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Hong Kong, China and the new macro game

|By Matein Khalid| Hong Kong now trades at 9.6 times earnings and 0.86 book value. Hang Seng valuations were gutted by the protest movements in Central and the Shanghai financial meltdown. The Hang Seng index is down 25% since late May and now trades at six times forward earnings, its post Lehman, post 2014 bottom. Hong Kong trades at its lowest price/book value since the Asian flu in 1998. My favourite Hang Seng megacaps? HSBC at 60 HK or a near 6% dividend yield. China Mobile, a play on 4G/data ARPU. Hutchison Whampoa, the flagship listed vehicle of Asian zillionaire Li Ka-Shing. Kerry Properties, a property developer trading at a 60% discount to NAV. The “noble hong” Swire, parent of the Scottish taipans who own Cathay Pacific. Deng Xiaoping promised “one country, two systems” in Hong Kong, the financial golden goose of the PRC. Hong Kong is now on sale in the stock market. Remember my old motto. The big money is made when things go from Godawful to just plain awful.

As I expected, the Chinese yuan devaluation shock triggered a global financial panic whose epicenter was Shanghai but whose shock waves were felt from Wall Street to the desert money souks of the Arabian Gulf. What next in China? I believe the biggest credit bubble in human history (250% debt/GDP in a $10.4 trillion economy) will require a massive money and credit reflation in the Middle Kingdom.
After all, Chiang Kai Shek tried this in the late 1940’s and lost China to Mao’s peasant armies. Deng reflated China after Tiananmen Square Zhu Rongi/Jiang Xemin reflated after the 1998 Asian flu, as did Hu/Wen Jiabao after Lehman’s failure in 2008.
The Beijing put has proven impotent to stabilize a self created Shanghai stock market bubble. The myth of Politburo and State Council omnipotence has been cruelly shattered (10% GDP growth forever, Comrade Chopsticks, hiyaa! Chunghua Number One, Marxist Son of Heaven!).
If Chinese money supply surges as I expect, the yuan could well depreciate 20% against the US dollar in the next twelve months. China’s reserves have fallen by $600 billion, meaning the smart money is fleeing China. If I am right, this means China will drastically reduce its holdings of US Treasury bonds at the same time as does the Federal Reserve (end of QE) and Gulf petrodollar recycling funds ($40 oil and Saudi budget deficit at 20% of GDP). This means the world must wait for an ugly liquidity shock and bond market sell off as US Treasury yields soar at a time when junk (ok, let be polite, high yield and Third World sovereign) bonds are in deep distress.
This means debt deflation, a credit crunch, bank failures and epic volatility (think Chicago VIX at 50 – 60) in financial markets. August was just the appetizer, the main course is coming this autumn/winter. Please channel the ghost of Dr. Friedrich von Hayek and the Austrian School’s theories on real world credit cycles. The laws of credit destruction that once ruined Habsburg Vienna will wreak havoc on global risk assets in 2016. Cash is not just king in a financial panic, as we learnt last week, it is king of kings. The real risk in life, as in the markets, are the risk you never knew even existed, the black swans of Wall Street.
China credit/property/stock market/shadow (that is, Ponzi) banking system bubbles are blowing up in real time. A 1.9% yuan devaluation will do nothing to defuse such a monumental, irrational financial time bomb created by the Red Emperor’s mandarins in Beijing. Shanghai shares are down 40% since June, with margin debt that had risen 30 fold since summer 2014. This is China’s Black Monday, 1929 moment and its financial contagion will gut the world money markets, as Lehman/subprime did in 2008. Sadly, this time the wolf is here.
A Chinese devaluation makes a global equities bear market certain. Note Hang Kong, German Dax, Apple, Yahoo and Emaar have all fallen 20-30% since June. Coincidence? Absolutely not. The new macroeconomic cross-asset correlation equation. The new macro game.
I doubt if China will achieve 2%, let alone 7%, GDP growth next year. King Dollar will reign supreme and cast a malign deflation shadow on the world. I agree with Citigroup that crude oil could fall to $32 and even hit new post Lehman lows below $28. To rephrase Tallyrand, the yuan devaluation was worse than a crime. It was a mistake. Now the world will pay the price for the Politburo’s blunder.
Emerging markets currency devaluations never stop at 3-4%. Just ask the next Turkish, Brazilian, South African, Indian, Malaysian or Russian citizen you meet. I was calling currency markets to preserve my family’s wealth as a teenager in General Zia’s Pakistan. We are bred to play six dimensional macro financial chess on Planet Forex.
Market View – Strategy and value in European shares.
Last week was financial bungee jumping in Europe and global shares. It did not surprise me that Germany’s DAX index dropped 20% from its peak since its blue chips have 10% of their sales in China. Yet Italy’s MIB sales exposure to China is minimal but it was the ultimate “mamma mia” moment in the Milan Bolsa once the People’s Bank devalued the yuan. Norway exports almost nothing to China save herrings/salmon (0.6% China sales) but the Oslo’s OBX’s oil/shipping/tanker exposure led to its traumatic falls. Even Roche, the world’s finest oncology Big Pharma, slumped to 250 Swiss francs in Zurich. The message is unmistakable. European equities forecast an imminent recession. Yet the Euro Area Composite PMI was 54 in July. The oil crash is a windfall for the Old World (ex Vikings of Norsk) and Dottore Draghi’s monetary bazooka is firing live rounds.
For now, the plunge in Bund/OAT/gilt yields means no safe haven trade is in bond proxy utilities and consumer staples companies without an emerging markets footprint. Thus no Nestle. No Unilever. No Danone.
Volkswagen has fallen almost 15% and now trades not much above my 150 Euro target from two weeks ago. Investors will not be reassured by central bank easing in China as long as deflation risk looms. This is an eerie echo of Japan’s two lost decades, when the Nikkei Dow tanked from 40,000 in 1990 to 8000 on the eve of Shinzo Abe’s election in 2012.
Even at Euro Stoxx 360, I am reluctant to bottom fish in Europe since I believe we could well revisit “taper tantrum” levels near 280 – 300 in June 2013. Valuation metrics mean squat when EPS growth and ROE will begin to sag. The European equity risk premium has spiked to 8.2%, when Europe cannot, will not and has not avoided contagion from a China hard landing. In Frankfurt and Stockholm, the correction has morphed into Mercado Ursa, which is definitely not a mall on Jumeirah Beach Road in Dubai!
The Stoxx Europe now trades at 14 times earnings but consensus EPS growth is optically high. I am looking for cheap megacaps with fortress balance sheets, share buybacks and juicy dividends in property, media, Big Pharma, healthcare, software and insurance. European exporters have faced a double whammy since the Chinese yuan devaluation coincides with the mother of all short Euro covering trades. As risks spasms convulsed the financial markets, carry trades were unwound. The Euro was the ultimate funding currency since summer 2014, when Dr. Draghi exorcised the demons of the Bundesbank hard money zealots and I begged my friends and readers to short the Euro at 1.3650. So the world was short Euro when risk went ballistic – and the Euro spiked to 1.16, a bloodbath for European indices.
Ivan Boesky’s mantra was “greed is good”, mine is “angst is gut”. So, achtung baby, ich liebe the DAX, with its 8.5% equity risk premium and generous dividend yield. Surely there is value in Daimler AG at a 5.8% dividend yield and seven times earnings despite China risk at €65? Or Allianz at 135 Euros, Credit Suisse at 25 Swissie, Barclays at £245 and Lloyds at £75? I used to trade the DAX at a 10% premium to European equities before the 2010 Greek debt crisis. Now the DAX trades at a 24% discount. An obvious macro pair trade with Sweden at 16 times earnings.
Italian banking is a safe haven theme. I doubt if the money changers of Milan and Venice have lent to Asia since the time of Marco Polo. Italian banking can deliver 15 – 18% earnings growth and is a proxy for Matteo Renzi’s restructuring. MSCI Europe Financials now trades at 0.8 times book value though I concede the Old World bankers are uniquely gifted at destroying book value since the time of Lorenzo di Medici down to Marcel Ospel at UBS. Note Stan Chart has traded down below my short target to 748 pence. No interest, duckies, capital raise risk too great but HSBC is a steal at 500 pence, BNP at €48, ING at 12 gilders and Julius Baer at 45 CHF.
Currencies – The Canadian dollar collapse, recession and banking crisis risk
The Canadian dollar has now depreciated to 1.33 despite the short covering spike in the Euro and the People’s Bank of China rate cuts, (as if rate cuts and RRR tweaking means squat at a time when the Middle Kingdom grapples with deflation!). While Chinese equities, crude oil and the loonie rallied after the gnomes of Beijing rolled out their latest monetary stimulus, the grim reality is that this is no panacea to China’s credit/banking/property/equities bust in the coming decade.
The 3 MBD crude oil glut and Saudi Arabia’s refusal to respond to Iran/Algeria’s pleas for a OPEC “swing producer” cut tells me that Brent crude could well fall again to $40 a barrel, especially since refinery maintenance season cuts crude demand in October. Permian Basin and North Dakota shale oil drillers hedged with oil swaps at $80 – 90 crude last winter and breakeven marginal costs have fallen to $28. The Toronto money markets price in a 25 basis point cut in the next twelve months. This is entirely possible since Governor Poloz and the Bank of Canada are desperate to boost Canadian manufactured exports to offset the loss of crude oil earnings, 25% of exports.
This is the real reason the loonie, a classic petrocurrency like the Norwegian kroner and the Russian rouble (but not the pegged Saudi riyal!), fell to 11 year lows. This is the precise macro relationship, as well as Bank of Canada policy choices and relative US/Canuck interest rates spreads, that anchored my strategy call to short the Canadian dollar at 1.06 in mid 2014. This strategy call was a money gusher for so many friends of mine in the Gulf (snowbirds in the desert – the Gulf is the new Bahamas!) and, of course, the most exclusive golfing clubs in Montreal.
The loonie collapse, to me, is a ominous canary of global deflation risk, though Ontario/Quebec’s debt binge and an ultra-dovish central bank governor helped make this strategic trade idea such as a phenomenal success. It is only a matter of time before the Bank of Canada cuts rates again and even embraces unorthodox monetary policy. Political risk in Alberta and the Federal election in October are also loonie negative. The Canadian “technical recession” will only deepen this fall. I expect a China hard landing and at least another 10% fall in the yuan. This is a disaster for the loonie since the PRC is Canada’s second largest trading partner. If oil prices fall to $32 as Citi predicts, the Canadian dollar could fall to 1990’s lows near 1.45. It is insane to bottom fish in the Canadian dollar.
US money centre banks were the darlings of Wall Street in 2015, with Citigroup, J.P. Morgan, Bank of America and even Goldman Sachs scaling all time highs. Then came the China yuan shock, Armageddon in global equities, a plunge in US Treasury yields on safe haven flows, hedge fund unwinding, post earnings profit taking and margins calls on leveraged speculators. Every interest rate sensitive bank on Wall Street was shredded as former US Treasury Secretary Larry Summers even called on the Yellen Fed to ease, not tighten.
Despite the tightest labour market in a generation and post crisis highs in auto sales/housing starts/credit card debt, the Fed cannot ignore the vicious cycle of 25 year correlation highs between crude oil’s free fall, King Dollar, Shanghai/Shenzehn, Asian/emerging markets currencies and epic volatility on Wall Street. To use Fedspeak, I can think Janet Yellen is “one and done” this autumn, with China and low inflation break evens as her rationale.
What will be the impact of mining/energy credit risk on Canadian banks, viewed with good reason as among the stablest credits in the Western world? Not benign! The Fed Funds futures in the Chicago Merc price in a February rate hike now. US Treasury two ten forward swaps have plunged to 250 basis now. The world again learns the hard way that the yield curve flattens in times of systemic stress and a spike in the Chicago Volatility Index. This makes Alberta/BC/Saskatchewan boonie banks (regionals) and Canadian life insurers are a no no for investors.
Written by

Mr. Matein Khalid serves as Head of Capital Markets and Advisor to the Chairman at Bin Zayed Group LLC. Mr. Khalid serves as the Chief Investment Officer of Salama. He manages Bin Zayed's global equities portfolios in the US, Russia, Latin America, Europe and the Far East. He is responsible for the Bin Zayed's hedge funds / private equities portfolios and external fund manager selection. He also advises the Chairman and board on investment banking relationships, financing and new issues in the international debt markets and merger/acquisition deal flow. Mr. Khalid has 20 years experience in the international capital markets and has worked with investment banks, private banks and securities firms in New York, London, Chicago, Geneva, Abu Dhabi and Dubai. He is an adjunct professor of banking and finance at the American College of Dubai, where he is also a member of the Board of Directors. Mr. Khalid writes on global financial markets and Middle East studies for newspapers and magazines in the UAE, Bahrain, Oman, Qatar and the United States. He has also taught courses on capital markets at J.P. Morgan Chase, (New York), SP Jain and Emirates Institute of Banking (Dubai). He has also taught at capital market seminars at Morgan Stanley (London), Chase Manhattan Bank (Geneva) and Barclays Capital (Hong Kong). Mr. Khalid has briefed ASEAN finance ministers and ultra high net worth investors in Hong Kong at the invitation of the chairman of Barclays Capital. He holds an MBA in finance and BS in Economics from the Wharton Business School and a BA/MA in international relations from the University of Pennsylvania in the US.