Thursday, September 29, 2011
Europe and all things European have been holding the world's attention to an extent that it’s all too easy to forget that life goes on elsewhere. One of the corollaries of the European shock has been a general global deleveraging rolling right through to the emerging markets.
TMM had some pretty dark things to say at the start of the year about emerging markets and particularly China. As trades go, this has worked – The Hang Seng and Hang Seng China Enterprises index has dropped gradually throughout the year and has really been hammered since August in particular. As noted by the esteemed commodities analysts at the US ex-investment bank, copper is very closely correlated to China fixed asset investment, which appears to have become public enemy number 1 of the People’s Bank of China’s latest tightening campaign. It dropped off heavily and has taken copper with it. See below the bonds of Evergrande, a property developer, and copper and China fixed asset investment. All jokes aside, the China real estate bond market really is copper with a coupon.
Much of what seems to have kicked off this panic is not anything particularly new to TMM: China has an unbalanced economy, is too dependent upon fixed asset investment and its banks end up short puts on a lot of bad investments. So far so good – China property, banks and basic materials have been a great short.
But here is where TMM find themselves out of line with the market thinking. First, you haven’t thought anything through until you consider the government and likely policy responses, given the command economy context. In TMM’s opinion watching the banking sector explode into a flaming wreck is not something the government will sit by and watch idly and the last time we heard of Wenzhou SME’s blowing up, credit loosening was not far behind. Similarly, some will point to high levels of inflation, but breaking China inflation down into food, non food and housing (see chart below; white line - food, orange line - non food, yellow line - rents), a big part of non-food makes it pretty clear that food is beginning to turn for its own reasons, while house prices and rents really are falling out of bed. Given what global financial conditions have been doing (and reading some chemical company transcripts), we are inclined to think that the global situation has gotten bad enough for the PBOC hawks to stay hooded when the local banks scream for looser credit.
In summary: the worst may be yet to come, but probably not in the next 6 months.
On valuation, China’s banks are about as beat up as they ever have been historically as you can see below:
On a back-to-basics corporate finance level they are looking cheap, assuming that most of the book value isn’t a complete write off. Now, bears may scream “BUT IT IS, INNIT?”, to which TMM would agree, - but then again we would also note that the government has demonstrated prior ability to take on pools of toxic loans, throw them in an AMC and forget about it for quite some time (lessons for the Europeans?). Being super short on the assumption that the banks will have to issue equity that will allow you to cover may not work. Given these numbers, if we see a combination of loans bought by Huarong and Cinda and a stimulus, we could see a squeeze that could rip this stuff 30-40% higher.
Which gets us to positioning data and, suffice it to say, the market has got itself very net short in copper per the COT data and the short sale turnover / total turnover picture in HK below is looking pretty extreme too.
And on that point, TMM are covering and running. When shorting Chalco and Anhui Conch looks more like a T8 Typhoon day in Hong Kong (see below), we’ll be back.
In the meantime, we’d rather sit out the next move down and not risk the squeeze and instead start thinking about what the next white elephant nation building/wealth expropriating capex binge China will come up with next. Rail? Soooo 2008! TMM are looking at stuff like this instead.