Why China’s hard landing is closer than you think

Things haven’t gone that well for Anthony Bolton since he came out of semi-retirement to launch the Fidelity China Special Situations Fund. If you’d believed in the China hype and subscribed at the fund’s launch, the shares you paid 100p each for would now be worth only 78p or so. You’d be down 20%. And that’s not even a lousy performance that can be totally explained by a fall in Chinese shares in general: the MSCI China index is down around 13% over the same period. We’ve never been keen on this fund (you can read my comments on it at launch: Why you should give this China fund a miss and my recent interview with Bolton: Buy China and gold, says Anthony Bolton), and we aren’t keen on it now. Why? Three reasons.

The first is that we have serious worries about the Chinese economy (more below). The second is that we have serious concerns about the Chinese stock market (iffy corporate governance and too much government control over listed entities). And the third is that the fees on this particular fund are way too high (1.5% plus a performance fee).

However, having seen Bolton’s recent manager’s report, we dislike it even more. In it he said he was “sorry to report” that the firm had “produced some very poor performance figures”. Given the fees Fidelity charges, we would prefer him to be sorry rather than “sorry to report”. Next, points out Citywire, he attributes some blame. The dismal performance of the Chinese market is not down to the fact that it might have been overpriced or that expectations for it were overblown. No, it is down to the fact that the “number of commentators looking for a hard landing in China has increased”. This, “together with negative views about the property market and the unofficial lending market, has led to Chinese shares performing worse than those in other markets”.

Hmmm. This reminds me slightly of the days (which I hope are past) in which people blamed MoneyWeek for falling property prices – as though us pointing out the dangers somehow created the dangers. I pointed out at the time, and have often since, that if we were capable of causing property crashes, we would have done it a great deal sooner than 2007. Falling property prices were in fact caused by overvalued property prices. In the same way market falls in China have most likely been caused by the fact that Chinese shares were overvalued, given the environment in which they operated. The truth is that the bears don’t have to talk up the creation of new dangers: China has them already – in spades.

Soc Gen’s Dylan Grice (one of the commentators Bolton would no doubt see as talking the market down) runs through a few in a recent note. The problem with China is that, despite all the talk of its specialness, it has over the last few years experienced a perfectly normal sort of financial mania. Kindleberger’s model of ‘Manias, Panics and Crashes’ has an event starting with “displacement” – a change in investor beliefs.

The next step is credit expansion; then comes euphoria; next is crisis – where prices level off, there is a period of financial distress and there are moves to increase liquidity. Finally as the distress persists, “the rush to cash becomes disorderly”. The “spell cast on the public’s imagination in stage one and strengthened in stages two and three now breaks”. Then we get the final step: “revulsion” – the bit where the “former object of speculation is now derided as an embarrassment”.

So where is China on this? Grice thinks the answer is that it has “recently moved from stage three to stage four”. Stage two saw huge credit expansion (in the form of very loose monetary policy in 2008). Stage three has been pretty obvious (“China is different”). But look at what’s going on and you can see Grice has a point on the arrival of stage four.

Swindles (“the bezzle”) are starting to appear (SinoForest, Chaoda Agriculture, train accidents on the back of mishandled contracts and so on), and there is a clear rush to liquidity in the property sector at least. It could all end very badly indeed. The point is that, while I don’t think it is likely, Bolton might turn out to be right on China. However, if he isn’t, it won’t be because people are talking more about China having a hard landing. It’ll be because China will have a hard landing.