China: The Emerging Markets Haven
The S&P China 500 is down 28.5% since January 26,1 an ugly and quick plunge that fits the common definition of a bear market. Who in their right mind would use “haven” in the same sentence as “China?”
We will, in context.
Compared to cash in a Zurich vault, no, Chinese equities are not even close to a haven. But is the Chinese equity market a haven compared to other nations in the emerging world? We hypothesize yes.
The Fragile Five
Part of the market's focus in 2018—and maybe 2019 too—is the so-called “Fragile Five” current account deficit nations: Brazil, Indonesia, India, Turkey and South Africa (the “BIITS”). Brazil has recently caught a rally in sentiment amid hopes that recently elected Jair Bolsonaro will implement free market economic reforms, but nevertheless, it is still one of the five countries watched like a hawk by market observers.
In Getting More Defensive in European Portfolios, we discussed the effect the Turkish debt crisis may have on its neighbors, particularly Europe and its banks. Along with Argentina, Turkey is at the top of the crisis malaise leaderboard, courtesy of a burgeoning hard currency debt load and runaway inflation that exceeds the state’s 24.5% official number. Its deep 6.3% current account deficit gauge of two-way capital flows is the icing on the cake.2
It is that latter metric -- the current account -- that is the primary reason the BIITS currencies came under pressure, although there are other factors. For example, South Africa’s expropriation of Afrikaner farms raises serious questions about general property rights in a country whose stock market has a history of state-mandated equity redistribution.
Which takes us back to China. Five-year credit default swaps, which gauge the cost of insuring against default by Beijing, pale in comparison to those of other emerging market sovereigns. For good reason. While it costs $384,000 per year to insure $10mm of hard currency 5-year Turkish debt, the price for covering Chinese exposure is just $72,000.
Beijing is no Bern or Oslo, but then again it also isn't facing down instability like many other emerging markets. From a risk-of-not-getting-paid-on-your-bonds perspective, China is one of those in-between countries— not the most stable, but nevertheless a veritable haven in the context of some of these other governments.
Figure 1: Five-Year Sovereign Credit Default Swaps (CDS) Prices, Emerging Nations
Figure 2 summarizes some of the risk drivers befalling the nations viewed as most risky by the credit default swaps market.
Figure 2: Market Concerns, Six Focal Nations
Beyond the already mentioned trouble-spot nations, embattled Russia is hit with sanctions for both the Crimean and Ukrainian invasions and the Salisbury poisoning, which involved the brazen use of a military-grade nerve agent on British soil. Then there is Russia’s support for the al-Assad regime in Syria, which, by the way, is in opposition to the U.S.-Saudi alliance.
As for Indonesia, the country had to tighten monetary policy this summer in an attempt to stave off the rupiah’s waterfall decline to levels last seen in the Asian contagion of the 1990s.
Mexico has long suffered from trade war headlines but now that the new trade deal with Washington was agreed, the risk is morphing into the very real concern that Andrés Manuel López Obrador (“Amlo”) will choose the Venezuelan or Cuban route instead of, say, the Chilean one.
China: The Relative Haven?
China is, of course not without warts. Coastal housing prices are in runaway territory, with cities like Shanghai witnessing home price-to-income levels that would make New York City blush. Then there is the Trump and Xi chest thumping, with North Korea smiling, stage left. However, we question how, even if all $619 billion of Chinese exports to the U.S. completely disappeared, it warrants sending the equities of China's $16.1 trillion economy3 into bear territory.
At this time next year, we suspect the market will still question South Africa’s property laws and Turkey’s debt serviceability. But China, a current account surplus nation, may be in a different place, a place where WisdomTree no longer feels alone in the darkness, wondering why so few investors even know about its massive tax code overhaul.
The South China Morning Post, Hong Kong’s paper of record, said this on August 27, in direct parallel with our Gipper Comes to China research note:
Ernst & Young estimates that changes in exemptions and tax brackets – including raising the monthly tax exemption allowance by 40 per cent to CNY5,000 per month – would trim the monthly burden of a taxpayer with a gross monthly wage of CNY60,000 by 16 per cent, to CNY11,006.
Individuals at lower income levels will fare better. Someone with a CNY10,000 monthly salary will see their tax bill slashed by 71 per cent to CNY115.
-Xie Yu, South China Morning Post (Hong Kong)
In CAD Terms
Look at the last sentence of the passage and convert CNY to CAD. Someone who makes $22,586 per would see a tax cut of $636. Tell us: what would happen to U.S. or Canadian retail sales or local stock markets if Trudeau or Trump started cutting tax liabilities on Wal-Mart-equivalent income by more than $600 per head?
In other words, while many countries may be dealing with debt issues or social unrest in 2019, it is quite possible that the images from China will be of packed shopping malls.
China is the haven in emerging markets, with an unappreciated upside catalyst poised to click when the market shifts focus from trade wars to tax reform.
Our TSX-listed WisdomTree ICBCCS S&P China 500 Index ETF (CHNA.B) is based on the S&P China 500 Index CAD, so it can be used as a solo holding to cover the whole country.
1Source: Bloomberg, through 10/30/18, in CAD.
2Source: Consumer price inflation from the Turkish Statistical Institute, as of 9/30/2018. Current account from Bloomberg, as of Q2/2018.
3Sources: Exports by Customs General Administration PRC, as of 9/31/18. GDP by the World Bank, with all figures in CAD