While Asian investors may have been waiting for Mid October and the end of the CCP conference for ‘something to happen’, US investors in China may have been waiting to see if there was any prospect of a bounce before realising their tax losses before the end of October. Thus the selloff in the ADRs that was replicated in indices like the China internet stocks or even the HSI may have much more to do with market mechanics – in this case the move from weak hands to strong hands, catalysed by tax loss selling – than any insight into the future direction of China. That notwithstanding, how and how quickly China opens up is going to be one of the key macro drivers for 2023.
In this part of the world (Hong Kong) there has definitely been a sense over the last few months that, once the CCP conference was out of the way, only then would things start to happen. Rightly or wrongly, there was a belief that nobody was prepared to take any risks until the issue of Xi’s third term was resolved. We ourselves commented that we believed Xi would indeed secure the third term back in August (see all eyes should be on the 20th Party Congress) in part because at the time there were some quite high profile western analysts asserting that the probability of it not happening was as high as 30%, perhaps not coincidentally leading to some subsequent dramatic social media posts appearing about Xi being under house arrest and there being a faction close to former leader Hu Xintao taking over. Obviously this turned out to be untrue, but the extra-ordinary scenes at the conference of Hu being publicly walked out of the conference (amid some very pointed body language), even if it was entirely innocent, appears to send a very strong message to any that would use him to challenge Xi.
The market’s opening response to the meeting has been to sell down the ADR stocks further and in what seems to be a case of capitulation by overseas investors trying to justify things as being ‘concern’ about the experience of some of the new team, while more concern about a lack of reformers and no end to zero Covid probably said more about dashed hopes of a rally to sell into. While on the one hand we suspect that a combination of domestic political pressure and a general need to ‘clean house’ has led to a number of long term overseas holders of ADRs effectively using the CCP conference as a catalyst to sell out, a bigger issue is likely to be the issue of tax loss selling. US mutual funds have an October year end for registering any tax losses (taxes are calculated on Net gains) and obviously for a $ investor, the ADR shares have been a source of considerable loss year to date (-60%).
To illustrate, let’s look at the large China Internet Fund, ETF (ticker: KWEB US) run by Kraneshares. We monitor this closely as it is one of the Thematic stocks in our basket – although its confidence score currently remains at 1 – i.e we currently have no allocation. The top ten holdings include the usual suspects, Alibaba, Tencent, Meituan, J.D.Com, Netease etc, a number of which are ADR stocks. Indeed, earlier this year, Kraneshares acknowledged that 57% of KWEB were ADRs, noting that they would be moving to Hong Kong listings by the end of this year. If we look at the chart we see that not only are there plenty of tax losses to be taken, but that the price broke its previous low on 3x normal volume. Someone is clearly selling. In size.
China ADR stocks – Tax loss selling?
If this is indeed tax loss selling, then the rules are that to prevent what is termed a ‘wash sale’, the seller can not buy back again for 30 days. More likely this wouldn’t happen anyway as this is likely capitulation, but it does represent another important piece of market mechanics – the transfer from so-called weak hands to strong hands. Once this is clear, then, usually, stocks reprice higher.
This selling fed through of course to the Hang Seng, where most of the ADR stocks are also listed and which has been tracking the KWEB lower all year, and thus the initial reaction from the Hang Seng to the CCP Conference was also to sell off…again, triggering lots of comments that the Hang Seng is now lower than it was at Handover in 1997. However, while technically true, and not wishing to let the facts get in the way of a good story, if we look at the total return on the Hang Seng, i.e allowing for dividends, then we see a different picture – the orange line rather than the white line in Chart 2: 150% return over the period, equivalent to an annualised return of 3.7% – actually not that different from a long term bond yield back then (such as existed).
Chart 2: Hang Seng ‘unchanged’ since handover…but it has actually returned 150%!
Hidden within that long term chart of course is the dramatic selloff in the Hang Seng exactly 25 years ago, when speculators attacked the currency peg, causing the Hang Seng to drop 40% in a month! Obviously over the subsequent decade the market went up almost four fold, before collapsing into the GFC in 2008 and then doubling in the decade after that. The point being that, in contrast to the US, local investors in HK have more of an emerging market mind set and are a bit more pragmatic about boom and bust.
Thus in discussing this background to the US versus Asia, we heard a great analogy from a very smart local investor who likes to compare investor behaviour to the Kubler-Ross 5 stages of grief – denial, anger, depression, bargaining and finally acceptance. Her view was that many western investors are currently still at anger, while Hong Kong has jumped to acceptance – although perhaps they are currently bargaining?
Perhaps we should be grateful that China hasn’t opened up yet?
The most important macro factor for 2023 is how and when China opens up again. The Zero Covid policy has trapped enormous amounts of real world liquidity inside China and initially that will start to feed into domestic activity, and then into demand for goods and services from the rest of the world. Here we suspect that Hong Kong may be a conduit for both physical and investment flows. However, we should be careful what we wish for; arguably the biggest driver to inflation in the west has come from the dramatic surge in demand as economies opened up after 2 years or more of lockdown into an environment where supply chains were seriously restricted. Whether it is accident or deliberate, slowing down the opening up phase will undoubtedly have helped contain inflation pressures, not just in China, but globally.
Zero Covid caused bankruptcy on the lockdown side and inflation on the opening-up side. Arguably China is aiming to avoid at least the second effect
Thus on the one hand, the world needs China to provide a stimulus to demand, but on the other, it doesn’t want China driving prices even higher. The reality is that even at the already lower rate of growth, China is currently adding around 20% more to global activity than the US is for every 1% growth. As the IMF data shown in the chart suggests, on a Purchasing Power Parity (PPP) basis, China now accounts for around 18.5% of global GDP and is forecast to rise to 20% of GDP by 2027. The US, by contrast, is around 15.6% of total GDP, forecast to drop to 14.3%.
China is heading to 20% of Global GDP
In addition, there are signs that when it does come back, China will be buying in its own currency, and thus has less of a need to earn $s from exports – meaning that its role in keeping prices down through cheap exports will not offset its role in pushing prices up through its imports. In other words, a return from China is likely to add to inflationary pressures rather than reduce them.
There are certainly signs in place that China is buying some of its raw materials in Rmb – including Oil and Gas and Copper (perhaps we should monitor the commodities prices in Rmb?) Also, with suggestions that Saudi Arabia wants to join BRICs – and by extension gets involved in the Belt and Road Initiative – the schism between ‘The West’ and ‘The Rest’ grows wider, threatening the $ hegemony. Thus along with the economic impact of China opening up, the pattern for 2023 is likely to be heavily influenced by how the $ emerges from the challenge to its dominance.
