The Chinese government has focused on a number of things some of which include:

• An anti corruption initiative.
• Rebalancing the economy towards domestic consumption.
• Maintaining financial stability and a certain level of economic growth.

The anti corruption initiative is a long term structural reform to strengthen the rule of law in China. The government appears to be serious about the rule of law despite doubts from many observers who see the law as a means of control. The Fourth Plenum saw an elevation of the Constitution which may signal that China is, albeit gradually, shifting to a rule by institution than by person. The anti corruption initiative is, however, a brake on growth, as many investment decisions and projects have corrupt elements in them and these projects may either fall away or need to be reorganized in a more acceptable form. Expect delays.

The rebalancing of the economy is an important factor in assessing China’s prospects. Most countries must by now recognize that globalization has been slowed if not reversed post 2008 as countries struggle to grow. In the aftermath of the crisis, the calculus recognized the constraints on fiscal policy, consumption and investment and naturally defaulted to exports to fuel growth. This placed the world in a state of a cold trade and currency war. In such an environment, currencies would range trade. Logical tolerable bounds would be 2007 levels for JPY and 2008 levels for the European currencies. These countries must also realize that the cold trade war is nearly over and that long term solutions need to be found besides beggaring thy neighbor. Cold wars are sometimes a balance of tacit collusions and conflicts. The end of such conditions will likely drive countries to pursue greater self sufficiency. A base of domestic demand and consumption is an important resource in the face of slowing or reduced globalization.

For many reasons, China’s growth is slowing. One reason is that unless one is the generator and owner of intellectual property, one’s economy is hostage to being a low cost producer. When costs rise, business moves elsewhere. China has long had a technological disadvantage compared with the West. It clearly recognizes this. The number of patents filed by Chinese firms has accelerated recently relative to the rest of the world.

It is hoped that this push to improve its competitiveness in intellectual property will result in higher productivity and a higher long term growth rate. In the meantime, however, growth has slowed from the double digit pace in the early 2000s to 7.3% at latest count. Some observers are quoting a rate of just sub 6% actual growth this year, slowing in 2015 and the coming years. If the economy indeed slows along this path, policy must be expected to adjust to a more accommodative state.

It can be argued that the PBOC misread the impact of the US Fed led global QE and easing policy on price levels in China. Certainly inflation rose steadily from 2009 to 2011 during which food price inflation ran into double digits. Concerned about inflation through tradable goods markets, the PBOC has been too tight. The low inflation in Europe, the US and Japan, the falling domestic inflation and the end of US QE has prompted the PBOC to switch to a more accommodative state. This will likely steady tradable goods while creating inflation in services and semi-closed asset markets.

If growth should slow more than planned it is likely that China will resume growing the economy through investment in infrastructure. This could provide some respite to commodity metals and energy markets regionally as well as globally. (Miners have been acutely weak of late and could represent a buying opportunity if China growth slows much more.) Another area of potential interest would be European and US industrial equipment companies.

Generally, the outlook for China is positive. Equities are relative cheap and growth is robust. The one impediment to the Chinese stock markets has been an overly tight PBOC. With a neutral to accommodative stance, the latent investment themes can be animated.

Longer term risks:

There are of course risks associated with investing in China. The anti corruption drive will deal, if tangentially, with corporate governance. There is a risk that the campaign might be a cynical and politically motivated power consolidation exercise. Only time will tell but the focus on constitutionalism is an optimistic signal.

The growth of leverage in the corporate and local government sectors, enabled by the bond and nascent securitization markets has been an area of concern. However, most of the debt is local currency denominated and therefore within the control of the government. Central government and household balance sheets are not overly leveraged. This will allow the government to bailout any credit issues that threaten to become systemic. A strong current account is not entirely relevant to the potential imbalances in Chinese credit markets but is a help in case of contagion into the hard currency credit markets.

Perhaps one of the most intractable risks to China is its irrevocable progress and the concomitant social change. The Umbrella Movement in HK, the troubles in Western China and Tibet, threaten the status quo. Government has to address the needs and wants of a new generation facing rising wealth and at the same time greater inequality. Greater freedom of information complicates this task. China’s vagueness about whether it is a secular (prescribed by the constitution) or atheist (preferred by the party) state remains unresolved, a dangerous condition given the correlation between ethnicity and religion in a country with significant diversity.

Geopolitically, the world has become a harsher place. The years leading up to 2008 saw relatively little turbulence between the major powers as credit fuelled prosperity tempered old rivalries. The world was, is and ever shall be a contentious place, however, pre 2008, the conflicts were localized and fragmented. The deceleration of globalization, the cold trade war, the competitive devaluations and monetary debasement make the post 2008 environment more fractious and fraught. The relationship between China, the US and Russia will have important strategic implications. One country is governed by institutions and offices, another by a party apparently shifting towards governance by institutions and offices, and the third by a man. The scope for policy miscalculations and mistakes are high.

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.