Month: August 2021

China’s ongoing regulatory/political onslaught against popular growth stocks has left investors rattled and confused. Given the tense relations between China and the United States and determined efforts on both sides to reduce interdependence, questions are being raised on the basic viability of investing in Chinese assets.

In one camp, the stalwart aficionados for investing in China are keeping the faith. These include two groups with fundamentally different motivations: 1. Long-term investors like Bridgewater’s Ray Dalio and global asset allocators who believe that the continued rise of China’s economy and its capital markets are inevitable and that Chinese markets provide a invaluable source of portfolio diversification. For these investors, periods of turmoil are temporary and provide buying opportunities; 2. Major Wall Street firms, such as Blackrock and JPMorgan, which for years have lobbied both Beijing and Washington to get access to the Chinese capital markets. Not surprisingly, in recent days both Blackrock and JPMorgan have encouraged their clients to increase investments in China.

The idea of investing in Chinese assets for diversification is certainly compelling. The current process of decoupling  of the world’s two largest economies may also reduce the correlation of asset prices and improve diversification opportunities. Given high valuations and low forecasted returns in U.S. assets, diversification may be of particular benefit at this time.

The argument for diversification is most compelling for fixed income. China has a strong currency relative to the USD and its fixed income markets currently provide a large positive yield spread to U.S. instruments. The Chinese government cares about maintaining a stable currency and a solid  and growing fixed income market as this is seen as a pillar of the long term objective of raising the profile of China’s capital markets and reducing dependence on the USD. Significant amounts of foreign capital have flowed into Chinese fixed income over the past year. This should continue.

For other assets, the case is less clear. Real estate in China is as overbuilt as in the U.S. and generally has lower rental yields than in western countries. Stocks are a complicated story with a checkered past and unclear prospects.

Strangely, to a significant degree what most investors outside of China think of as Chinese stocks are an ingenious creation of Wall Street and Silicon Valley. U.S. venture capital firms who backed almost all the major China tech firms (Tencent, Alibaba, etc…) allied with Wall Street and a compliant Securities and Exchange Commission to bring these companies to  U.S. stock exchanges in the form of Cayman Island registered shell companies. Concurrently, the SEC agreed to significantly lower reporting standards for foreign issuers, supposedly to promote the development of U.S. capital markets. Ironically, none of these firms could have listed in China where listing and reporting standards have been and continue to be much more rigorous.

Unfortunately, the chickens have come home to roost. Weirdly, both Chinese and U.S. regulators now concur that the U.S. listings were a mistake. The disastrous recent listing in New York of Didi Chuxing, which was done hastily to ease the exit of VC firms, may have been the death knell for this model. This poses a serious problem for current VC investors in China’s tech “unicorns” who will probably have to list in China’s domestic markets from now on.

Moreover, the problems for the “unicorns” do not stop there. Recent political developments in Beijing indicate a strong negative bias against a large segment of the tech sector. One of the key attractions for the VC model of investing is the “winner-take-all” nature of many tech sectors built on scale and network effects. This dynamic, which leads to huge growth and value creation for investors, is anathema to Beijing. The emasculation of Alibaba’s Jack Ma was a warning that Beijing will not brook dissent from tech billionaires. The wealth concentration and political power that “winner-take-all” tech has given to U.S. moguls like Bezos and Zuckerberg is seen by Beijing as incompatible with its vision of a “harmonious” society led by the Communist Party.

It is also evident that Beijing sees the current U.S. driven tech model as an impediment to China’s economic development objectives as dictated by the China 2025 industrial planning goals. The primary focus of listed tech firms and unicorns has been directed at what authorities now see as either frivolous consumer distractions (e.g., e-commerce, gaming, social chat and video) or else fintech applications that disintermediate and destabilize the state-controlled  financial system.  Beijing believes that these firms are mobilizing scarce financial and human resources that would best be allocated to key strategic industries (semiconductors, electric vehicles, quantum computing, etc…). The following chart shows just how misaligned venture capital is with the government’s objectives. Interestingly half of the recent valuation of China’s unicorns was in fintech, presumably in companies that aim to disintermediate China’s state banks. However, as we saw in the case of Ant Financial, the authorities have no tolerance for anything that weakens state banks ability to serve as a pillar of China’s state capitalism and direct capital to preferred sectors.

China’s political agenda regarding corporations goes beyond tech. Beijing’s latest slogan – “common prosperity” – guides corporations to ‘continuously improve themselves in patriotism, innovation, integrity and social responsibility” ; in other words, to follow the dictates of the communist party.  The after-school education sector has already been crippled by regulators under the pretense that it accentuates inequality and unsocial behavior. This means tech companies will be expected to invest in areas of interest to Beijing, in a form of social service.

Looking forward, the problem for China’s stock market may be that heavy-handed government intervention in corporations to meet social and economic mandates will likely hamper profitability and investor support, resulting in lower valuations. As in the rest of the world, over the past decade in China the tech sector has been the driver of earnings growth and stock market appreciation. Without the dynamism of stocks like Tencent and Alibaba, which gave the Chinese market a high growth profile (exactly like the FAANG stocks in the U.S), the opportunity set in China will look more like those in other emerging markets; that is to say, dominated by cyclical, low growth value stocks.

 

The fact is that, despite the huge success of the tech sector, China’s stock market already has had underlying weaknesses. China’s corporate world is heavily dominated by a combination of very large state companies, which have the low-return profile of publicly managed firms around the world, and provincial government-sponsored firms that participate in “strategic” sectors, following the guidance of Beijing. The herd-like behavior of these local government firms leads to overinvestment and low returns. This occurs repeatedly, as we are seeing today with massive investments in electric vehicles and semi-conductors by local government firms. Finally, we have non-strategic sectors, such as consumer goods and services, where private entrepreneurs dominate and compete ferociously for market share.

This combination of a prevalence of state and local government firms and ferocious competition for private markets results in low returns and mediocre growth in earnings. We can see this in the following chart which shows the historical growth in earnings denominated in U.S. dollars for the Shanghai Exchange, the MSCI China Index (MCHI) and, for comparison purposes, the S&P500. When seen in relation to GDP growth, the contrast between China and the U.S. is shocking. The past three decades in the U.S. have been the heyday of financial engineering (leverage and buybacks) and globalization /offshoring and tax cuts have resulted in a major expansion of profit margins for U.S. firms. This has caused an extended period of earnings growth well above GDP growth, which is unprecedented. Meanwhile, in China corporations have sacrificed earnings to meet government objectives which has resulted in an equally extraordinary (by global standards) and extended period of earnings growth well below GDP growth.

 

Without the sizzle of tech stocks, Chinese equities may become a much more mundane affair, more in line with other emerging markets. This raises the question of whether the market should trade at lower multiples. We can see in the chart below that price earnings (PE) and cyclically adjusted price earnings (CAPE) ratios have been trending higher. If the government persists in suppressing dynamic private firms, we should expect multiples to move lower.

In conclusion, the prospects for Chinese stocks look poor, as it is probable that the market is experiencing a de-rating. Investors should focus their attention on the fixed income markets where they will be aligned with the policy objectives of the government.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Brazil’s dismal economic performance since the debt crisis of the 1980s has made it the poster child of the “middle-income trap.”  Over this period, Brazil’s economy, like those of most Latin American countries, stopped converging with developed economies, in sharp contrast to the high-growth emerging markets in East Asia and Eastern Europe. This extended period of economic failure has led to rising anxiety and calls for new approaches from policy makers and intellectuals  of both the left and the right.

Brazil’s Finance Minister Paulo Guedes has argued for a liberal agenda of privatizations, trade liberalization and smaller more efficient government, but he has run into the rock-hard resistance of powerful interest groups which extract benefits from the status quo and he has had only tepid support from his boss, President Bolsonaro. Unfortunately, though Guedes’s “Chicago School” framework would have produced high returns if introduced decades ago  today  it  seems woefully anachronistic in the context of a global reaction against neo-liberalism and the renewed popularity of industrial policy in the U.S. and its allies (WSJ). More in tune with the times, Brazilian financier Andre Lara Resende has caused an intellectual ruckus by advocating that Brazil break out of its torpor by adopting Modern Monetary Theory, the combined expansion of money printing and fiscal expansion that President Biden is pursuing in the U.S.  The underlying premise for both Lara Resende and U.S policy makers is that their respective economies have an abundance of high return public sector investment opportunities (infrastructure, basic research, broadband access, education, etc…) that pay for themselves through higher productivity and GDP growth and are easily financed today given the current extraordinary financial conditions of excess savings and historically low interest rates.

Lara Resende’s thinking reflects a profound change in the popularity of developmentalist economic theories in favor of a more activist state. The phenomenal rise of China with its super interventionist public sector and its sector-targeted industrial policies occurred during a 40-year period of neo-liberal tendencies and public sector retrenchment in the West. But now the pendulum has turned and a new generation of influential economists, such as Carlota Perez and Mariana Mazzucato, are convincing policy makers in the West that the public sector has a critical role to play in inducing innovation and growth. The Biden Administration is particularly smitten with these ideas, believing that these policies will put the U.S. on a higher, socially equitable and greener growth path.

In Brazil, these state-supported developmentalist policies have been deeply out of favor since the 1980s. Even the leftist ideologues of the PT administrations of Lula and Dilma rejected industrial policy in favor of social welfare initiatives. Since the 1980s, the Brazilian state’s capacity for investing in public goods has been severely eroded. Despite chronic fiscal deficits and a near-doubling of the ratio of public debt to GDP over the past decade, almost nothing has been spent on infrastructure. Also, government support for critical sectors through financial subsidies and research and development has dwindled. Over the past decades as government capacity for investing in public goods has fallen Brazil has become increasingly reliant on private capital for the scarce investments made in physical infrastructure, education and healthcare.

But this was not always the case. In fact, the kind of strategies advocated by Lara, Resende, Perez and Mazzucato have a better track in Brazil than neo-liberal ideologues like Guedes would admit. We can point to two of Brazil’s great success stories of the past decades as evidence of this: agroindustry and Embraer.

 

• Brazil’s world class agro-industrial sector was heavily supported by the public sector which sponsored through the agriculture research institute, Embrapa, innovation breakthroughs in tropical agriculture. Also, a wave of investments in roads and highways and port infrastructure during the 1970s provided the physical backbone for grain exports. Finally, for decades through Banco do Brasil, the government has provided cheap investment and working capital to the farm sector. All of this public sector support has induced the enormous success of thousands of entrepreneurs in the farm sector and related activities (services, meatpacking, etc…).
• Brazil’s aircraft manufacturer Embraer was heavily promoted and subsidized by the military regime (1964-1980) and provided with a captive market for military and civilian planes. The company’s success was always tied to the state-run Aeronautics Institute of Technology (ITA) which partnered with leading global research institutions such as MIT to achieve a high level of academic excellence. ITA has educated the vast majority of the engineers employed by Embraer, and one of its graduates, Ozires Silva, was the driving managerial force behind its success. Embraer and ITA are both based in Sao Jose dos Campos and support a cluster of world-class aeronautics expertise.

In today’s Brazil there are many opportunities to use the public sector to promote strategic industries that generate growth and employment. For example, tourism could benefit from long-term planning, infrastructure investments, vocational training and preferential tax and financial regimes. Green technologies, from ethanol to solar and wind, also would benefit from public support. The automotive industry stands to be thoroughly disrupted by electrification over the coming decade unless the public sector has a plan to maintain the country’s relevance in this industry. Unfortunately , under current circumstances there are serious impediments to pursuing these efforts; namely, the insolvency of the state and chronic fiscal incontinence.

The Impossible Trinity

Lara Resende assures that there is a long list of badly needed investments that would increase growth and productivity and therefore pay for themselves. However, given Brazil’s current high debt levels and chronic fiscal deficits, how do you convince financial markets to accept higher public debt levels? Any indication of increased public spending today, no matter how well intentioned,  would trigger capital flight, a weaker BRL and higher nominal interest rates. Under current circumstances, Brazil is severely constrained by The Impossible Trinity, the concept in economics which states that it is impossible to control the exchange rate, capital movements and monetary policy at the same time. In Brazil, any version of Modern Monetary Theory that pretends to finance stepped-up fiscal spending and debt accumulation  would almost certainly result in a combination of higher inflation and currency devaluation unless capital controls were imposed. Of course, any hint from policy makers that they are thinking of stricter controls on capital flows would accelerate outflows.

Whatever the MMT proponents say, in Brazil, and in many other countries around the world, there is no way to get around the fact that the current very high debt levels are an impediment to growth and tie the hands of policy makers. After a decade of quasi-recession conditions, Brazil will not follow a path of austerity to reduce these debt levels. So, in the end, it will have to follow the path of financial repression like developed countries were able to do in the 1950s and hope to do again this decade. Hopefully, Brazil will not try to inflate the debt away (which would place the adjustment burden on the poor) but rather will find a way to pass the cost to Brazil’s rentier class.