Wednesday, April 26th, 2017

The Missing Piece of Chewing Gum

It was famously said of Gerald Ford, the 38th President of the United States, that he couldn’t fart and chew gum at the same time. There are occasions when financial markets show the same incapacity to multi-task, and this may be one of them. For the last month investors have obsessed about the French elections, what this means for globalisation, Brexit and the future of the euro. The result was important and we share the relief that various “nightmare” scenarios have been avoided. The danger is that they immediately switch to thinking about the prospect of a US tax reform extravaganza, without paying any attention to the rest of the world.This includes China, which we are concerned about for the following reasons:

1. Since the Chinese New Year holiday we have had no clear signal about the direction of Chinese equities. Our models show them improving relative to Chinese government bonds, but the probability curve keeps switching from convex to concave and the signal quality is consistently poor. Both suggest a lack of conviction from local investors. We normally get a clear signal one way or the other in the early part of their financial year, driven by the local government budget cycle.

2. The equity market and the currency are both trading in a very narrow range, which invites the suspicion that both are being managed more actively than usual. Neither on its own would be that unusual, but both together for an extended period suggests that the authorities may be concerned about something.

3. Compared to global equities we find that China is rated neutral and has not moved out of a very narrow range since the beginning of 2017. It is normally a significant under or overweight, or if it is neutral, it is in transition from one state to the other. We have just put Hong Kong onto the positive watch-list, but the link with China has become much weaker over the last two months.

4. Our equity sector model has Financials, the largest sector of the mainland market, ranked at #7, down from #1 at the beginning of January and #3 in the middle of March. Our leading indicator suggests that the sector has further to fall and at the current rate of progress we would downgrade to underweight sometime in May.

5. Although the UK mining sector does not depend exclusively on China, we would expect the major moves in both to be closely linked. Our recommendation for UK Materials relative to the UK index has gone from maximum overweight at the beginning of February to just above neutral now. At the current rate of change, we would expect to downgrade to neutral in the next two weeks.

We freely admit we do not have the killer chart which proves that China is either going to blow up or shoot the lights out. But by this stage of its financial year, we would normally have a good idea of where it was going and why, and the fact that we don’t makes us nervous. Superficially all is well. GDP for the first quarter has just come in above forecast. Low volatility should be good news. But in a year when emerging markets are outperforming, it should allow Chinese equities to do better than they are. How do we get investors to focus on the absence of a fart or a missing piece of chewing gum?

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