• Long term positive China on reform and liquidity.
• Medium term volatility from valuations and IPO issuance.

1. There are reasons to be optimistic about the Chinese economy in the long run due to structural reform. Current growth rates will slow but China is reorganizing itself to a more durable model.

   1. Political reform, notably the leaning away from rule of Party to rule of Law. The renewed importance of the Chinese constitution.

   2. Economic reform. Refinancing the local governments, lowering debt service costs. Rebalancing leverage away from over leveraged local governments and corporates towards households and central government.

   3. Financial market reform. The introduction of market discipline such as fewer bailouts and thus more use of the bankruptcy code.

1. The PBOC is in the midst of expansionary policy.

   1. QE lite via LTROs with muni bonds as HQLA collateral.

   2. Cutting interest rates

   3. Cutting RRR.

   4. General deregulation of the banking and savings industry.

   5. This will favor the banks.

1. The stock market has been very volatile.

   1. Valuations in parts of the market have overshot fundamentals.

   2. The market has simply run up too high.

   3. IPOs are sapping fund flows.

1. Not all parts of the market are overvalued.

   1. HSCEI is trading on 9.4X 2015 est earnings.

   2. SHCOMP is trading on 17.5X

   3. Shenzen is trading on 36.9X

   4. ChiNext is trading on 97.2X

Today we take a look at IPO activity.

1. Market capitalization is rising faster than SHCOMP due to the increased volume of IPOs.

2. June MTD China announced IPOs total over 75 billion USD (as at 26 June). This compares with an average of 27 billion per month for the last 12 months.

3. We estimate the 12 month cumulative IPO volume as a percentage of market capitalization in the second chart below*. IPO volume is definitely diverting capital away from the market.

Chart 1: Normalized Market Cap, SHCOMP and IPO issuance. 

Chart 2: IPOs as a percentage of Market Cap. 12 month moving sum.

When we buy an equity or a bond we buy a claim on a business but with differing payoffs, rights and obligations. The rational investor would first decide if the business in question was something they wanted to own before deciding on whether to own it through the equity or the debt. If indeed the business was attractive then the analysis would progress to which claim to buy, an analysis which would take into account the prospects for the business, the riskiness of the business and the available claims. The assessment would be made on a risk adjusted basis and not on the absolute attractiveness of the claim. I say this because if it was decided that the most senior claim was the right one, leverage could be used to scale the investment to the right size. If for example equity was the right claim but the investor was targeting a low risk, then a deleveraged position could be taken (that is pairing the position with cash).

We apply this methodology with the prices before us. Its really the best we can do. The methodology may well drive us to hold lots of cash for example if equity was the more attractive claim, yet our desired volatility was lower than the unlevered cash equity. In this case we would hold a deleveraged position, meaning a portfolio of positive cash and positive equity.

Current valuations are quite balanced. Looking at aggregates, equities are cheap compared with government bonds but they are fairly priced on a historical basis when compared with corporate bonds. The spread of investment grade corporates to treasuries is moderately attractive and at this point at least, a comparison of high yield to investment grade yields is equivocal.

The investment problem is that government bond yields are too depressed. Valuations made against government bonds are a risky practice since yields are likely to rise and could render reasonably priced assets expensive quite quickly.

It was low interest rates in 2003/2004 of 1% in the US, now a princely level, which saw the reach for yield in that decade which was sated by ratings arbitrage, necessary because institutional investors were constrained by ratings requirements. The ratings arbitrage resulted in clever constructs like CLOs and CDOs. Demand for yield drove demand for CLO origination which in turn drove demand for ABS and in particular RMBS origination to the point that the banks were more willing to lend than the homeowner was to borrow. This was the tipping point.

As we reach for yield today we should be aware of the balance of enthusiasm between lenders and borrowers. When lenders are more motivated to lend than borrowers are to borrow it is usually a sign of a credit bubble.

The behavior of the EUR may have been confusing. If we look at the daily volatility since the Greek situation began its crescendo we have seen the EUR weaken on good news (of a deal) and strengthen when there was bad news (of no deal.)

This is not so irrational. Notwithstanding any plan for retaining Greece within the Euro, Greece’s business model is not working. Current plans for reorganization from both creditors and debtor do not present Greece as a going concern. Therefore, retaining Greece in the Euro must be negative for the EUR and lead to weakness, while a Greek exit would remove a source of uncertainty, inefficiency and cost from the Eurozone which is positive for the EUR.

How rational are markets? We often expect markets to react to bad news badly, regardless of the underlying logic. Could this be a case where the market is being remarkably rational?

Analgesics are addictive. Since interest rates were deployed to manage the economic cycle we have seen the Fed Funds Target Rate decline, making lower lows and lower highs (1980, 1984, 1989, 1995, 2000, 2007) as the Fed has been repeatedly enlisted in the bailout of asset markets and the economy.

Now that a new policy tool has been invented it will doubtless be counted upon to support further crises and excesses. This is the nature of moral hazard. We cannot un-discover QE.

With Fed Funds at 0.25% there is no room for cutting it any further. We will be fortunate when the Fed finds itself in a position to reset its policy tool higher but should another crisis or recession occur, with Fed funds at these low levels, the Fed’s balance sheet can and will be deployed. While the balance sheet may shrink in the next 7 to 8 years, one can reasonably expect it to expand over a longer time frame.

If you were careful, responsible and diligent and didn’t overextend yourself buying that big apartment in the prime central area and the second apartment to rent out, but maintained a reasonable debt to income and debt to equity ratio, you did OK but you certainly didn’t do as well as the guy who bought bigger than he could afford, was less than candid on his loan application for his buy-to-let in prime central, levered himself to his eyeballs and got bailed out when central banks the world over cut rates and did whatever they possibly could to ensure that a free market selection process for weeding out imprudent risk takers was confounded and conservative and responsible investors were disadvantaged.

The interventions and bailouts were entirely unfair. The bailouts were sold to us by the governments that the investment banks had the world over a barrel and that Wall Street had Main Street as hostages and human shields.

And now we are told (in a Bloomberg article Jun 18, 2015) that As the Rich Bounce Back, the Middle Class Stays Stagnant.

When income and wealth inequality are moderate, there is less motivation to challenge the status quo. However, at some level of inequality, when the bottom half of the population by wealth ask themselves what the probability is that they and their children might progress to the top half through diligence and effort, and the answer is pretty low, then change may come.