Re-assessing China Risks (Part One)
Re-assessing China Risks (Part One)
Zero covid risk is gone, but what about the rest?
I am Qi Wang, CEO of MegaTrust Investment (HK), a boutique China fund manager based in Shanghai and Hong Kong. Total 25 years of experience in Chinese and global equities. This is my blog for MegaTrust clients and professional investors.
While it’s good that the zero covid policy is over, most of the China risks from last year continue into 2023, with no signs of improvement. This is echoed by Hong Kong market’s roller coaster ride year-to-date.
Regarding zero covid, we did not know this as a real risk until April 2022 (in hindsight). And no one, really no one thought the Hang Seng Index would touch below 15,000 last year (14,687 on October 31, 2022).
Now in March 2023, I wonder what new surprises we’ll get this year. It’s important to assess the key risks thoroughly before thinking about the opportunities.
Is China Risk Lower Now than Last Year?
Not necessarily.
Heading into the New Year, the consensus view was that 2023 should be better than 2022 for China. This was my thinking also two months ago, mainly because the biggest risk - the zero covid policy - was removed.
However, every other risk still stands in 2023. Plus new risks on the horizon…
The Fed Mood Swing
Here is my summary of Wall Street’s views on the U.S. economy, inflation and interest rates. Very soon ChatGPT can do a better job than me digging through all 533 pages of reports. What the heck? ChatGPT can easily write some of the lukewarm reports itself.
Currently, most expect the Fed to raise rates to around 5% by mid-2023, and hold it there. Others expect the Fed to continue raising rates in the second half. There’ve been wild swings between these two views recently.
For example, the market was elated in early February when the Fed replaced the word “pace” of rate hikes with “extent” of rate increases. This was viewed as a “slightly dovish” sign by investors. In less than a month however, the market took roughly the same statements as hawkish and panicked. Nasdaq had an intra-month drawdown of more than 7% in February because of the mood swings.
Two monks were arguing about the flag in front of a temple. One said: "The flag is moving." The other said: "The wind is moving." The Sixth Patriarch happened to be passing by. He said: "Not the wind, not the flag. Your mind is moving."
Zen story from 7th Century A.D.
I’ll say the Fed is largely consistent with its policy statements. Not much change here. It’s neither the Fed nor the data moving so much. It’s the investor mindset that’s changing. This is not so much a Fed mood swing as a market mood swing!
Here is a new model to think about. It’s neither the FOMC policy nor the macro news that moves the market today. It’s the market that decides on a certain path itself and looks at the data points selectively to reinforce the direction. In this respect, the market can be extremely short-sighted and volatile.
What does this mean? Even if you have perfect foresight to the Fed’s future policy roadmap, you could still lose money trading the market. Because it’s not always obvious how the market will react, what’s priced and what’s not…
How do we deal with this increasingly random walk? First, don’t try to outsmart or outmaneuver the market. There is nothing wrong going with the flow sometimes. Second, don’t over-complicate things. If your strategy is based on a path dependent chain of Fed rate actions, you are taking a lot of uncontrollable risks. Allow more flexibility and simplicity in your strategy. Third, look for mismatch in long-term expectations and find investment / trading opportunities from there. This is more art than science.
For example, apart from the mood swings, I think the market vastly underestimates the length of this interest rate up cycle. Too many analysts focus on whether the rate will rise by 25 bps or 50 bps next month. Not enough stress tests and scenario analyses on what happens if 5% interest rate persists for one to two years. How about another three to five years?
A 5% interest rate may seem high in today’s context. But 5.4% is the historical average of the Fed Funds Rate since the 1970’s. Just the average not the ceiling. Don’t you think we need to prepare for at least an “average” scenario for a prolonged period?
I don’t think the U.S. stock market has priced in over one year of 5% interest rates (and the dismal economy being implied here). This is the long-term expectation game I just mentioned. Rate hikes may last longer than expected, which means the U.S. stock valuation will be compressed, and any market rally will be short-lived.
The situation is somewhat better for Chinese equities (China A-shares), as China is in an interest rate down cycle and there are more room to cut.
The Good Old U.S.-China Relations
We’ve been deceived by Biden and Xi. From their G20 meeting last November, we thought the U.S.-China relations may have plateaued, i.e. stopped deteriorating. Right after G20, there were unconfirmed talks of Bliken visiting China and a possible trip by Xi to the U.S. This is clearly not happening.
On second thought, perhaps neither Biden nor Xi tricked us. This is also a case that neither the flag nor the wind is moving, but our mind has changed. In hindsight, it was wishful thinking that the U.S.-China risk could be mitigated.
The balloon incident was not the real trigger, in my view, but a symptom of an unhealthy and distrustful U.S.-China relationship. Certain faction of the U.S. government already had a certain outcome in mind and used the balloon as an excuse, I think. Just like what I suggested earlier: the stock market took the Fed data points selectively to reinforce a pre-formed view. Go figure.
On the U.S.-China relations, we’ll host our research partner CFRA/Washginton Analysis in Hong Kong next week. As a MegaTrust client or a paid subscriber to Daily Reflection on China, you are welcome to join our private meeting or group lunch on March 8 (only one seat left for the lunch). Just email me here (qi.wang@megatrust.com.hk) if you are interested.
For context, Washington Analysis (WA) is a U.S. policy research firm based in Washington D.C. We did a U.S.-China relations webinar back in December 2022 when WA correctly predicted the U.S. sanctions on China’s next generation DNA sequencing technology and the related company BGI. New sanctions on BGI were announced just days ago… In addition, the U.S. Congress’ scrutiny on the U.S. investments in Chinese technology is also high on our agenda.
We will provide a written summary of the Washington Analysis meetings in Hong Kong at the end of next week. To be continued…
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