China's Crash: Postponed

August 22, 2014

Contrary to popular belief, China is not necessarily headed for disaster.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Tyler Mordy, president and co-chief investment strategist of Toronto-based Hahn Investment Stewards.

Sophia Loren once said that “mistakes are part of the dues one pays for a full life.” In the world of investing, as in life, the trick is not to repeat the same ones.

Yet investors seem to make similar missteps with disheartening regularity. Even the well-staffed professional portfolio manager labors under a long list of occupational hazards: the seductive lure of linear extrapolation, the itchy trigger finger and, of course, the vicelike grip “group think” effortlessly secures on the collective conscience.

Where might the above mistakes be occurring today? China may be one. The bulls (if we may speak for the handful of them still holding their day jobs) are seemingly near extinction. China bear sightings are much more common.

The gloomy case is widely known. Overleverage, overbuilding and overcapacity plague the economy. Return on investment for the state sector is in chronic decline and residential home prices remain elevated. On top of that, a large, opaque "shadow banking system" poses a systemic risk to the entire credit system.

We get it. China comes with risks.

The problem is that a crash this widely advertised rarely shows up. Financial markets have already priced in a significant slowdown. China’s onshore A-share market is down more than 50 percent since its 2007 peak. Despite being voted the “most groundbreaking new ETF of 2013” at’s annual awards dinner, the Deutsche X-trackers Harvest CSI 300 China A-Shares (ASHR | D-51) has only gathered about $310 million in assets.


Let’s separate fact from fiction.


First, much of China’s slowdown has been coordinated by policy. Many starry-eyed China watchers predicted real GDP growth of 10 percent-plus indefinitely. But there are limits to linear thinking. While trends can stay in place for some time, lines often bend, or even break and gallop off in unexpected directions.

China’s new path is driven by broad recognition that the growth model of the last 30 years is neither balanced nor sustainable. The new model must rebalance away from export and investment-led production toward private consumption. “Made in China” and Western consumerism can no longer be intimately linked. This is a necessary shift if China is to avoid the so-called middle income trap, which ensnares most emerging economies that are dependent on cheap labor for growth.

GDP per head in China is now approaching $10,000. To move beyond this level, productivity must dramatically improve. That requires a litany of change—reduced corruption, middle class rights and an improved operating environment for the private sector. A campaign against corruption has already begun in earnest (the Communist’s disciplinarian arm has investigated 63,000 people this year).

A critical next step is to establish a robust social safety net and thereby reduce fear-driven high household savings rates. This will lead to a virtuous cycle of consumption, job growth and, ultimately, higher real wages and corporate profits.

Second, while predictions of an imminent collapse in China’s debt levels are widespread, the probability of this happening anytime soon is low. As card-carrying members of the change-anticipation club, we understand the desire to divine the big turns. To be first to spot the outlines of a looming crash can be glorious.

But most warnings in the investment industry are false alarms simply because big turns are rare events. Experts overreact to little turns, mistaking a cyclical adjustment for the secular, career-enhancing kind (full disclosure: We have erred in that fashion before).

No one disputes that China must deleverage. Debt has grown rapidly, especially in the corporate sector since the global financial crisis. The country’s credit-to-GDP ratio rose about 75 percentage points from 2008 to 2013 (from 145 to 220 percent).

However, the path of debt reduction is now the central question. Most are superimposing recent deleveraging experiences—the Asian crisis in the late 1990s or the eurozone’s austerity drive since 2008—onto China. Neither of these scenarios is likely.

At under 10 percent of GDP, China has very low foreign debt. Most debt creation is financed by China’s massive domestic savings. A loss of confidence by its foreign creditors would not suddenly force China into a downturn similar to the previous Asian crisis, which China essentially sat out.


A prolonged austerity-driven path is just as unlikely. The market’s main concern is overinvestment in housing in underpopulated cities and worthless public works projects. But these excesses are the result of targeted policy-driven efforts to steady growth. There is little risk that policymakers will suddenly turn and tighten credit.

The more likely deleveraging path will be akin to the experience of Taiwan since 1987. Like China, Taiwan had an undervalued currency, an export-driven market and a persistently large current account surplus.

As the currency appreciated and the economy rebalanced away from exports, the government increased infrastructure spending and national leverage soared. When debt stopped rising, it was a slow decline downward. Growth moderated and deleveraging occurred over an extended period. That is China’s most likely course over the coming years.

All of the above leads us to our final point. A slowdown in China’s economy will not necessarily lead to subdued stock market returns. In fact, GDP growth tends to be negatively correlated with the stock market (most likely because investors overpay for headline growth).

China’s stock market also has a long list of positives. Next to Russia, the A-share market is the world’s cheapest equity market, trading on a forward price/earnings multiple of 9, versus 14 for the MSCI All-Country World Index. China’s regulatory environment has also been steadily improving, and domestic capital markets are progressively liberalizing (index providers are also considering future inclusion).

Where to next? To be sure, the biggest risk to China’s stock market is breaking up state-owned enterprises to endorse more privatization. This transition will surely come with dislocations and unknown risks.

But markets are made at the margin and quickly discount future events. The important point is the direction of change, which remains positive. Ultimately, China is entering a period during which most investors expect a crash with an undervalued stock market that is still almost entirely owned by domestic investors. That combination says “buy China.”

Tyler Mordy, president and co-chief investment officer of Hahn Investment Stewards, is a recognized innovator in the design and application of global macro ETF managed portfolios. He is widely interviewed by the financial media for his global investment strategy views, as well as ETF trends. CNBC has called him one of the “best independent ETF experts.”



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