The only thing normal about this summer seems to be the seasonality around markets as they increase risk aversion in the face of of light volumes and low liquidity. While we should ignore short-term traders as they try and make markets based on news around Covid variants, the hit to the Chinese education stocks at the end of the month marked a genuine shift in medium term risk. Going forward, investors wanting to participate in Chinese economic growth will have to do it based on Chinese rules and regulations. Meanwhile as western politicians, central bankers and regulators push for ever greater control over economies and markets, the biggest long term risk is that a deadly combination of Zero Covid, Zero Interest Rate and Zero Carbon policies produces a collapse in returns on capital in western markets and a return of stagflation. It’s currently a risk rather than a prediction, but it needs watching.

Short Term Uncertainties

The summer months tend to have ‘bad seasonality’, principally due to the general lack of activity and hence lack of liquidity, as well as the absence of key decision makers on trading desks. As such the mindset tends to be more risk-averse and any ‘event’ is regarded as an opportunity to raise cash. In the terminology, the risk premium rises. These sorts of markets can nevertheless lead to opportunities beneath the surface in both equity and credit, as a lot of babies tend to get thrown out with the bathwater. We believe this is what has happened with a lot of the reflation/inflation trades in recent weeks, where profit taking in the underlying commodities has followed through to attempts to sell the stocks and themes that have proved short lived. In part this has been because the corporate results season has largely come in better than expected and the operational gearing effect of higher sales exceeding high fixed costs has delivered strong profitability into the bottom-up trading models’ price forecasts. Indeed overall, despite the talk of a ‘melt up’ in equities, the valuations, as measured by our IRR models continue to stabilise and return to something close to ‘normal’ after the distortions of Covid and Covid policies. Note that a high IRR means markets are ‘better value’ as in effect you need a higher discount rate to derive the current share price from consensus forecast earnings and dividends.

Internal Rates of Return models suggest that even as markets rally, they are normalising value thanks to higher earnings

We prefer the IRR approach to simply looking at trailing PEs, or even forward PEs, since it essentially looks at what discount rate would need to be applied to consensus forecasts to achieve today’s price level. As such it strips out the effects of ultra-low QE-distorted bond yields and gives an estimate to the implied cost of capital/return on capital. No models are perfect of course (as if we haven’t realised that in the last 18 months) and we would not wish to ascribe undue accuracy to outputs when so little exists in the inputs, but they do help us put things in context.

Meanwhile, the short term ‘noise traders’ in the FX and commodity markets have recently taken to trading the short term Covid Variant news flow as a lead economic indicator and, while it is largely useless, it is probably no more or less useful than most of the short term data they normally use, meaning that medium and long term investors should treat it the same way they regard Non Farm Payrolls and ‘flash’ PPI numbers, i.e ignore it. Importantly, when looking at the notion of reflation trades, a general level of inflation is less important than ‘pricing power’ within the supply chain and obviously Covid related shortages have tended to confuse some of the more ‘traditional’ mechanisms, leading to some surprises and profit warnings at the company level. For example, the short term setup cost of oil rigs to take advantage of increased demand/higher oil prices is being seen as a reason to sell down oil drilling companies at the moment rather than as an upfront ‘maintenance cap-ex’ expense.

Medium Term Risks

The risk is not whether you own Chinese stocks, but how you own them

The biggest story of July, however, came right at the end of the month with the dramatic sell-off in Chinese education stocks following a leaked announcement that the Chinese government no longer wished to see the industry being run for profit. While the sector itself is not very large in terms of market capitalisation, the rush to sell Chinese stocks by western investors extended rapidly into the tech and internet space and in particular for many of the big “China Tech” ADR names listed in New York, such as Baidu and Ali Baba, leading to the ironic observation that many Chinese tech indices and China A-Shares generally performed much better than Emerging Market Funds and ETFs, many of whom were heavily exposed via the China ADR space. The issue behind this apparent dichotomy is largely a technical one, but raises some medium term risks – or indeed longer term trends. The issue at stake here is that historically these Chinese tech/consumer stocks raised capital in the west through vehicles known as Variable Interest Entities, or VIEs. Rather like Schrodingers famous cat, these entities existed in a quantum state of being both wholly owned by Chinese investors (to suit the regulator) and simultaneously wholly owned by the western investors. As we noted in more detail in a separate piece (opening the blind eye), this was a pragmatic structure where both sides turned a blind eye to the obvious contradiction, but is clearly one which the Chinese have now deemed past its usefulness.

Our take is that the Chinese authorities have decided they needed to reassert the primacy of socialism over (unlimited) profitability. To them, education is a public good and should not be a source of speculative profits and while tech and other companies can be profitable, even highly profitable, they must never equate profitability with political control. The Chinese believe in State Owned Enterprises rather than (what they see in the west) Enterprise Owned States, where big business has too much power. The history of China/Western investment relations in the last decade has been one of gradual realisation that China wasn’t going to follow the standard Emerging Market playbook as written by large multi-nationals.

They have clearly also decided that they no longer need access to western capital to help set pricing of assets. Note that, unlike most emerging markets, China never lacked sufficient internal saving to meet investment requirements, rather that they lacked a developed domestic financial infrastructure. The subliminal message here then is that they now feel they can manage without Wall Street, something that must be troubling the likes of JP Morgan and Citibank right now.

There used to be an old joke under the previous regime of Hu Jintao and Wen Jiabao that you knew the Who and When of China, the question for investors were thus about the Where, the How and the Why? The answer was largely agreed to be,1) In New York, 2) using ADRs and VIEs and 3) to access Chinese profits while avoiding Chinese regulation. That is clearly no longer the case, the answers are now likely to be 1) Hong Kong or Shanghai, 2) Using ‘normal’ share structures and 3) to access Chinese profits while accepting Chinese rules and regulations.

Long Term Trends

Somewhat ironically in a month when the Social and Governance issues around owning Chinese Education stocks had attracted far less attention than the ongoing obsession with the Environmental (read Climate Change) component of ESG, central banks, regulators and large investment industry groups continue to fall over themselves in promoting ever-increasing levels of government interference in investment markets, particularly through ESG, which we continue to believe is the Trojan horse through which politicians and ideologues can take control of the majority of the west’s investment capital to allocate in line with their own agenda (and not necessarily that of the people who actually own the savings).

The most terrifying words in the English language are: I’m from the government and I’m here to help.” ― Ronald Reagan

Indeed, there is a risk that the ‘War on Covid’, which has succeeded in turning everywhere into the joyless equivalent of the Security check in Zone at Heathrow Airport, becomes like the preceding ‘War of Terror’ and that the ‘temporary’ restrictions imposed are never removed. Part of the problem is that those now required to grant permission for a return to the old normal have little or no incentive to do so, after all, they have little upside and mainly downside in the decision. Having essentially reversed the common law principle of ‘everything is allowed unless it is banned’ to something approaching the Napoleonic or Justinian law principle of ‘everything is banned unless it is allowed’, the risk is that with Common law principles goes economic growth. Asking permission of a bureaucrat has never led to the invention or innovation of anything and the concern for investors in the west is to what extent Europe, in particular, is led down the path of emulating the former Eastern Europe in terms of productivity and growth. Remember that the fall of the Berlin Wall unleashed a wave of productivity and lower cost but highly skilled workers into the west that triggered the deflationary boom of the 1990s. Reversing it raises the biggest risk to markets, stagflation.

Onto this we should add concerns not only about enduring Covid restrictions on trade, productivity and commerce, but also about the upcoming ‘Green’ restrictions that are seemingly ratcheted up every time there is another ‘Climate Emergency’ summit. As this article argues powerfully, there is no such thing as ‘Systemic Climate Risk’ in financial markets because the arguments are well rehearsed (whether you agree with them or not) and the prospects of ‘stranded assets’ for energy companies are already in the price.

The stock-market crash of 2000 was not caused by losses in the typewriter, film, telegraph, and slide-rule industries. It was the slightly-ahead-of-their-time tech companies that went bust

John H Cochrane

What they are doing, however, is politicising central banks and financial regulators at a time when most market commentators are not old enough to remember how markets applauded the move to ‘independent’ central banks. The systematic risks are the ones not discussed, such as removing things that do work before their replacements are ready and effective and in particular by encouraging, indeed forcing capital, into perceived ‘Green Winners’ many of whose only attraction is their ESG score and their market cap dominance in a ‘desirable’ index. As we noted in The not zero risk of zero risk policies, a world of increasing bureaucratic interference and regulation, be it in the name of Public Health, QE or Climate change (or indeed diversity) is not one compatible with the level of expected long term returns currently embedded in markets. As such political interference claiming to be ‘market solutions’ is probably the biggest systemic risk to markets for long term investors.