Friday, August 21st, 2020

Two Red Flags from China

It has been a long time since our Chinese equity sector model had anything interesting to say. All models go through periods when they are not important to our world view, and we need to be careful in China because the stock market has always been affected by direct official intervention. However, we believe the messages are more important than the caveats, so here they are:

  1. The recommended weight of the Technology sector has clearly peaked and is now on a downwards trajectory. In recent years, this has been a good lead indicator of how the weight of the US Technology sector would behave, though the time lags have been variable.
  2. The recommended weight of Financials is approaching a multi-year low, which is also the low since the Chinese first allowed the managed float of the CNY in 2004.

The chart of the relationship between Chinese and US Technology needs a bit of interpretation. There are two significant anomalies, the first in 2016, when the US sold off, but China didn’t, and the second in 2019 when the US rallied, but China didn’t. The first anomaly was due to the de-rating of Apple, when investors feared that the i-phone had reached peak sales and Apple’s offering of services was still underdeveloped. The second was due to the breakdown of US China trade talks in May 2019 and the tweet-driven chaos surrounding this subject, which lasted until Q4 2019.

Apart from these anomalies, we have three clear instances of a downturn in Chinese Tech coinciding with or leading a downturn in US Tech. The first is April 2014, which was followed by the US in September – a gap of five months. The second is October 2016, when both peaked at the same time, and the third is March 2018, when the US followed with a four-month gap in July. In our last note (Party Like It’s 1999, 8th August 2020) we argued that it was time to take profits on US Technology. We believe this signal from China provides important support for this idea. We are not interested in specifying the time lag between the two countries. The message is that you should be taking profits in both and that you should start now.

The second flag relates to the health of the Chinese Financial sector. The long-term chart of Financials relative to the rest of the index is starting to get ugly. The current recommended underweight is -47%, against a recent low of -54% in March 2014. This is the lowest the sector has ever been since the free-float of the renminbi in 2004. The short-term charts reveal a sector which recently broke down through a critical support level and which has a high-conviction, deteriorating lead-indicator. None of this is good news.

China is not the only country with a troubled banking system, but it has experienced the fastest growth in total debt to GDP of any major economy over the last 10 years. We don’t think that the government will allow a banking crisis to develop, but that means that the banking system may have to be recapitalised – part of which would have to come from the country’s foreign exchange reserves. There is also the nightmare scenario, where the Hong Kong dollar is repegged to the renminbi rather than the US dollar, effectively allowing China to expropriate Hong Kong’s FX reserves. Banking crises always have FX implications, even when they are contained – and that’s why the rest of the world needs to pay attention.

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