Tuesday, February 27, 2007

China Syndrome

Feels like the old days, panic in the air, confusion in the portfolio, too much information and not sure where to start - like the buttons on the control panel of a nuclear reactor are blinking and the labels are in Chinese. These days it is very difficult to understand the interconnectedness of the markets with global hedge funds dominating trading volumes, derivatives linking various markets and asset classes, and pools of risk money concentrated like never before. Correction or bear market? How long to clean up?

Seen from the calm streets of Pakse, the China meltdown appears to be a a combination of the Chinese government's attempt to intentionally cool the market off, a technically hugely overbought market and slowing export markets (US). This is a market largely closed to international investors and is dominated by retail investors. The Chinese have a well known tendancy towards herd mentality and appetite for gambling - a deadly combo. But the Chinese savings rate has led to the accumulation of over $2 trillion in mattress accounts - bigger than the entire stock market capitalization. It seems the real issue for China is when will the sucker investor, the government, stop buying.

Partially confirmed by the new US capital purchasing numbers and the growing slump in housing, this correction likely telegraphs that the export demand driver from the states will slow in the coming few months. No surprise; the US consumer is extended, leveraged and just about out of gas. This will impact China's economy, but maybe by bringing GDP growth down from 11% to 7-8% - an outcome the Chinese government might look upon favorably. Not great for the commodity plays and other marginally priced items, but not a disaster for world markets per se.

While there are lots of questions about what this world wide sell off means, one thing we can observe is the psychology of the markets. There seems to be a lot of market money on a short trading trigger reminding us of hedge fund involvement and the lack of investing conviction that it often carries. The pros are all aware there is very little risk premium in the market and the sell-off seems to suggest the pros do expect a reversion to the mean.

A sell-off after the last few months of up and to the right behaviour seems long overdue. The real question to ask: is this a simple reset, a needed blowing off of steam to remind investors of the downside and start the process of resetting risk premiums? Or is this a reason to exit equities world wide, batten down the hatches and wait out a bear market? Valuations in the US are high, but not off the chart. Valuations in Europe, the same. In Asia X-China, valuations appear reasonable and national and corporate balance sheets are in wonderful condition. But even if fundamentals appear solid, in the high beta markets it's the state of risk capital - its rate of growth - that determines values.

I'm thinking the following: the world markets have to psychologically de-link from the China stock market. I think this gets done quickly, in a few days. Then we have to consider the leveraged positions of the hedgies - maybe there comes a blow up or two and a month of high volitility. Then we have have to re-assess exactly where the US economy is, and likely conclude a sharper slowdown is comming sooner than expected. Take your pick: housing slowdown, declines in corporate profitability, falling dollar.

The gains of the past few year will moderate over the coming months and it will be increasingly difficult to find the kind of upside beta we have become used to. Global money flows are moderating - foreign reserves from non-oil trading are experiencing declin
ing growth rates and oil based surpluses have likely peaked their growth rates as well. The formation of multi-deca billion merchant and hedge funds is also leveling. With a consensus of slowing US growth and coming rate cuts, the carry trade get re-evaluated. The overall growth in risk oriented capital is slowing and the growth in concentrated pools of capital such as oil money is doing the same.

We also have to consider political risk. Much of world equity market performance has been created by what appears to be improved government behavior - more laissez fare - as the rising tide lifts all boats, poor and wealthy alike. But in corrections, the masses usually get hurt and governments usually have to respond. Thailand already has, China is beginning to, and I assume others will follow. Risk premium will slowly come back driven by both financial and political concerns, slowing the growth of world wide capital formation and lowering equity returns all around. Governments are not sure how to respond: money supply growth continues at record levels, while interest rate head up.The global liquidity bubble might have just peaked.

So what do you do? You should look for spreads in the fixed income market to widen according to risk - junk, sub prime and developing market issue yields will see larger spreads against treasuries and eurobonds. Shrinking risk capital leads to lower premiums in emerging equity markets. US rates start heading down again and Euro rates stop heading up. Fiscal policy in some places will change - new taxes are coming. Currency speculation will moderate, a good thing for places like Thailand. With an overall increase in fixed income yields, the equity earnings yield should go up with improved earnings or declining stocks. For the US, I assume the later, for the Euro markets it could be the former. Overall equity volitility should increase. Commodities will still be connected to China growth and Middle East tension, both of which are politically driven. They could work work for a while longer, long enough for everyone to try and hide in them - a nice blow off rally.