So, finally, we come to the end of this brief China series ending with the things Our Man is watching to help with timing an investment, and the instruments he’s considering using.
Timing
- Inflation and Bank/Credit Tightening:
Inflation is the major factor that Our Man is following in China as its presence causes the Chinese government to have to choose between its competing realities; with the 23% differential between 09's monetary M2 growth and nominal GDP suggesting its arrival is more than likely. To allow inflation (and with it, wage inflation and other rising costs of production) risks both allowing Chinese goods to become less competitive (i.e. more expensive) globally and potentially encourages the use of credit for further speculation.
However, how does China prevent inflation? With its currency pegged to the US Dollar, monetary policy is somewhat constrained and limited by the FED's actions. Thus, China will most likely have to use its control of the banking system to restrict the flow of capital into the economy. Though it unquestionably exerts far more control over its banks than other countries, China is likely to find that encouraging banks to lend is somewhat easier than persuading them to reduce their lending. We are already seeing signs of this; while 2009's bumper 10trn Yuan of loans (up from 4trn in 2008) was supposed to be reduced to a 'mere' 7trn Yuan in 2010, the Banks apparently didn't get the message (issuing an alleged 1.1trn Yuan of loans in January alone) leading to the imposition of the first steps of credit tightening.
Why does credit tightening matter? Speculation, especially in property, requires new buyers to continue to cause prices to rise. While this is true in most bubbles, it is particularly the case in those that generate no/limited income (i.e. real estate); the income generated by the asset is not sufficient to cover the interest (let alone the principal) on the loans used to acquire the asset, thus the only way the bubble can continue is for asset value to rise (perpetually). A slowing of credit growth is likely to negatively impact the number of buyers (or at least the number of buyers that can get adequate financing); if executed and managed perfectly it helps deflate the bubbles slowly, if not the bubble unwinds all too rapidly as existing buyers are unable to meet their interest (or margin) calls and become distressed sellers.
- Loosening of Foreign Capital Controls/Floating the Yuan:
Our Man looks at the loosening of foreign capital controls and Yuan flotation as the likely final throw of the dice by the Chinese; this move to appreciate the currency (as Japan did after the Plaza accord in the mid-late 80's) and potentially transfer ownership (and thus risk) of inflated assets from domestic Chinese holders to (hot money?) foreign investors. However, beyond the possibility of transferring risk to foreign investors there is little long-term advantage for the Chinese in letting the Yuan float. Unlike the Japanese, whose businesses were already at the technological and productive cutting edge (and thus had some pricing power) China’s industry has no such comparative advantage and relies predominantly on low costs to compete. Couple this with the universal belief that (after flotation) the Yuan could only appreciate, leads Our Man to suspect that after the initial euphoria (which could last many months) of a Yuan flotation, we are more likely to see the Yuan depreciate (to help maintain China’s low cost production, and ensure that over-capacity may potentially be used) in the medium-term.
- Loosening of Foreign Capital Controls/Floating the Yuan:
Our Man looks at the loosening of foreign capital controls and Yuan flotation as the likely final throw of the dice by the Chinese; this move to appreciate the currency (as Japan did after the Plaza accord in the mid-late 80's) and potentially transfer ownership (and thus risk) of inflated assets from domestic Chinese holders to (hot money?) foreign investors. However, beyond the possibility of transferring risk to foreign investors there is little long-term advantage for the Chinese in letting the Yuan float. Unlike the Japanese, whose businesses were already at the technological and productive cutting edge (and thus had some pricing power) China’s industry has no such comparative advantage and relies predominantly on low costs to compete. Couple this with the universal belief that (after flotation) the Yuan could only appreciate, leads Our Man to suspect that after the initial euphoria (which could last many months) of a Yuan flotation, we are more likely to see the Yuan depreciate (to help maintain China’s low cost production, and ensure that over-capacity may potentially be used) in the medium-term.
How to Play a Slowing China?
Given that Our Man is constrained to US-listed equities/ETFs and bonds, it seems the best way to play a slowdown in China is through Commodities/Commodity-related instruments. The simple reason is that China, despite representing only c8.25% of Global GDP is the marginal buyer of commodities -- e.g. China is 50% of global demand for Steel, 45% of global demand for Aluminium and 40% of the demand for Copper. Since Our Man's account isn't allowed to trade commodities directly; the choices we're left with are Commodity Stocks and Commodity-related ETFs. Each has its own benefits, and problems...
Commodity Stocks -- FCX (Copper)
Sadly, Our Man is likely to be restricted in trading these as he has spent most of the last 3months+ (with only a modicum of success) trying to persuade his boss to go short & buy puts in this space. A simplified core of Our Man's arguments are as follows:
- Using LME data there has been a 30-year historical negative correlation between Copper prices and Copper Inventories (i.e. as copper prices go up, people hold less inventories). This broke down in Q3-Q4 (see here)
- There are no significant impingements on global supply, and supply exceeds production (as per the International Copper Study Group)
- China represents 40% of global copper demand (see link to ICSG report above)
- Technically, the copper spot price and the FCX chart have both broken down
- The cash cost of production for the copper majors is $1.00-$1.20
Given the excess supply, and speculative inventories out there, Our Man has been arguing to his boss that now that the charts are technically broken copper stocks (and longer-term way out of the month puts on them) are the single best instrument to express an equity view. To express this, Our Man would consider either a small amount of premium in long-dated (e.g. Jan-11) well out-of-the-money puts (e.g. 30-strike for FCX) or waiting for further confirmation of the technical breakdowns and then using the same premium to invest in a rolling hedge of closer to the money & short-dated puts.
Given that Our Man is constrained to US-listed equities/ETFs and bonds, it seems the best way to play a slowdown in China is through Commodities/Commodity-related instruments. The simple reason is that China, despite representing only c8.25% of Global GDP is the marginal buyer of commodities -- e.g. China is 50% of global demand for Steel, 45% of global demand for Aluminium and 40% of the demand for Copper. Since Our Man's account isn't allowed to trade commodities directly; the choices we're left with are Commodity Stocks and Commodity-related ETFs. Each has its own benefits, and problems...
Commodity Stocks -- FCX (Copper)
Sadly, Our Man is likely to be restricted in trading these as he has spent most of the last 3months+ (with only a modicum of success) trying to persuade his boss to go short & buy puts in this space. A simplified core of Our Man's arguments are as follows:
- Using LME data there has been a 30-year historical negative correlation between Copper prices and Copper Inventories (i.e. as copper prices go up, people hold less inventories). This broke down in Q3-Q4 (see here)
- There are no significant impingements on global supply, and supply exceeds production (as per the International Copper Study Group)
- China represents 40% of global copper demand (see link to ICSG report above)
- Technically, the copper spot price and the FCX chart have both broken down
- The cash cost of production for the copper majors is $1.00-$1.20
Given the excess supply, and speculative inventories out there, Our Man has been arguing to his boss that now that the charts are technically broken copper stocks (and longer-term way out of the month puts on them) are the single best instrument to express an equity view. To express this, Our Man would consider either a small amount of premium in long-dated (e.g. Jan-11) well out-of-the-money puts (e.g. 30-strike for FCX) or waiting for further confirmation of the technical breakdowns and then using the same premium to invest in a rolling hedge of closer to the money & short-dated puts.
Commodity-Related ETFs -- These fall into two buckets; Basic Materials/Mining-related ETFs and (Resource rich) Country ETFs.
- Basic Materials/Mining ETFs such as IYM, VAM or UYM are an inefficient way of playing commodity stocks. They're inefficient due to the diversification which means that they lack the explosive downside of an individual name (e.g. FCX). Furthermore, their size is also smaller than that of the major companies thus they don't offer any liquidity benefits. As such, for Our Man to be involved with these ETFs it would require Our Man to believe there's a sharp fall coming in a shorter (i.e. <3 mos) time horizon.
- Country ETFs, in particular China (FXI), Australia (EWA) and Brazil (EWZ).
- Basic Materials/Mining ETFs such as IYM, VAM or UYM are an inefficient way of playing commodity stocks. They're inefficient due to the diversification which means that they lack the explosive downside of an individual name (e.g. FCX). Furthermore, their size is also smaller than that of the major companies thus they don't offer any liquidity benefits. As such, for Our Man to be involved with these ETFs it would require Our Man to believe there's a sharp fall coming in a shorter (i.e. <3 mos) time horizon.
- Country ETFs, in particular China (FXI), Australia (EWA) and Brazil (EWZ).
Unlike the Basic Materials/Mining ETFs, from a directional standpoint EWA/EWZ have the advantage of having a currency play embedded within them. Given that Our Man would be looking for a substantial move in the underlying markets, such a move is potentially likely to cause substantial capital flows from the currency. Of the two, Our Man far prefers Australia (reasons outlined below) though again the paucity of longer-term options available means that Our Man will have to wait for further deterioration and use a rolling hedge of short-term close to the money puts (if he does indeed manage to get any trade on).
Our Man's favourite trade idea
Since Our Man can't put this on in his portfolio and his day-job is for a fund that will only trade equities, it would only be fair to let you all take advantage of his favourite idea centred on this idea of a Chinese slow-down! As you know, Our Man thinks far too much about these things, so here's a brief summary of the process that got Our Man to the idea:
- The idea stemmed from further pondering regarding the Australian ETF.
- The economist Steve Keen, one of Our Man's favourite, has been talking about the US-style credit bubble(private credit at 250%+ of GDP is more than comparable to the US) and the over-valuation of the Australian housing market for most of the last 3 years (see his blog). This was reiterated recently by data in the 6th Annual Demographia International Housing Affordability survey (here) where 3 Australian cities ranked in the top 4 globally (and 10 in the top 20) in terms of affordability.
- Given how Australia has benefited from both its own and the Chinese stimulus, Our Man believes a decline in China will have a negative impact on Australia. For example, looking at the impact of the global slowdown on Australia (using data from Australian FED) shows something very surprising -- during Q2-2009 Australia have negative nominal GDP (i.e. the volume of stuff they made declined) and saw deflation. Any more prolonged repeat of that would likely have a similar impact to what we saw in the US thus an obvious to play the derivative of this decline would be through construction cos, homebuilders or banks that have ADRs in the US. Sadly, those that do don't have listed options that make such a move worthwhile.
- Additionally, it's also clear that people are universally bullish on Australia; the Aussie dollar was one of 2009's best performers (partly on the entire China-related story) and the Aussie CB's decision not to raise rates last month was a surprise. Despite this, economists still expect future rate rises and the upward sloping yield curve in the bond market tallies with this.
- Given Australia's low government debt-to-GDP (c18%) credit risk is clearly low and Our Man became curious as to whether there were any US dollar-denominated (don’t want that AUD currency risk!) Australian Government bonds he might be able to purchase.
Why? Simple, any slow-down in China will hurt the Australian economy directly (reduced demand), but also have secondary impacts (bringing the credit issues and home-over valuation issues to the fore, in the same way that happened during the US slowdown). History shows us that Central Banks react to economic slow-downs (irrespective of the cause) by cutting interest rates. Thus, given the potential for both an economic slowdown and a housing market issue in Australia, instead of seeing the rate rises that investors currently expect we could see (if Our Man is correct) substantial interest rate cuts. This fall in interest rate (and yields) would be good for bond prices.
Why? Simple, any slow-down in China will hurt the Australian economy directly (reduced demand), but also have secondary impacts (bringing the credit issues and home-over valuation issues to the fore, in the same way that happened during the US slowdown). History shows us that Central Banks react to economic slow-downs (irrespective of the cause) by cutting interest rates. Thus, given the potential for both an economic slowdown and a housing market issue in Australia, instead of seeing the rate rises that investors currently expect we could see (if Our Man is correct) substantial interest rate cuts. This fall in interest rate (and yields) would be good for bond prices.
- However, as you no doubt guessed, there are no US Dollar Australian Government bonds out there. However, when further thinking about the reasoning why Our Man was interested in bonds, it also became clear that they were not the best instrument.
So what is the best instrument?
Our Man would say Australian interest rate options (on a specified US-Dollar amount – i.e. with a currency hedge).
Simply put, the market currently expects Australian interest rates to be in the region of 5% in 2-years time. If Our Man is right, then they will be substantially lower and thus by purchasing the right (but not the obligation) to receive, in 2-years time, interest at the rate of 4.5% on 1-year money will prove spectacularly attractive. Furthermore, since this is an out of the money option (and Australian interest rate volatility is expected to be low) it is a cheap trade (cost is the equivalent of c10bips per annum, i.e. an interest rate of 4.25-4.3% would break-even) with definable downside (the premium invested).
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