As market practitioners, we know that markets are a mix of the logical and the emotional, of systems and of narratives and that the more short-term a market, the ‘noisier’ it is, which is another way of saying how much it is driven by narrative. Making sense of the narrative is a key part of what we refer to as Market Thinking and is based heavily in behavioural finance and behavioural economics and recognising who is driving the narrative at any particular time is thus important in understanding not only how it fits in with the underlying fundamentals, but also the risks and rewards of going with or against it.
Market Thinking is all about ‘making sense of the narrative’ - including who is driving it
Currently we observe that the narrative on China has become relentlessly bearish, particularly from a number of the wire services. This, combined with the sudden uptick in incoming enquiries on the subject, has naturally got us thinking - not necessarily to be contrarian, but to try and understand who is pushing the narrative and to what end. In the first instance we see a continuation of the ADR justification trade; international investors forced to divest from the ADR markets following the Chinese Education stock ‘shock’ this time two years ago have created a ‘sell-the-rallies environment that is being ‘explained’ as down to bad economic and stock market fundamentals. This, of course, is also comforting to those selling at ever lower prices in the way that economics was used to justify selling out of tech stocks two years after the Dot Com bust.
To the ADR trade we now add the Geo-Political trade. During Covid, China was parked in the ‘too difficult’ box, such that a China recovery was not even on the radar for most 2023 year-ahead notes. Then, the sudden appearance of a ‘China re-opening trade’ around Chinese New Year produced an excited bullish tone from commodity markets only to be replaced by disappointment when the projected demand for commodities did not exceed the increased supply. What it also did however was remind western policy makers of the economic threat from China, which, combined with a perceived need to ‘help’ the current pro-US Taiwanese government retain power at the upcoming Elections in January, has clearly brought the politicians into the narrative management game. Many international investors, scarred by the ADR debacle and wary of ESG-like politically driven asset allocation, are rightly fearful of a forced divestment of Chinese stocks and are thus getting out early, extending the sell the rallies behaviour into wider Chinese markets.
When Politics comes into markets, institutional investors see higher risk premia and welcome a negative narrative as ‘cover’ for selling
Thus, here too, sellers are keen to embrace a negative China narrative, one that the politicians are only too happy to provide of course, and our sense is now that the noise markets are also sensing a trade on the short side - hence some of their ‘in house’ sources pushing the narrative. For example, the sudden concerns about Country Garden, the property developer, while on the one hand a good story, are hardly new. The stock is down 92% over the last two years and is now being kicked out of the Hang Seng index, with a market cap now of around $3bn, more than half of which is held by the founder. Yes, it does have a reasonably large amount of foreign currency debt and yes, it is true that Beijing is unlikely to help out foreign owners of its US$12bn of high yield $ bonds, but this is hardly a crisis - unless you want to make it appear so. Which some people clearly do.
So is there money to be made in taking the contrarian view? One thing we do know is that the narrative is rarely if ever changed by facts - it is what Keynes meant when he said that ‘markets can remain irrational longer than you can remain solvent’ -rather, it is a question of time horizon. Keynes was referring to the FX markets, where a leveraged speculation based on fundamentals may be right in the longer term, but may be impossible to sustain. But even in less leveraged areas like equities, as legendary value investor Ben Graham put it, while in the long run it is a weighing machine, “in the short run the market is a voting machine” and as politicians understand all too well, voters tend to be more emotional than rational.
The reality is that markets will push a narrative so long as it is profitable to do so, but the minute they sense exhaustion, they will produce the equal and opposite narrative and try and push the other way. Ironically that pivot often occurs just at the point when the narrative is most compelling, since that is when the last investor is ‘in’ (or in this case ‘out’.)
Thus, the first thing we would look for is the extent to which the narrative stops ‘working’ in the noise markets, but secondly to look for the ‘less obvious’ trades that may indeed be contrarian. For example, the latest obsession is the ‘weak exports’ from China. On the one hand this appeals to the notion that China is a classic emerging market dependent on exports and is thus ‘in trouble’ (the geo-political angle), while on the other is being used to support the ‘ who is the next China?’ angle being used to justify selling Chinese equities and switch to other emerging markets.
China’s exports are down on 3 months but up 40% on pre Covid levels, while GDP growth is still 3x the latest level in the US and 10x that of the Eurozone
In this example we would point out in the first instance that the latest level of Exports in July 2023 was $3466bn, compared to $2496bnn in July 2019, ie almost 40% higher than the pre Covid level. Secondly, that while Chinese exports did indeed fall in July for the third straight month - by 9.2% - so did exports from South Korea and India, both by 16%, while Singapore’s July exports were down 19.3% year on year and Vietnam’s down 15%. Hardly a China specific problem, so the first lesson is put things in context and the second is to be careful where you think you should switch to. Equally, if we look at the breakdown of the numbers, we can see that, aside from the short term noise around tariffs and exports being brought forward, the value added component of Chinese exports is increasingly staying within China and within Chinese companies. Finally, we would point to the estimate of the July net trade balance - exports minus imports - being $70bn, ranging widely between $92bn and $57bn. The actual number came in at $80bn, which we would normally regard as a positive shock.
This coming week sees the BRICS meeting in South Africa and the Japan/S.Korea US Summit at Camp David presenting two alternative visions for the world economy, it’s inevitable that politics is going to affect the narrative.
But with not only Jackson Hole coming up this week - which tends to get the macro community excited - but also a Camp David Summit coming up between the US, Japan and South Korea, the need to put China in a bad light is heightened - as demonstrated by Joe Biden’s campaign speech last week when he said China’s economy was ‘a ticking time bomb’ claiming it had “the highest unemployment rate going” (it doesn’t) and that is was growing at only 2% - as opposed to the 6.3% it actually achieved in Q2. This actual rate is around 3 times the level in the US. And without inflation. But here too, the lack of inflation is being spun as a ‘problem’ of too little demand, when it is more to do with both an excess of supply and a lack of policy error during Covid - i.e China did not massively increase both fiscal spending and its money supply like the west did. Throw into the mix that China is benefitting from not cutting itself off from cheap energy and resources and a proper examination of China’s current economic situation becomes a damning indictment of the western governments’ policy actions. Something western governments are obviously not keen on, especially as at the same time, there is the important BRICS meeting coming up in South Africa, where a large number of the ‘Global South’ countries are talking about wanting to join the broader BRICS group. It makes sense that the US would want to present the alternative camp in the worst possible light right now. Then there is the unrest going on in Francaphone West Africa and Niger in particular to add to the whole multi-polar tinderbox - but that deserves greater space than we have here.
There is a psychological phenomenon known as Illusory Truth, the notion that the more we hear something repeated the more we believe it to be true. This is a key part of propaganda of course, but we also do it with the things we tell ourselves. Telling ourselves that China is collapsing helps justify not investing there, but it doesn’t mean that it is true. And sooner or later the narrative will turn. Equally using the very same positive arguments that we are ignoring about China (or ignoring the same negative arguments) in order to justify buying other markets instead is unlikely to generate a favourable outcome.
So what to do? Well, with the obvious caveat that this is a blog for information purposes only and not giving investment advice, we would suggest that investors make their own judgments on the underlying fundamentals and recognise that there may continue to be a time while noise markets - be they FX, commodities or short dated bonds - continue this narrative, fuelled by the powerful narrative machine that is western governments - but that, like Keynes learned, they should avoid leveraged speculation based on those fundamentals.
Firstly, as noted, be careful of embracing ‘the next China’ stories where the positive narrative is as flimsy as the equal and opposite negative narrative on China. Second, longer term time horizons present both opportunities in China names and threats to non China names - BYD for example now sells more cars in China than VW, and particularly EVs - an area where China is looking to dominate export markets as well (hence the hysterical articles about Chinese spying on western consumers through their EVs in an attempt to regulate competition). These and other exports retain far more of the value added ‘in country’ than historic lower value-added goods, such that the headline macro number, even if it is much ‘better’ than the current narrative would have us believe, is still far less important for investors than the retained company earnings. Equally, as discussed in a recent note, simply picking up on Caterpillar’s comments on weak China demand without noting that its big Chinese competitor Zoomlion has dramatically increased its export share of sales is to only see half of the situation.
We need to look beyond the macro narrative and into the cash flows.