding, looks a good option. It holds several high-quality names, and is very focused on pricing power.
Finally, India, the bright spot within emerging markets. We’d opt for the Franklin India Fund, which is also quite concentrated and looks for long-term, quality investments that can grow through the economic cycle .
Max: I’ll be a bit contrarian and pick some emerging-market funds. For China, I’d either opt for our own Investec All China Equity fund, which mixes ‘A’ and ‘H’ shares, or Fidelity China Special Situations (LSE: FCSS). In emerging Europe, the Baring Emerging Europe Trust (LSE: BEE) – which holds Lukoil – is on a discount of more than 10%, yields more than 4% and the manager is more bullish than I’ve known him for a long time. For Latin America, I’ll go for the Investec Latin American Smaller Companies. Smaller stocks have underperformed in Latin America in the last five years. If the region bounces back, small companies will outperform.
There are several good Asia funds. Pacific Assets has a brilliant record, but it’s got 11% in cash and I’d like to see that invested before I get excited. It’s also a good chance to get back into the Baillie Gifford Japan (LSE: BGFD) and Shin Nippon (LSE: BGS) funds – those funds are trading around net asset value now, but they’ve outperformed by 48% or 55% in the last three years.
Finally, in the resources space, I like energy private-equity fund Riverstone (LSE: RSE). The oil price has halved, but its asset value has gone up, because it kept the money in cash and invested wisely. You’re owning North American energy players in a private-equity vehicle. And if you really can’t make up your mind, you could buy the Investec Global Natural Resources Fund, which holds both oil and miners.
China’s not as bad as you think
Everyone is gloomy about China, writes Merryn Somerset Webb. But amid the forecasts of dramatic collapse, there are some numbers you should pay attention to. The most recent report from the China Beige Book (jammed with proprietary data on all things Chinese) presents an almost happy picture. The Beige Book has been reporting on China’s slowdown since 2012 (as have we). But now, in the aftermath of China’s surprise devaluation in August, its authors reckon global sentiment on China is far too bearish.
Everyone thinks the slowdown is intensifying; it isn’t. Last quarter, “job growth inched up for a second straight quarter, as did margins, and wage growth moderated only mildly. Capital expenditure also ticked up for a second quarter” after falling for four quarters.
Everyone thinks China is suffering deflation, due to the plunging official PPI (producer price inflation), and that this is hurting profits. Nonsense, says the Beige Book. “A common story is that the CPI [consumer price index] reflects wages, and the PPI sales prices, so their recent divergence… is eviscerating companies’ bottom lines”. But “for now, the CPI is being driven by food, not wages, while the PPI is being driven by imported commodities, not domestic oversupply.” So these things are not hitting profits – backed up by “the responses of thousands of firms in our national survey.”
In short, China doesn’t have deflation; it has low and stable inflation – which is what economies are supposed to crave. So China has slowed, but there is no collapse in sight. Capital Economics is another upbeat outfit. Its own indicator suggests that China is growing more slowly than the official data suggest. But we already know that. What is interesting, given the growth panic, is that, like the Beige Book, this measure doesn’t “support the view that conditions have deteriorated recently”.
Instead, growth has strengthened, and “appears to be on an upward trajectory”. Domestic freight volumes are up; electricity output growth is positive again; cargo through China’s seaports is at an eight-month high; and “growth in passenger traffic” is up too, says Capital. And don’t worry too much about this week’s poor manufacturing survey – “Caixin’s manufacturing PMI has not provided a particularly good reading of the health of the broader economy in recent months… with most of the key leading indicators… now looking supportive, we continue to expect a cyclical recovery.”
Investing is about seeing things that other people aren’t. Today, everyone is seeing the slowdown in China that we started talking about some years ago. Not everyone appears to be seeing the signs of improvement that Capital Economics and the Beige Book are seeing. There is opportunity there – as George Osborne appears to have noticed. As he said in this week’s speech at the Shanghai Stock Exchange: “Whatever the headlines, regardless of the challenges, we shouldn’t be running away from China.”