China Equities -49% From Peak, But Still Adverse Risk/Reward

We continue to wait for the financial crisis to hit some of the Developing Markets before we'll be more comfortable fully rebalancing our somewhat underweight equity allocations. We see a crisis-of-confidence in some Developing Markets as just one of the signposts that it's safer to raise weightings significantly, but an important signpost.

We see China as the bellweather for our call, and we still see the risks somewhat outweighing reward for a 1-2 year time horizon. One the one hand, its economic dynamism continues in many regards, and its equity market has gotten a lot cheaper, nearly cut in half since its peak, and with P/Es in the low-20s for example. On the other hand, we worry about the effects of China's artificially weak currency, its inflation problem, its opaque financial statements, its immature banking system, its real estate bubble, and so on.

An insightful post by professor Michael Pettis at Peking University adds to our view that the economic slowdown that is spreading around the world could treat the Developing Markets more harshly than is generally believed. First, he details the spike in "hot money" flows to China, which will make it more difficult for China to keep its currency weak and its export machine well lubricated.

Second, Pettis describes why he thinks Chinese companies' financial conditions have deteriorated, perhaps more than the much-reduced equity markets discount. It gets to the heart of our reason for slowly raising our Developing Market weightings specifically, and equity weightings generally, following the selloff since the peak in '07:

• In [the 4/19 edition of the South China Morning Post, reporter Shirley Yam] wonders about the much-repeated claim among many of the mainland’s larger firms that “profits and profit margins have dropped because of raw material and fuel cost increases.”

  Displaying a journalist’s cynicism she decides to look at a number of companies to check to see if their margin declines have really been caused by commodity price increases or other factors over which managers have no control. “Is this the sole reason, or just a convenient excuse for inefficient management to pass the buck?” she asks. As she explains in her article,

  This is an increasingly relevant question given the global business environment has turned from deflationary to inflationary where raising costs is the norm. I read through the 2007 annual reports of 10 major state-owned enterprises. The results were disappointing.

  It turns out that the companies she examines have all seen distribution expenses, administrative costs and staff expenses shoot up much faster than revenues – two to eight times as fast. Rather than enjoy economies of scale they seem to be suffering massive diseconomies of scale.

  This kind of thing worries me not because I care about the how managers choose to spend and/or waste money. It worries me because boom times like the one we have enjoyed in China since 2003 often lead to rigidities and excesses in corporate activity and balance sheets that make it very difficult for them to survive sharp turndowns, and this is precisely one very common such type of rigidity.

  Corporate costs can grow much more rapidly than revenues while still allowing the company to show significant increases in net profits as long as revenues are surging, as they have been for Chinese companies in recent years. In case however of a slowdown and a decline in revenues, or at least a sharp reduction in revenue growth, it can take a long time for management to get rising costs under control. The result can be a collapse in cashflow, profitability, and perhaps creditworthiness.

  This is likely both to increase the risk of a sharp, adverse financial adjustment (as companies ability to withstand a downturn is seriously weakened) and to increase the adjustment cost if such a downturn takes place (deteriorating creditworthiness immediately increases financial distress costs and causes corporates to engage in systemically adverse behavior).

  Readers of my blog might easily accuse me of always focusing on the worst case scenario and always looking for problems. Perhaps that is because as a former bond trader I tend naturally to pessimism – after all bond prices tend to have limited upside and nearly unlimited downside, so it pays to worry about the downside more than the upside. But as someone who has experienced too many financial crises and who has written extensively about the history of capital flows and financial crises, I am also pretty sure that when things go wrong nearly everything goes wrong at the same time. This is not a coincidence. It is simply the way unstable balance sheets work, and during boom times companies tend systematically to build risky balance sheets – by, among other things, letting costs get out of control.