Running off the rather positive news smattering by Bloomberg yesterday, here comes perhaps the biggest one.
US ETF’s look massively primed to pounce on the Hong Kong-Shanghai Stock Connect, and that is even without considering what the vanilla equity managers are set to do. This position is obviously hard to analyze – no real funds are committed to anything and the data is rather hard to get at, but the sentiment is all the clearer. To be honest, I had not really considered the global access to Hong Kong before, and means of using that as a “back door” to Chinese equities after the Stock Connect goes live.
Think the Alibaba IPO made a splash in markets? Well look at this kind of like (a much smaller and slower) IPO of China! If there are large block trades and early trade cutoffs due to bumping up against the RMB 23.5 billion (US$3.8 billion) daily quota, then the “Continuing Global Offering” can largely be considered a success. The block trade data will be significant since it indicates whether bigger traders are involved. These traders may or may not be buying up larger equity chunks to distribute them to others, either in direct funds or in dissecting the chunks and distributing them to their clients. For reference, the quota would mean that it would take more than two months of trading to move a net cash flow large enough to cover Alibaba’s market value at launch, and three months to cover their market value at the end of day one!
What then are the likely effects and data I will be looking out for?
The first thing is block trade nature. Second comes internal Hong Kong market turnover, tightly followed by volatility. Spikes and increases are of course expected, but just how the market will develop afterwards is a little bit like looking at a sum of several Bessel functions about long enough to get an idea of the initial slope: you know that it’s gonna be a big splash, you know that there’s gonna be a lot of weaving back-and-forth, but where you’ll ultimately end up after 2nd and 3rd order effects are in play is anyone’s guess… (More wave-propagation function applications in finance please!) Over the long term, it will be interesting to see if there is any P/E ratio development over both the markets in their entirety: the HSI and the SHCOMP are both valued rather poorly on a P/E basis, so absolute values and direct comparisons will be really interesting.
Currency- and economic effects in Hong Kong:
On top of this is a development I expect to start becoming active in the week leading up to the Stock Connect activation – right when the Fourth Plenum of the CCCPC is held – strains on the Hong Kong money supply, with particular care given to the changes in Closing Aggregate Balances. This would possibly cause new money to flow in to Hong Kong, with the hope of transiting through to China or being held in Hong Kong against asset claims on Chinese equities, either way implying that a lot of cash flow and a lot of commissions are gained in Hong Kong, perking up the economy but also forcing the HKMA to defend the currency peg. They would do this by going in and pushing more cash into the banking system via the closing aggregate balances and thereby create a two-front inflation hit. Keep in mind that while the US$ has been super strong against all other currencies as of late, the HK$ has been trading in the strongest HK cent range for a multiple-majority of 2014, and the last time it wasn’t in the strongest two HK cent range was in late 2011! Here’s a chart to jog your memory:
So the HK$ is trading strong, despite slowdown fears in China, worries about protests, and through the different vagaries of the Hang Seng Index. I do expect rather heavy duty work for the HKMA in pumping in money in to defend the peg given these outlooks, and therefore, (given the analysis under the link to the closing aggregate balances post) that the market could really go up significantly. This is especially true if the Fourth Plenum is clearing the way for reforms that might actually diminish the need to retrain corporate profits, but I wouldn’t bank on it. In the mean time, I will be pretty confident in my gambling sector shorts and use the money to better effect in the Hong Kong financial industry (HKEx, please return my love?), or by placing the money in major Mainland China-exposure stocks like Tencent, alternatively hitting both at the same time (BOC HK or ICBC International, anyone?).
Short-term, I think this might really give a jolt to the Hong Kong PPPC values as it will represent two shots of fresh money actually being dumped into the economy and put to circulation to a higher degree than currency appreciation. Will this be enough of a bribe to make Hong Kong accept whatever leadership it has and any interference in their affairs by Beijing? I doubt it, but perhaps people won’t be in widespread protests on the streets if there is PPPC YoY growth in the range of 4-6%.
Chinese capital market effects:
If this “CGO” goes well, according to what is considered well by IPO standards, there should be a few things happening:
- Diminished resistance for cross-border investment structures, which could hopefully allow more open private equity- and venture capital cash inflow into China, through Hong Kong.
- More equity market financing in China (subject to regulations), knowing that there is an equity demand and a larger pool of liquidity being able to trade the contracts.
- Additional power to Xi Jinping to drive economic reforms.
- Released pressure on corporate loans meaning less of a crowding-out factor that might actually direct some capital to LGFV’s in China, reducing capital strains locally.
- General capital market development, allowing:
- funds to build size and get to the point where accepting more funds won’t derail the stock market.
- bond markets to hopefully grow as well, now that there are more things to do with the RMB’s gotten through trade or other ways than putting them into a RQFII program investment of bonds. This would be the “holy grail” of capital market developments as it would thus allow more of the Chinese markets to open up smoothly, while allowing for greater currency circulation and lesser controls.
Rosy, isn’t it? Well, this is all if the “CGO” is smooth. Crackdowns, large nonperforming loans, spread defaults, or other reason for strains in the effective liability structure (both on and off the balance sheets!) in China could really delay this. As any current watcher of Japanese developments could tell you, lack of economic reform could easily leave the market with morning-after re-evaluation of the prospects, and that isn’t a nice feeling.
Word of advice to willing investors:
I think I need to tell you this. Especially if you’re reading from the US, but a lot of Europeans and possibly Japanese (as of late) need to look at this. The perspective I’ll try to imprint on you is that which naturally follows after answering the question: how highly does China, the CCP or Xi Jinping value equity investors?
Disregarding the knee-jerk reaction that “It’s a communist country that wants to steal your money and distribute it to the people in theory and steal it for the cronies on top in practice”, China will probably look at the equity market in the same way that they have in the last decade: “Nice to have but we ran out of paper putting more important things on our priority list.”
- China doesn’t have large pension- or insurance funds that stand and fall with the markets, least of all the equity markets. No-one fares poorly who didn’t go in being really prepared or really stupid. The equity markets in China go down and the number of people being pitied is somewhere between zero and nought.
- Benefits to shareholders, the average Chinese, the Chinese banks, or local governments? “Hmm, one group is speculating with disposable income, the other is wanting improvements in wealth through costly reforms or will cause unrest, another is financing our companies to the tune of US$15 trillion and the final one is the very base of our power and more-or-less our debt anyway? It’s a really tough call. Still, I clearly know who isn’t getting money.”
- Relative sizes of capital: US$15 trillion vs. US$4 trillion. ‘Nuff said.
China has a view of the economy that I kinda admire, for however much it goes against economic thinking in the west: “If it is systemically important, we will be there and shore it up if it so costs us a pound of flesh. Most likely we don’t have to since we already control these things anyway.” Banks and how they have been handled in the last ten years is a really good reference here, but the question is whether China can structurally sustain another massive stimulus package, 2008-style. (Most bets seem to be on “no” here, so contrarians have their work cut out for them.)
The reality is then that China evaluates you, the equity investor, according to your place in the capital structure. And China evaluates the capital structure rather similarly to what a credit ratings agency should do: “Equity capital is nice to have for the companies, but I really only care as long as it covers risks well enough that debt- and bondholders need not worry. If anything is done to improve the equity payout at the cost of creditworthiness someone knows they’ll have a stern talking-to.”
If you haven’t gotten it already that means you are at the very bottom, below the area of the list of priorities that fits on paper.