China : separating myth from reality.

The secular growth of China is one of the most significant themes for investors around the world. Some believe Asian economic fundamentals are stronger and more stable than they have been for years. This is fuelled by the remarkable changes in China, the re-awakening of Japan and an increasing amount of intra-regional trade.

Clearly China continues to operate in an environment of strong GDP growth, low inflation and easy monetary policy. The government continues to implement reforms and restructuring in order to boost corporate efficiency and the A-share market. The upward pressure on the Renminbi remains and this is supportive of continuing foreign exchange flows in the Hong Kong-China financial markets.

We’ve interviewed Bo Hong, senior PM at Horizon Capital, a Hong Kong based long/short equity hedge fund that invests in greater China to help us separate myth from reality.

Variance Capital Management: You’ve always stated investors should be watchful of investing in China simply basing themselves on the strength of headline growth numbers. Does that still hold true?

Bo Hong: Absolutely. Stock markets value companies future cash flow or earnings streams not the pace at which the underlying economy is growing. That certainly holds true for greater China. Profitless growth is never rewarded by capital markets and if you look closely at performance of Asian markets over the past two decades we’re almost at the same levels we were in the late 80s. Cyclical markets can correct very quickly as profitability tends to disappears as soon as new entrants with access to cheap capital start chipping away at existing company’s newly expanded margins.

VCM: Is competition and oversupply getting worse at the present stage in China?

BH: It’s not getting better that’s for sure. It appears most central banks are behind the curve and whilst the pace of GDP growth in China and the rest of the world is showing no signs of abating, monetary policy is still very accommodative. As long as borrowing costs stay low oversupply will be an issue. On the other hand, the demand side of the equation is stronger as global demand growth for Chinese products is still very healthy.

VCM: For some the outlook for Asian markets is so promising they believe the financial imbalances in the US economy are much more serious than any potential threat posed to investors in Asia. In particular, investors should embrace the cyclical nature of the Chinese economy to benefit from the strengthening economic environment. Do you agree with this?

BH: It’s hard for me to agree with such a statement. Let’s not forget America is China Inc’s largest customer. Common sense dictates that anyone (may it be a company or a country) who’s largest client is in difficulty will have difficulty surviving without them. Both economies are so intertwined at present that Chinese markets will be directly affected by any events that affect the US consumer.

VCM: The Chinese markets have outperformed most other Asian markets year-to-date. Do you think this is sustainable?

BH: Firstly it appears there was a bit of catching up to do after last year. Chinese markets were flat overall in ’05 after a blistering year for Japan, India and so forth. Bargain hunting led some global investors to look at attractively priced Chinese companies. That was at the beginning of the year and it appears now Chinese equity markets are a little ahead of themselves. Through this past month the impact of the weaker dollar on Asian equity markets was becoming increasingly apparent. Markets with pegged exchange rate regimes continue to outperform markets with dirty float regimes. Last year Americans were exporting potential rate hikes to China and countries with independent central banks had stronger markets. Now it seems to be the other way around.

For now though continued expectation of further currency revaluation and consequent capital inflows are helping sustain historically low interest rates. As a result, China’s yield curve remains significantly below that of the US in spite of the currency peg. China is the last major economy not faced with the prospect of continued monetary tightening. Most markets with independent central banks are suffering this year whilst  This dynamic will continue to support China’s economic expansion as well as its capital market, even while risk is taken off in other similar markets.  

VCM: Do you feel the recent emergence of hedge funds focused either on individual country markets, to take advantage of the investment opportunities presented there, or utilizing different investment strategies such as relative value or distressed debt, are a clear sign of the growing liquidity and depth of Asian markets?

BH: Liquidity is a very fickle animal in Asia. A US stock listed on a US market has a multitude of players interested in it at any one time both on the long and the short side. It finds its equilibrium as it balances out the buy and sell orders from arbitragers, long only funds, dedicated short managers and a myriad of other strategies. In Asia, liquidity is unidirectional. Every one comes in at once when the markets are “hot” and move out at once when they turn. When investors are buying, it may give the impression that markets are liquid, but don’t be fooled, it’s only one sided. It is sometimes very difficult to take the opposing view. Japan is obviously the exception to this.

Furthermore, it is still hard to short some Asian companies. Borrowing costs can sometimes be high especially the very smallest companies, with a degree of transparency which varies compared to the Western World.

VCM: Last year you were monitoring the situation in Washington quite closely as pressure was mounting for the Chinese to revalue their currency. Clearly a currency revaluation would trigger a near term rally in the Chinese stock markets. Do you still think this is imminent?

BH: The ravaluation of the Renmimbi is off the table for a while. It has become a political question which has a lot more to do with events in the Middle East rather than the growing US deficits. The US needs China to reign in Mahmoud Ahmadinejad in Iran and prevent the country from developing its nuclear program. America needs Chinese help to keep the pressure on Tehran and won’t compromise their effort by pushing currency reform at the same time. The US government’s primary responsibility is towards its citizens on national security issues. The economy, although important will have to take a backseat for now.

VCM: In conclusion, how do you feel you should position your fund to add value?

BH: At a time when the global economy is red hot, it is hard for people to realize that economic growth has little or no correlation with changes in equity values in Asia, even though it is indisputably empirically true. At Horizon capital, abundance and efficiency never quite excite us, but scarcity and constraints do.

In this, we believe one of the few ways a red hot global economy, as we are in today, can possibly translate in rising equity value, is that it is most conducive to creating disequilibrium for specific industry and sectors by disrupting previously stable economic relationships along supply chains. While we have not renamed ourselves as “the Horizon bottle-neck fund”, we are increasingly focused on these out of whack relationships as exciting investment opportunities. By appearing inconsistent with common intuition, they represent great opportunities to catch the market by surprise. We live in a period when a US cent could soon become worth less than the zinc it’s made of. What if sugar prices moved higher than cookies from the same mass?

Precisely because the red hot economy has done so much to destabilize economic relationships and that the world’s Central Banks are so reluctant to abandon a gradualism that has lost its context, great wealth will be created and destroyed under these dynamic changes, all happening seemingly by stealth. Surprise! Economic growth may be good for investors in Asia, for once, after all.

Russia : a buying opportunity.

Liquidity into emerging markets funds has achieved records since the beginning of the year. Given the Gazprom rebalancing at the beginning of the year, a large part of these funds seemed to be flowing to Russia. Until recently, Russia was this year's best performing Emerging Market and Gazprom trading daily volume continues to stay around 50m shares, translating into USD 400-500m trading value a day. These past two weeks have showed what can happen to emerging markets though if managers decide to withdraw their funds on a large scale. Russian equity markets are down 10% for the month (clawing back from 25% at the bottom), though still up 31.6% for the year as foreign investors have sold the asset class on the back of increased risk aversion. Mattias Westman of Prosperity Capital Management, a Moscow-based long only fund manager, who invests primarily in Russia would argue this is a buying opportunity. Russian markets should decouple from other emerging markets over time as the fundamental story takes hold.

We stated in a past Variance Capital newsletter that the tightening of EM spreads in recent years has been mainly caused by the search for yields. As the disinflation process continues apace, the nominal yield on US Treasuries, Bunds and JGBs has fallen to post-war lows. Many investors with quasi-fixed liabilities such as pension funds and life insurance companies were forced to accept higher risk. At the same time, the world has been awash with dollar liquidity, the flip side of the huge and growing US balance on current account deficits much of which ended up in emerging markets and improved their credit quality. This in turn made it easier for institutional investors in the OECD countries to look further a field for investment opportunities. Russia has clearly benefited from this but it’s important to scratch beyond the surface.

“Compared to other emerging markets Russian fundamentals remain extremely strong” claims Westman from Prosperity Capital and adds “Russia’s currency reserves are such that the currency will remain stable even if the trade surplus diminishes on a mid-term horizon. The oil and commodity prices explosion has resulted in a huge balance of trade surplus and strong upward pressure on the rouble. To prevent this, there have been large-scale interventions and as a result reserves have risen above US$200Bln. Foreign assets far exceed foreign liabilities by now and thanks to Russia’s currency reserves the country enjoys unmatched financial stability among EM . At the same time, domestic liquidity has grown at high rates protecting its capital markets over time.”

With the budget is balanced at $30/bbl oil and progressive taxation starting at $27/bbl on crude exports, the country has a significant downside cushion even if commodity prices decline. Expenditures are growing but look to grow only at the same rate as GDP. It’s also worth noting that by the end of this year Russia will be the 10^th largest country by GDP, overtaking Canada. “Russia’s fundamental story is about the transformation of its economy both in the oil&gas sector but also in other industries. As a matter of fact, by now the country’s fastest growing companies aren’t in oil&gas. Transformation is evident in other regions and industries” claims Westman. “Productivity gains are evident everywhere because legacy assets are still highly undermanaged. Thanks to restructuring and consolidation the oil industries has moved from 40 to 50 companies and independent refineries at the time of privatization to only 5 oil majors today and we think now this happening across a number of industries”.

Domestic growth story is also gathering pace as retail and financial services are experiencing a boom at present. “In 2002 a new Russian pension system, based on the Swedish funded system, was launched and has been gaining traction ever since ” opines Westman and adds “2% of employees salaries is now going into funded pension pillar and legislator envision increasing it to 4%. Beneficiaries are already able to choose their asset managers, including private one, and by 2012 the total assets in the pillar could constitute over $100Bln. Not only will the financial services industry directly benefit from this but this new class of institutional investors will also drive capital markets from equity markets to mortgages.”

“Regarding the equity markets and taking into account the recent correction, blue -chips now look attractive compared to their intrinsic value. Momentum buying has increased this year due to Russia’s added weight in indices. On other hand, the most value is to be had in the emerging mid-cap space where growth and productivity gains are the strongest.” opines Westman and concludes “Russia has one of the strongest macro stories around and we strongly believe investors should see current corrections as buying opportunities as it decouples from other emerging markets.”  

May : a perfect storm for CTAs.

In the past 2 years several fund of funds have tried to protect their portfolios through traditionally uncorrelated strategies i.e. CTAs or trend followers. Unfortunately, this choice has contributed to most of the volatility in the portfolios without bringing about any real benefits.

The bulls on the strategy claim empirical data shows long term, trend following strategies act as highly valuable tools to protect a portfolio of hedge funds. Their source of return varies from most other strategies as they’ve been very good in the past at extracting value out of shocks in the markets.

Then there’s the whole commodities argument. The 20 year bear market in commodities created severe disruptions in supply which could only raise prices as emerging markets grew. In order to benefit from this expected long term up trend some FoF managers privileged an allocation to commodities in their portfolios through long term CTA programs. According to the bulls, global inflation in commodities is characterized by periods of up and down trends and trend followers are their preferred instruments as they can potentially be profitable in both trends.



Unfortunately, this benefit doesn’t hold true anymore. In today’s choppy markets where reversals are fast and loose and trends last for shorter periods of time, LT trend following strategies have failed to give the necessary diversification benefits. From a purely a priori standpoint it makes sense that a strategy that enters the market after breakouts and periods of price stabilization would have difficulty acting as a hedge.  “Many multi-frequency managers have a global average holding period of 4 weeks, meaning that most of these programs wouldn't be able to catch a sharp 1 week reversal (e.g. in base metals). They would rather reduce their positions and wait for the establishment of a new trend. It's true that CTAs have historically provided good decorrelation in difficult equity markets (Aug 98, Sep 01) but it seems that in these cases, the programs were already positioned on the short side before the event (i.e. they didn't switch their positions on the back of the event but increased their short positions) claims an investor in London who follows the strategy closely and adds “According to me, this has led (based on biased/blind quantitative analysis) to the belief that CTAs have an insurance/long vol. characteristic. I would rather consider CTAs as a very efficient way to capture medium term market trends agnostically, regardless of their direction.”

May of this year and April of ’04 are cases in point. From my research, diversified CTAs were, on average, down between -1% and -6% for the current month. The programs suffered from the sharp reversals in the equity indices and base metal markets where they had long positions. Given their multi-frequency trading style, they have significantly reduced these long positions but have not reversed them yet (low frequency models are still generating long signals which have offset the shorts signals coming from the high frequency models). Programs have significantly reduced their margin to equity ratios to conservative levels. Long positions in base metals, energy and equity markets have nevertheless accounted for the bulk of the gains for trend following programs so far in 2006.

On the other hand, high frequency programs did relatively better in May as they could reduce their losing positions much faster (no long signals coming from the low frequency models) and even switch some of them.

Interestingly enough this incapacity of LT trend followers to anticipate inflection points coincides with low rates and the world wide surge in liquidity. This has led to high levels of correlation between markets where the slightest bit of inflation data in the States will trigger a meltdown in EM, commodities, equities and bonds. Based on daily numbers, this correlatetion is nowhere more evident than in the futures market. This makes it more and more difficult for programs using daily data to reach a good level of diversification (this point has actually been observed in several programs over the last 2 years). Short term trading managers believe the only remaining way to achieve diversification at the portfolio level (until the next convergence) is to use intra-day trading models based on tick data.

“Maybe for those who still strongly believe in LT trend following strategies their best bet is to focus on managers who try and anticipate future moves a la Global Macro” opines Valere Costello of Invesdex in Bermuda. Depending on the sophistication of the models, this "anticipation" would have to be very backward looking though (e.g. crossing moving averages) or need to react to a market move (e.g. break out systems). More complex models would assess the likelihood of the trend's direction (e.g. this probability would be the output of a multi-variable function (moving averages, current length of the trend, historical distribution, volatility, skew, kurtosis...) and will give a risk allocation according to it - any unclear signal would lead top very small positions.

“Only a few models are based on trend reversal anticipation. Some contrarian programs do that (e.g. Fort Contrarian) although  I don't see any systematic CTA increasing its positions before the move happens. That's probably why some like to allocate to discretionary CTAs” claims an investor in the UK.