John Authers

There’s More Than Ukraine. How About a China Pivot?

I have a problem. Nothing matters to the short-term future of markets more than the situation in Ukraine. Another “risk-off” exodus from stocks to bonds as the news bleakened in Thursday’s trading makes that clear. My problem is that I don’t know what’s going to happen next there. Neither does anyone else (with the possible exception of Vladimir Putin.) Beyond suggesting that this isn’t a great time to take any big new positions in investments that are exposed to the situation, I don’t have much to say.

So here are some observations on issues that are likely to persist whatever transpires on the Ukrainian border.

The last few months have seen a dramatic pivot toward a more aggressive and hawkish monetary policy by a range of western central banks. Is it possible that the People’s Bank of China is in the course of turning in the opposite direction?

That is the contention of Iain Cunningham, a portfolio manager with asset management group Ninety One, who says that Chinese policy makers “pivoted” in late 2021, and scarcely anyone noticed. To be specific:

In November last year the People’s Bank of China’s third quarter monetary policy deleted three key phrases that were in prior reports:

the valve of money supply will be properly controlled
refraining from adopting indiscriminate credit stimulus measures
maintaining implementing normal monetary policy.
The removal of these hawkish statements opened the door for easing in 2022.

This week Yi Gang, the PBoC’s governor, appeared to back this argument in comments to a central banking conference. The case for a more lenient policy is bolstered, in the mind of many investors, by the ongoing problems for real estate finance. The difficulties of China Evergrande Group have left the headlines of late, for good reason. But real estate-backed high yield bonds are falling again. Their collapse, following a decade of liquidity-fueled expansion, has been spectacular.

However, there are arguments against this. China has been anxious for years to find a way to deflate its credit bubble without causing a Lehman-style disaster. It’s possible they actually mean it when they say that their policy is biased toward stability. And actions to date don’t suggest an actual pivot. Mike Howell of CrossBorder Capital in London, who I cited earlier this week, points out that there is no sign as yet of any new liquidity, once you look through the usual distortions in Chinese data caused by the Lunar New Year celebrations.

Judged by deeds rather than words, then, China seems to be still preoccupied by the task of getting its credit in order and avoiding a crisis. That at least is Howell’s contention. He said:

We have argued persistently for many months against the hope that China is about to undertake a massive policy stimulus. It is simply not going to happen, as it did in the past. “Stability” is the new watchword. The PBoC operated a relatively tight monetary stance last year and so far shows no signs of changing that in 2022.

The PBoC might ease a little, on this analysis, but it won’t throw caution to the wind and deliberately inflate a new bubble, as it did in response to Lehman in 2008.

Even if this is right, and China continues to be relatively conservative, there’s still a case for Chinese investments. Simply put, the country’s equities have crashed out of favor in the last year. This is how MSCI’s China index has performed relative to the rest of the emerging markets over the last five years, in common currency terms.

We all know why China is out of favor. The clampdown on the private sector, the worsening relationship with the West, suspicions that the “zero-Covid” policy is turning into a lead weight, and the situation in Hong Kong add up to a powerful list of bear points. Even bulls on China like Cunningham accept that the picture for growth is cloudy. He said:

Yes, Chinese growth is likely to weaken further in the coming quarters but increasing action by policy makers adds to the likelihood that risk markets can look through any such domestic weakness, all else being equal. Obvious external risks to Asian markets remain in the form of extended developed market asset valuations and our expectation for faster than expected Federal Reserve tightening.

But these risks are arguably in the price. Risk premia is elevated in China and the broader Asian market, sentiment is depressed, and policy change will likely lead to a more constructive future macro and market backdrop.

Ukraine understandably monopolizes attention for now. But the chances are that everyone’s eyes will be glued to China again before long. Particularly if the PBoC does decide to get dovish, it could change the calculus for the rest of global markets, and also provide a buying opportunity in Chinese stocks for those who can stomach the governance issues.

Another trend that appears to be Ukraine-proof is the sudden ascendancy of cheap stocks. Generally when times are tough, investors look for shelter in value stocks, but they’re most concerned to find quality — companies with resilient balance sheets and reliable profitability. This time around, cheapness seems to be all that investors want. Meanwhile, there’s a revolt against expensiveness.

Patrick Palfrey of Credit Suisse Group AG illustrates this nicely. This is how the S&P 500 and the MSCI EAFE have performed so far this year, along with the performance of the most and least expensive stocks by trailing price/earnings ratio.

Moreover, value still seems to offer value. The gap between the P/Es of the most and least expensive stocks has narrowed, but remains considerably wider than the historical norm.

Meanwhile, the historical evidence is that growth stocks are a bad place to hide in a major crash. For those who are jittery, growth must seem particularly unappealing. The following numbers are from James Monroe of Investment Metrics, and show the relative performance of a range of growth factors during the Black Monday crash of 1987, the bursting of the tech bubble in 2000, the Great Financial Crisis, and the Covid selloff two years ago — which is revealed to be an extreme outlier.

It’s hard to see growth stocks recover while anxiety about Ukraine, and about the Federal Reserve, remain high. And to give an idea of the market vengeance wreaked on growth stocks that aren’t cheap, this is what has happened to the market values of Meta Platforms Inc. and Cathie Wood’s ARK Innovation ETF since the market hit bottom during the first Covid shutdown.

There is ample chance for growth companies to recover, of course. But their market value is unlikely to do so until calm returns.