To every China bear alive, this year’s outperformance in mainland Chinese equities (known as the A-shares) is a complete fluke. It’s only a matter of time for the correction.
President Trump’s announcement via Twitter on Sunday that a trade truce extension was in order due to progress in recent trade meetings gave the long-China traders a reason to pat themselves on the backs. Wall Street largely made the right call on China this year. Consensus was for tariffs not to go from 10% to 25% on March 1, as the hawks in the Trump cabinet had threatened.
Besides that 60-day extension, there are three things that have turned the A-shares into the most overbought emerging market around.
A Stronger China Currency
Part of the recent negotiations between Washington and Beijing includes some sort of foreign exchange agreement. That agreement has China promising not to let its currency weaken too much against the dollar.
It is easy to argue that this is a set up. Washington doesn’t want China to tap into one of its greatest weapons to avoid the extra costs associated with tariffs — foreign exchange rates. A weaker renminbi could make tariffs moot as Made in China becomes cheaper due to the currency variable.
But if China holds to its promise, and the renminbi strengthens, this totally pulls the rug out from under the short-sellers who have been waiting for a 7-to-1 exchange rate for over a year. They closest they came was Oct. 1. The currency settled at 6.97 to the dollar. It’s now 6.68.
“Investors often assume that a higher renminbi exchange rate would be a sacrifice or a problem for Chinese policymakers, one made in order to secure a trade agreement with the U.S.,” says Hans Redeker, global head of forex strategy for Morgan Stanley.
Redeker thinks that a stronger renminbi is better for China because it gives the locals more spending power, increasing imports, and helping to turn China into the consumer-led growth market everyone expects it to be.
“China may be willing to accept a stronger renminbi,” Redeker says. “It may even promote it as it would help in rebalancing the economy. We must ask if a U.S.-China forex accord is in the cards,” he says.
A stronger renminbi could mean a weaker dollar compared to a basket of other major currencies, too. Trump also likes a weaker dollar because it means U.S. exporters can compete with other countries on pricing.
More generally, now that Trump has agreed to extend the ceasefire, close China watchers think that Robert Lighthizer, the U.S. Trade Representative, can’t be too happy with this. Another two-month extension just gives China more time and Trump’s contemporary Xi Jinping has more time left in office than Trump has.
“Any ultimate deal will still run into issues around enforcement,” says Nick Marro, China analyst for The Economist Intelligence Unit. “That has been a problem that has plagued the bilateral relationship, including under Obama, owing in part to the degree to which these structural issues are embedded in China’s policy framework. This is unlikely to change even if we do see some type of deal later on, particularly because the credibility of the U.S. appetite for punitive trade actions may now be in question.”
Worth noting, if Trump does not bring in Democratic party hawks on China, namely House Speaker Nancy Pelosi and Senate Minority Leader Chuck Schumer on a final trade deal, as he hinted he would, then there is the risk that the president sees China as his issue and his issue alone. That could mean that Trump and the Republicans do not see the Democrats as being concerned about China and will make the 2020 election more about a referendum on him, and domestic issues rather than foreign policy. If so, any “win” is a “win” for Trump, even if that means a few billion more in sales of American soy, chicken, pork and cotton to the Chinese.
Xi Jinping can take a sigh of relief if that is the case.
More A-Shares In The MSCI
MSCI will announce more mainland Chinese equities to be added to its MSCI China A Inclusion Index on Thursday, which has a free float market cap of $745 billion. Some fund trackers are estimating between $70 billion and $125 billion of fresh active and passive inflows into Shanghai and Shenzhen listed companies this year. Any fund benchmarked to that index will be buyers, even if they go underweight.
Foreign ownership is estimated to reach around 10% of China’s A-Shares versus around 2.5% today.
Brendan Ahern, CIO of KraneShares, thinks the inclusion factor will be raised from 2018’s 5% to 15% on Thursday.
MSCI is adding 235 Chinese companies to the index over time.
“I also believe they will add ChiNext stocks in 2019 and mid-caps in 2020,” he says about China’s version of the tech-heavy Nasdaq Index. By adding ChiNext stocks and mid-caps, it would potentially make the MSCI China different than the CSI-300, which is what the Deutsche X-Trackers China A-Shares (ASHR) ETF currently tracks. That’s the main China A-shares ETF in the market right now.
One mainland broker said the rally might have legs as retail investors come back in after sitting out 2018. Moreover, anyone in Hong Kong that has been short the renminbi and thinks its time to give up on that play have used renminbi to buy Shanghai and Shenzhen listed shares yesterday.
The near-term is positive for China’s A-shares. Global investor positioning in mainland Chinese equities is neutral at best.
Richard Turnill, a strategist for BlackRock, thinks the addition of more Chinese companies in the MSCI could “quadruple the weighting of A-shares in its emerging markets equity index to nearly 3% from 0.7%.”
The ongoing unwinding of negative sentiment on China means that value isn’t as big as it was in late 2018.
More China Stimulus
China is still stimulating its economy. Credit is on the rise.
The Securities Association of China has reached out to its members on cutting fees and taxes which led to a significant rally in financial services stocks listed in the mainland. The Peoples Bank of China released their quarterly report last week that shows further bank reserve requirement ratio cuts are coming, allowing for targeted stimulus versus a broad interest rate cut.
There is increasing anticipation that China’s stimulus trickle down effect is occurring. Wall Street has been clamoring for more spending in China and they are getting it. Banks are finding companies to lend to.
Where are we now?
China got its trade truce. To get it, they said they will spend $30 billion on American agriculture imports, which means around 40% more of what they imported last year. This could be unrealistic.
They also got China to agree not to weaken the renminbi.
China is unlikely to move further on intellectual property, having already changed laws to protect those rights. It is unclear what else the U.S. wants them to do on that as China is unlikely to allow for past grievances to be filed in a Chinese court.
MSCI’s inclusion numbers have always driven up A-share prices and interest in Chinese stocks. It is always a short-lived rally.
Stimulus can only go so far as Xi has stated that he does not want to overstimulate. He remains tough on real estate, a favorite money dump for the Chinese, and wants to keep the provinces from revving up the shadow banking engines.
“There are no specific details about China’s concessions on U.S. demands,” says Ed Mills, public policy analyst at Raymond James. Key among the signals they are watching for is how these agreements and promises are enforced.
Washington has been skeptical of China’s follow-through on key items, and would need to deliver on those items before the threat of 25% tariffs is removed.
Until Lighthizer gives up on Trump, and his like-minded colleague Peter Navarro follows suit, China faces a doubling of tariffs now by May 1.
Trump doesn’t want memoranda of understandings. He wants a trade deal, something he considers to be more enforceable. A trade deal could include Pelosi and Schumer.
Investors will be watching for some sort of agreement during the Trump-Xi meeting in Florida next month. That meeting has not been scheduled yet.
“We appear to be heading towards the home stretch,” says Mills. Developments over the next several weeks will be crucial as markets figure out how much longer this lasts. Even if tariffs did double, at least by then investors would be able to get down to business of picking the winners and losers. Markets would crash for a while, then move on.
Right now, the trade war has markets in limbo. Even if the A-shares are signaling the end is near.