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5 Ways To Profit From A China Downturn In 2020
Is China’s economy headed for a crash in 2020? It’s an extreme question that would be laughed at by many. After all, most believe that China is the world’s new powerhouse, off the back of near 10% annual growth over the past decade. And the vast majority of economists and policymakers are sanguine about the country’s economic prospects, pointing to still healthy data and confidence in recently-announced structural reforms to steer China in the right direction.
But as Asia Confidential outlined in a recent post, the bulls’ arguments are looking much weaker post two spasms of credit stress. And there are four crucial things that these arguments seem to ignore:
- The investment-driven, debt-laden economic model of China simply isn’t sustainable
- Extraordinary credit growth is yielding less and less benefit as investment returns deteriorate
- The recent spikes in inter-bank rates and high-profile debt defaults (China Everbright Bank International, (0257) and bankruptcies (coal mining group, Liansheng Resources Group) point to severe stresses within the financial system
- The structural reforms are a long-term positive, but short-term net-negative for the economy.
For the record, we’re not predicting a China crash this year. We’ll leave sure-fire predictions (which are often wrong) to others. What we are suggesting though is the odds appear to favour a more serious economic downturn in China over the next few years. And that those odds have increased given recent events.
Today we’re going to look at the bulls’ views in depth and what’s wrong with them. We’ll also delve into the countries and sectors which seem most vulnerable to a China downturn. While the Chinese stock market has been a dog for years and told a large tale about the country, many of those most reliant – either directly or indirectly – on China investment demand still seem to be priced for better times ahead.
The bull case
First, let’s take a look at the bull case for China’s economic prospects. In simple terms, it goes something like this:
1) GDP growth accelerated in the third quarter to 7.8%, up from 7.5% in the prior quarter. According to the bulls, this shows that the economy is recovering, or stabilising at worst, thanks to various stimulus measures and government interventions into the inter-bank market.
5) Most, including this author, think Xi Jinping may be the man to make the tough decisions to propel China’s long-term growth after the previous regime neglected much-needed reform. Clearly, he’s been focused on consolidating his own power; economic reforms should come next.
6) If the economy does suffer a major downturn, China has ample resources to fight such an occurrence, in the form of almost US$3.7 trillion in foreign exchange reserves. This should ensure China doesn’t have the so-called hard economic landing which critics predict.
What’s wrong with it
The weaknesses in the bull case are the following:
- Almost everyone agrees the that export-led economic model used by China over the past 30 years is unsustainable going forward.
- Previous transitions from export-led models in Japan and South Korea have led to sharply lower economic growth.
- Faith in government to engineer a smooth economic transition is also contrary to much historical experience.
Let’s run through these one-by-one.
It’s important to understand how China’s economy got to be so big in a short space of time. The speed of economic ascent has no parallel in modern times and it’s been the result of a classic export-led growth model.
What this means is that China has been able to mass produce goods on an unprecedented scale given the appetite for these goods abroad. This has helped lift industrial investment well beyond the level which would be needed if it focused solely on the domestic market. And it’s been aided by a key competitive advantage on the global stage: cheap labor. The end result has been that China has been able to suppress domestic demand and pour resources into investment.
The reason why this export-led model is unsustainable is that China now produces so many goods that the rest of the world cannot possibly absorb them all. China’s gotten to big for its own good, in crude terms.
When the 2008 financial crisis hit, Chinese exports plummeted and the limits of the model became apparent. However, China cushioned the blow by implementing massive stimulus measures. In effect, it sunk even more money into investments, such as infrastructure, property and factories. The problem to this day is there hasn’t been the end-demand for these investments. In other words, export demand has remained soft and domestic demand for goods hasn’t been able to pick up the slack.
And a bigger problem is that the much of the investments via the stimulus were debt-financed, principally to state-owned firms. These firms were deemed less risky by banks.
That’s created an issue for small firms which haven’t had access to bank financing. Given reduced export and domestic demand, they’ve had to resort to financing from outside the banks, the so-called shadow banking system. They’ve had to pay much higher interest rates as a consequence. And it’s widely known that the collateral used for non-bank financing is less-than-solid, on average.
As you may be able to see from the above, the export-led model which China has used over the past 30 years is running into a dead-end. What the new leadership is now trying to do is transition the economy towards more domestic consumption, so that it can perhaps make up for the drop-off in export growth.
The history of transitions from export-led models doesn’t make for pretty reading. These transitions, for Japan in 1973 and South Korea in 1991, led to sharp slowdowns in economic growth, as seen in the chart below.
Lastly, faith in the new leadership to deliver a successful transition appears misplaced. As noted above, we think Xi Jinping is the right leader to steer the country for the next decade. And many of his proposed reforms have merit and should help in re-balancing the economy.
However, the fact is that China has hemmed itself into a corner where there are limited solutions in the near-term. Cut back on credit-driven investment and GDP falls sharply. Keep the party going and risk a larger blow-up in the not-too-distant future. Moreover, the bulls conveniently downplay that implementation of structural reforms would be a net-negative for growth in the short run.
As for the argument that China can always use its foreign exchange (forex) reserves to provide further stimulus to prop up the economy, the people who purport this have little knowledge of basic economics.
If China were to use substantial forex reserves in this way, it would become a large net-seller of U.S. Treasury bonds. To prevent a spike in interest rates, the U.S. central bank would have to significantly step up purchases, funded ultimately by private citizens savings. Less of these savings would dampen U.S. consumption and ultimately, Chinese exports to the US. In other words, a move by China to substantially cut forex reserves would not only be a disaster for the developed world but for China itself.
Are recent events a tipping point?
If you agree that China’s current economic model is unsustainable and that any transition away from it will be difficult, the question then becomes, ‘when might a more serious downturn occur’. The short answer is that no one really knows. But recent events are beginning to show severe stresses in the economy. Perhaps a sign of things to come.
First, it’s clear that China is trying to keep the investment boom going to aid GDP growth. Though overall credit growth has slowed somewhat, it’s still likely to be up 20% in 2020. That’s much higher than nominal GDP.
The continuing credit binge is why property prices in China have remained strong, even though many have seen a bubble in this space for several years.
The problem is that the credit boom is resulting in less bang for the proverbial buck (or yuan in this case). Recent manufacturing surveys have shown a slowdown.
In addition, there are warning signs of serious stresses in the banking system. Two episodes of spiking inter-bank rates (where banks lend to each other) over the past six months suggest a very fragile credit system. With both, the central bank had to inject money to keep credit flowing, otherwise it would have risked skyrocketing inter-bank rates, resulting in a wave of defaults across the country. There is only so long bad debts from bad investments can be rolled over and covered up though.
Also, there has been widespread corporate credit distress. Coal miner Liansheng Resources Group, has made recent headlines, ending up in court for owing almost US$5 billion. China Everbright Bank has also belatedly admitted to a US$1 billion default on a loan back in June (coinciding with the first spike in inter-bank rates). There are many other rumours of Chinese corporates in trouble. This is hardly surprising with debt/income among corporates at 5x and total corporate debt to GDP being 125%.
In sum, you have still abundant credit-driven investment, but slowing economic output, softening inflation, inter-bank system ructions and corporate debt troubles. Hardly signs of a healthy economy.
Best ways to bet against China
If you agree that China’s economy is in serious trouble, the next question is which markets, sectors or companies are most vulnerable? The fall-out from a China downturn would be enormous and widespread, but here is a list of things which appear most susceptible were this to happen (our favourite shorts in order of preference):
1) Australian banks. Mining contributed 50% of Australian GDP growth in 2020 and that’s set to slow sharply. A China downturn would send that contribution into negative figures and that’s a big deal when mining contributes about 9% to GDP. The Aussie banks are exposed to this slowdown, are among the most expensive banks in the developed world and have huge exposure to a mammoth property bubble which has ironically been driven by Chinese buyers of late. Commonwealth Bank Of Australia., (CBA) is the most expensive bank in Australia and probably the most short-able.
2) China property developers. Given the risks to the bursting of the investment bubble, the good times for property developers are unlikely to last. State-owned China Resources Land (HK: 1109) appears one of the most at risk.
3) The Chinese yuan (vs USD). This will surprise many people given the yuan strength in 2020. However, the yuan is overvalued in my view and highly vulnerable to a downturn in the economy. Moreover, there’s the added issue of yen depreciation which has to provoke a reaction from other prominent exporters, such as China, at some point.
4) Fortescue Metals. This Australian iron-ore miner is near 52-week highs as the price of iron ore has recovered nicely. But iron ore and steel are highly vulnerable to a China downturn in investment. Fortescue Metals Group Ltd, (FMG) isn’t cheap, has high leverage and is therefore probably the best short in the iron ore space.
5) The Aussie dollar. Yes, the AUD has pulled back a long way already. This could well be a market signal of trouble in China, by the way. But whichever metric you use, the Aussie remains overvalued and would end up much lower should a China downturn eventuate. The Australian central bank talking down the currency is an additional negative factor.
You’ll probably notice that the list doesn’t include large parts of the Chinese stock market. Keep in mind though that this market (Shanghai Composite) is already down more than 60% from their 2007 peak. This market has signaled trouble in China ever since 2008, but too few have paid attention. Put simply, much is now priced into Chinese stocks. There may be a strong case for the potential inclusion of some of China’s second tier banks though as they’re the most vulnerable in the financial sector to a downturn.
AC Speed Read
– There are many signs that China’s economy is in serious trouble.
– The signs include still booming credit growth but lower growth, softening inflation, spiking inter-bank rates indicating stresses in the financial system, as well as large corporate defaults and bankruptcies.
– These things combined have increased the odds of a more severe China economic downturn this year.
– The best ways to bet on a China crash include shorting the following: Australian banks, China property stocks, the Chinese yuan and iron ore miners such as Fortescue Metals.
A Guide to Understanding Opportunities and Risks in Futures Trading
Basic Trading Strategies
Dozens of different strategies and variations of strategies are employed by futures traders in pursuit of speculative profits. Here are brief descriptions and illustrations of the most basic strategies.
Buying (Going Long) to Profit from an Expected Price Increase
Someone expecting the price of a particular commodity to increase over a given period of time can seek to profit by buying futures contracts. If correct in forecasting the direction and timing of the price change, the futures contract can be sold later for the higher price, thereby yielding a profit. If the price declines rather than increases, the trade will result in a loss. Because of leverage, losses as well as gains may be larger than the initial margin deposit.
For example, assume it’s now January. The July crude oil futures price is presently quoted at $15 a barrel and over the coming month you expect the price to increase. You decide to deposit the required initial margin of $2,000 and buy one July crude oil futures contract. Further assume that by April the July crude oil futures price has risen to $16 a barrel and you decide to take your profit by selling. Since each contract is for 1,000 barrels, your $1 a barrel profit would be $1,000 less transaction costs.
|Price per barrel||Value of 1,000 barrel contract|
* For simplicity, examples do not take into account commissions and other transaction costs. These costs are important. You should be sure you understand them.
Suppose, instead, that rather than rising to $16 a barrel, the July crude oil price by April has declined to $14 and that, to avoid the possibility of further loss, you elect to sell the contract at that price. On the 1,000 barrel contract your loss would come to $1,000 plus transaction costs.
Note that if at any time the loss on the open position had reduced funds in your margin account to below the maintenance margin level, you would have received a margin call for whatever sum was needed to restore your account to the amount of the initial margin requirement.
Selling (Going Short) to Profit from an Expected Price Decrease
The only way going short to profit from an expected price decrease differs from going long to profit from an expected price increase is the sequence of the trades. Instead of first buying a futures contract, you first sell a futures contract. If, as you expect, the price does decline, a profit can be realized by later purchasing an offsetting futures contract at the lower price. The gain per unit will be the amount by which the purchase price is below the earlier selling price. Margin requirements for selling a futures contract are the same as for buying a futures contract, and daily profits or losses are credited or debited to the account in the same way.
For example, suppose it’s August and between now and year end you expect the overall level of stock prices to decline. The S&P 500 Stock Index is currently at 1200. You deposit an initial margin of $15,000 and sell one December S&P 500 futures contract at 1200. Each one point change in the index results in a $250 per contract profit or loss. A decline of 100 points by November would thus yield a profit, before transaction costs, of $25,000 in roughly three months time. A gain of this magnitude on less than a 10 percent change in the index level is an illustration of leverage working to your advantage.
Assume stock prices, as measured by the S&P 500, increase rather than decrease and by the time you decide to liquidate the position in November (by making an offsetting purchase), the index has risen to 1300, the outcome would be as follows:
A loss of this magnitude ($25,000, which is far in excess of your $15,000 initial margin deposit) on less than a 10 percent change in the index level is an illustration of leverage working to your disadvantage. It’s the other edge of the sword.
While most speculative futures transactions involve a simple purchase of futures contracts to profit from an expected price increase — or an equally simple sale to profit from an expected price decrease — numerous other possible strategies exist. Spreads are one example.
A spread involves buying one futures contract in one month and selling another futures contract in a different month. The purpose is to profit from an expected change in the relationship between the purchase price of one and the selling price of the other.
As an illustration, assume it’s now November, that the March wheat futures price is presently $3.50 a bushel and the May wheat futures price is presently $3.55 a bushel, a difference of 5¢. Your analysis of market conditions indicates that, over the next few months, the price difference between the two contracts should widen to become greater than 5¢. To profit if you are right, you could sell the March futures contract (the lower priced contract) and buy the May futures contract (the higher priced contract).
Assume time and events prove you right and that, by February, the March futures price has risen to $3.60 and the May futures price is $3.75, a difference of 15¢. By liquidating both contracts at this time, you can realize a net gain of 10¢ a bushel. Since each contract is 5,000 bushels, the net gain is $500.
Net gain 10¢ bushel
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Favor commodities whose spot prices is higher than the next nearby futures
Traders are likely to make more money in coming months from holding soybean futures than corn.
CHAPEL HILL, N.C. (MarketWatch) — Those of you interested in a commodity-trading strategy might consider betting on soybeans over corn in coming months.
That’s because the spot soybeans contract is trading for a higher price than comparable contracts expiring in the near future, while just the opposite situation prevails for corn. If these two commodities adhere to the historical pattern, a trader investing in soybean futures will beat the one in corn.
This greater profit would be realized when the contract you hold approaches expiration and you roll it over to the one whose expiration comes next. If that next contract is trading at a lower price, as currently is the case with soybeans, you pocket the difference as profit. But if that contract is trading at a higher price, your so-called “roll return” will be negative.
Sounds too easy, doesn’t it?
But, historically, roll return has been the source of almost all of the profits from investing in commodities, according to a study that appeared a decade ago in the Financial Analysts Journal: The Tactical and Strategic Value of Commodity Futures, by Campbell Harvey, a Duke University finance professor, and Claude Erb, a former commodities manager at fund manager TCW Group. (The two recently updated that study, with similar results.)
To illustrate the benefit of focusing on roll returns, the researchers constructed a hypothetical portfolio that, each month between July 1992 and May 2004, invested in the six commodities that were then trading most like soybeans is today and shorting the six most like corn currently. This portfolio’s return was 2.6 percentage points per year better than it would have been had it invested equally in all commodities.
Even better, this hypothetical portfolio was 23% less volatile, or risky, than the equally-weighted portfolio. As a result, its risk-adjusted performance was more than four times better.
To be sure, as Prof. Harvey stressed in a recent email, these results reflect an average over many years, and the roll return wasn’t always positive when investing in commodity futures similar to soybeans today (or negative for commodities similar to corn today). So there is no guarantee that you will do well by investing in soybean futures or that you will do better than if you had invested in corn futures.
Another qualification: The pattern the researchers documented applies primarily to futures contracts tied to real assets (such as grains and industrial metals) rather than to financial instruments (like stock market averages, currencies, and even gold). So focus on real assets if you want to try your hand in coming months at basing a commodity trading strategy on various commodities’ term structures.
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If you aren’t inclined to trade directly in commodity futures, an alternative is to invest in exchange-traded funds that themselves do so — such as the Tecurium Soybean Fund SOYB, -0.57% and the Tecorium Corn Fund CORN, +0.15% . One possible trade right now, for example, would be to invest in the soybean ETF while shorting an equal dollar amount of the corn ETF.
That hedge will make money even if soybeans go down, so long as they don’t fall as much as corn does.
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