China again

Equity markets in Europe initially did not react well on Thursday to Janet Yellen’s comments, deliberate or otherwise, as to when we should expect the first US interest rate rise. It took US investors later in the day to restore some calm to equity and bond markets. 

Apart from US interest rates, the subject that continues to focus investors minds is the outlook for China. I was recently reminded by a friend and vastly experienced now semi retired fund manager, of some of the philosophies he based his career on: do not focus on the short term; have the confidence to swim against the tide; and not be swayed by the herd instinct. He agreed one has to be diligent with one’s investments, but do not overreact to newspaper headlines as that can often damage investment returns. One of his favourite quotes that has always stuck with me is “equities go up 70% of the time therefore an equity investor is by default right 70% of the time”, the problem for many is the 30% can be very painful, as 2008 proved. 

He went on to use China as an example, and investor’s current obsession with the moderating growth outlook for the region. He rightly pointed out that at some stage the growth would have slowed as the Chinese economy changed from being investment and export led, to consumer led. In his view, this is a natural progression and in the long term has to be positive for the overall global economy. 

Following the China theme, much is written about the state of shadow banking in China, and how investors are ignoring the risks. After last week’s corporate bond default, speculation has been increasing that the Chinese government are contemplating letting a small property developer go bankrupt. An analyst from Nomura was quoted in the Telegraph, in which he described how a default could lead to systemic crisis in the region. My immediate reaction to reading that was that asking a Japanese person for their views on China, is probably on par with asking a Scotsman his views cricket; you are unlikely to get a totally unbiased view. 

The best way to monitor the financial strain within an economy is to watch interbank rates and Credit default swaps. The interbank rate that most people are familiar with is the London interbank offered rate or LIBOR. In the case of China the one to watch is HIBOR (Hong Kong interbank offered rate). This represents the rate at which one bank charges another bank to lend it money, and the one most analysts focus on is the 3-month rate. For example, during the height of the Lehman crisis 3-month LIBOR rose from a few basis points to almost 400 basis points, The good news is that at present HIBOR has hardly moved from its long-term average. 

Credit defaults swaps are in effect the price a bank charges to insure on a bond default. Like any insurance policy the rate goes up if investors feel the likelihood of a default is rising. At present, as with the interbank rates, the Chinese CDS price is not showing any real signs of investors pricing in a higher default risk.

Posted on March 21, 2014 .