PMC Weekly Review - June 10, 2016
A Macro View – China Back in Focus
Next week, MSCI will decide whether to add Chinese A-shares to the MSCI Emerging Market Index. That situation has reawakened investor attention to Chinese stocks and the country’s economy as a whole. Goldman Sachs reported this week that the Chinese government is understating the economy’s leverage growth this year by almost 25%. As investors digest Goldman’s report and await MSCI’s decision, it is useful to take a step back to understand why China is so important to both the global economy and US investors.
As the world’s second-largest economy, China has its second-largest stock market. Its impact on global financial markets is real: Recall the sharp domestic equity sell-off in August 2015, when China allowed the yuan to drop against the US dollar. Because China’s economy is second only to ours, investors must pay attention to what happens there, as it will have an impact on both their portfolios and the global economy. Even if they only invest in domestic equities, a portion of investors’ portfolios is exposed to China via the revenues generated from US businesses that derive profits from outside the US. And potential financial contagion is yet another exposure risk.
That’s why investors should pay heed to Goldman’s report and MSCI’s A-shares decision next week. As China’s economy slows, its debt load could be an issue, as repaying it will be increasingly hard to do. Depending on whom you ask, China’s national leverage, which includes public- and private-sector debt, is somewhere around 300% of the country’s GDP. Some say it is 275%, and others say it is 325%, and therein lies the problem, as Goldman Sachs implied. No one knows what the real debt numbers are, and no matter who measures them, those numbers seem to be growing as China’s economy is slowing. The dilemma combines a shadow banking system, a lack of understanding of where this debt resides (or even how to calculate it), and a lack of faith as to the quality of this debt. Sound familiar? Anybody who lived through 2008 can explain it.
The US is not immune to high debt: Our total debt to GDP is around 335%, down from a peak of 365% in 2009. But the difference is in transparency—the market has a lot more faith in the accuracy and quality of our reported debt. Our reported numbers aren’t perfect—they’re just closer to being perfect. Investors have less confidence in China’s official government numbers, as the Goldman Sachs report notes. The more uncertain investors are, the more reluctant they are to lend to China and Chinese companies. As witnessed during the credit crisis, as well as the numerous bank runs throughout history, confidence is everything when it comes to investing. Once investors lose confidence, they stop lending. And that is how financial crises begin.
MSCI’s EM Index A-shares decision next week coincides with rising investor concern over China’s escalating leverage. As a reminder, 27% of the EM index comprises H-shares (shares listed in Hong Kong) and shares listed abroad. Adding A-shares will increase that figure to 40%, although the most likely scenario is that they will be added slowly to the index over time—the current proposal is to add 5% in the first year (less than 1% of the index weight). Despite this gradual approach, investors may feel the impact, signaling a glimpse of the future roadmap. A-shares include a high percentage of state-run companies that are less efficient and potentially have more problems with bad debt. When banks are removed, A-shares valuations tend to be much higher, and are higher still when state-run companies are not included. We believe that adding A-shares to the index will increase exposure to both debt-heavy, state-run companies and over-valued private enterprises. With more than $1.5 trillion in assets in various MSCI indices, the addition of A-shares will force investors’ exposure to them through both passive vehicles and active managers with tight benchmark constraints.
In reality, investors’ direct and indirect exposure to China will likely increase in the coming years as its economy slows, debt concerns rise, and valuations become stretched. It’s something investors should focus on.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.
Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.
Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.
Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.
© 2016 Envestnet. All rights reserved.