The China A share market surged last week. It is time to reiterate my optimistic appraisal of the China market. It is not too late.

Back in July, we noted that

1. China equities were underowned.
2. China equities were trading cheap.
3. China equities had been in a 6 year bear market. This was most likely the consequence of the PBOC’s tight monetary conditions.

We postulated that the PBOC’s stance was driven by inflation concerns in the traded goods sector and the volatility in the commodities and food markets. 3 years ago food prices were rising at nearly 15% YOY and has since hovered between 2.5% to 5% since. It is likely that the PBOC views the US Fed’s expansionary balance sheet policy as a source of inflation in the traded goods sector and felt it necessary to compensate. Another concern was the growth of the Shadow Banking system in the form of off balance sheet funding vehicles. This is a more complicated topic but one which I believe has less of an impact on PBOC policy. The reason is that credit can be isolated in a semi closed economy whereas traded goods are sufficiently open to be impacted by international flows.

The trigger for the buy recommendation was the impending end to the US Fed’s expansionary balance sheet policy. With the end of QE, while the Fed’s balance sheet will not likely shrink quickly, or at all in the short term, it is at least static. The latitude that this provides the PBOC in expanding liquidity to support a slowing economy is important. China’s inflation has slowed to 1.6% with food inflation down to 2.3%. Widespread global disinflation will impact the traded goods markets in China providing further room for expansionary policy. The impact on semi closed markets, whether by nature or regulation, such as services and asset markets, is inflationary.

I previously held that China had a long term innovation deficit and that it had to buy or otherwise acquire technology. I am still of this view, but there are nuances to that view. The cutting edge of technology remains in the developed Western economies, bit China is catching up. There is a chance that this long term trajectory can be reversed.For investors and traders, a shorter time frame is more relevant.

One of the more important developments in China took place last week. The Fourth Plenum produced a number of interesting and constructive signals. The Central Committee chose to reduce the influence of local level officials over the legal system, establishing circuit courts with greater independence from local Party officials. There was some woolly announcement about accountability and transparency of government but details were scant. The most important announcement was the elevation of the constitution within the rule of law. The consensus is that the Party’s authority would not be weakened by constitutionalism but an optimist would hope that while the Party might not be compelled to work within the constitution, it might work with the constitution to more efficiently and fairly govern the country. Certainly this focus on the constitution places the anti corruption efforts in a less cynical perspective.

Bottom line: We are likely to have an expansionary PBOC and we are hopeful that concrete legislative reform is underway. At the same time we have cheap stocks and healthy growth at a time when developed markets face deflation risks and other emerging markets like LatAm face stagflationary risks, China is a good place to invest.

ECB QE:

QE is not just quantitative, it is qualitative. Until underwriting standards are dropped, credit creation in the private sector Eurozone will be moribund. How can the ECB get it going again? Purchasing sovereign bonds will do nothing more than flatten term structures and tighten sovereign CDS spreads making it cheaper for governments to borrow. This is not the idea since fiscal rectitude is still expected even of the Club Med, at least by the Germans. At best it helps debt service a bit. Buying off the run corporate and covered bonds and ABS will not help either since it does not encourage new lending. In any case the market for covered bonds and ABS is too small for the ECB to be really effective. To be really effective, the ECB needs to be bold and reckless. It needs to underwrite blind pools of ABS and agree to purchase ABS printed on a TBA (to be announced) basis, where any collateral pool conforming to predetermined criteria are eligible. There is currently only one market which operates on this basis: US agency mortgage backed securities. QE there at least has kept mortgage rates down and spurred a durable housing recovery thus improving household balance sheets and reinvigorated HELOC origination. If the ECB abandons prudence and embarks on underwriting TBAs, private commercial banks will be converted into outsourced or third party credit underwriting agents, earning fees instead of spreads and deploying less scarce capital.

The current interest expense on public debt of the US treasury presents an interesting picture. Given the current term structure, 2 year treasury FRN’s are an extremely attractive means of financing. They trade at some 4 basis points over 3 month T bills, which trade at about a basis point.

Assuming that the 3 month T bill trades up to 230, which is where the 2 year 2 year forwards are trading, this means that the existing stock of FRNs would see an increase in interest expense from 0.01% of total debt service, to 0.6%, an almost negligible increment. The math changes if the issuance accelerates. If we cynically assumed that the Fed worked only for the Treasury, a CFO would look at the trade off of financing between 2 yr fixed and the floating rate, in 2 years time. If the 2 yr rate was 230, then what latitude would the Fed have in raising interest rates? It turns out, quite a lot.

Unfortunately, at this point, I have not the resources to conduct a thorough study of the US treasury’s funding needs and planned issuance and what a rational CFO would structure the balance sheet. Let’s see if I can co-opt the research team to do some work for me…

Just as an aside and an aide memoire…

For the year 2014, UST issuance will roughly look like:

160+m of 2y FRN

168m of 30y

260m of 10y

350m of 7y

420m of 5y

340m of 3y

360m of 2y

Globalization and the opening of trade and capital between countries led to a reduction in income and wealth inequality between countries. The mobility of financial and intellectual capital also led to a widening of inequality within each country. Since the global financial crisis of 2008, countries have had to reexamine their economic and commercial models. Domestic inflexibility has led many countries to pursue mercantilist policies aimed at gaining a competitive advantage over trading partners. Re-shoring is an example of a large scale, secular theme associated with mercantilism. From 2008, the world has witnessed a slowing of globalization. Countries have incentives to deglobalize. Large, developed countries with sufficient domestic demand will pursue this strategy while traditional exporters who have weaker intellectual property generation capabilities are likely to recognize the balance of power and pursue their own domestically focused policies. Deglobalization is likely to lead to a divergence in income and wealth between countries, reversing the trend of the period of globalization. There is no evident impact on income and wealth inequality within countries. That is left to a separate analysis. Country risk premia have diverged since 2008, most notably within the Eurozone, albeit for reasons surrounding the robustness of its currency union, and appear to be driven by deglobalization. This is a long term trend with implications for security valuation across equities and credit globally.

There is policy fatigue in Europe. The recent LTRO has had poor take up, a mere 83 billion eur compared to 290 billion at the first 3 year LTRO.

The first LTRO allowed banks in the euro area to do something they had not been able to before, to trade out of their foreign debt and into their local debt, and to buy more bonds. It was an outsourced QE. The current LTRO allows banks to do nothing new. In fact, the conditional nature of this LTRO makes it less attractive. Moreover, the euro area banks are in the midst of recapitalization and until this is done, LTRO’s are merely liquidity operations that require capital for animation, capital which is yet scarce.

This is positive for Europe. A ‘big gun’ solution might be a better analgesic but this current incremental policy provides a protracted and incremental support for European risk assets. It is, to be clear, a dangerous game, but it lifts the market steadily. Given the tepid response to the LTRO the ECB will be forced to do more, and do more it will.

Let me make a wild and reckless forecast. The ECB will design a TBA market for ABS underwriting not only secondary market ABS but blind pool primary issues, in effect co-opting the commercial banks to be their originators.