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Podcast: We need to talk about China

5 June 2018

Michael Power reflects on how much longer an emerging markets index can continue to embrace, as its core weight, a country that within a decade may well have the world’s largest economy.



Lindsay Williams: Michael Power is an Investment Strategist at Investec Asset Management in Cape Town and Michael Power has penned a power piece on emerging markets and also, with specific reference to China, a piece called “We need to talk about China”. Michael Power is on the telephone now. Why do we need to talk about China, Michael?

Michael Power: Well, it’s the dragon in the room, if not the elephant in the room. We are now seeing its weighting in the MSCI EM Index upgraded because of the admission of the A-shares. I say the admission of the A-shares – they are coming in at an initial weight of 2.5% of their market cap, going up to 5% in September. 

Were all the A-shares to be accepted as is at the moment, that would increase China’s weight in the index to 42% and, given that there is a lot of Asia that basically dances to the Chinese rhythm, we are now seeing a situation where emerging market fund investment is, by and large, Asian fund investment, with a few decorations around the edges from the rest of the world, which is why I think we need to speak about China because we are now heading for a situation whereby, within eight years, China will probably be the world’s largest economy and is MSCI EM telling us that they are still going to classify it as an emerging market even if it is the largest economy in the world?

It is already the second largest market cap in the world and at the end of last year, of the 16 largest Asian companies, including Japan, 13 out of 16 were Chinese.  Only Samsung, Toyota and Taiwan Semiconductor made the cut.  So we are now in a situation where China really is waking up in terms of its size and the system that reflects the measurement of that is just not growing fast enough to accommodate it.

Lindsay Williams: Okay. The way you introduce your “We need to talk about China” piece, you say the following: “In the past, the investor would have been broadly right to call the end of any emerging market party by monitoring the twin tides of US dollar liquidity and the mineral commodity price cycles. If one of these two tides was ebbing – the US dollar appreciating, mineral prices falling – the emerging market party would likely be drawing to a close. If both were receding, the party would almost certainly be over.” Are they both receding?

Michael Power: Yes, they are but the party isn’t necessarily over because Asia itself isn’t necessarily a hostage to those two tides. In fact, Asia is increasingly, as I say later in the article, becoming part of the tide itself and the point is that we are now moving out of a stage where emerging markets was really a hostage to dollar liquidity and commodity prices to something completely different.

Lindsay Williams: When you penned this article, obviously what has happened over the last 48 hours in emerging markets and in developed world markets, so-called developed world markets, European markets, United States market wasn’t apparent yet.  I mean the manifestation of the market moves wasn’t there but the groundwork had been done. Have you been surprised by the last two days and what do you think has caused the last two days?

Michael Power: No, I haven’t been surprised. In fact, I have been calling for this event for some time now and I do regard Italy as the Achilles heel of Europe and, indeed, the Eurozone. I think, obviously, the exact timing and event sequence that we have experienced over the last few days has probably caught all of us unaware but the underlying reality of Italy is that it is an accident waiting to happen. Its debt to GDP ratio is 135%. It is 10 times the size of Greece in terms of economic size. Its debt is 7 times that of Greece. It has unfunded pension liabilities of 350%.

It is the largest bond market in Europe, larger than Germany, France or Britain, fourth largest in the world and it has basically got, by the grace of Draghi over the last seven years/six years keeping interest rates at unbelievably low levels and buying up Italian government bonds, into the ECB balance sheet. The total purchases, not just Italy but all of the south basically, is 2.3 trillion euros now, on top of which there is a backdoor mechanism by which Germany has been supporting the south through something called Target2 and that has some 444 billion euros. It has gone Italy’s way.

So it is only a matter of time that when liquidity started to dry up and interest rates started to edge up that, unless the underlying fundamentals of Italy have solidly improved, which I do not believe they have, they were basically going to be – as Warren Buffet always says, when the tide goes out, they are going to be caught swimming naked.

Lindsay Williams: Yes, indeed. Certainly, they are not naked but they are in their underwear at the moment. Is this just an excuse for the markets to say to themselves well, I need something to justify a selling-off or do you think this is a real situation, far, far 'realer' (if that’s a word) than Greece was all those years ago?

Michael Power: I think it’s the latter. I think that in any case markets were coming towards the end. We saw yield curves were flattening. We see the DX (Dollar Index) has started to get stronger again. There were other events taking place (Argentina, Turkey) that were not directly connected to this but I think that what is happening in Italy in the moment, obviously brought on by its own political cycle, is hastening the process by which the economic cycle that we have all enjoyed since basically 2008 is now running into, I think, 107 quarters of expansion and, you know, we are now – sorry, 107 months of expansion – we are now at the end of that.  We are in the second longest expansion since World War 2 and it was only a matter of time before that, in the normal course of cycles, came to an end. I think this event in Italy is essentially bringing that all about very quickly.

Lindsay Williams: Where does China fit in with what we are seeing in Italy and what we are seeing on the world’s markets, not just equity markets but also capital markets, which is another interesting story because I notice that the US ten year is in the low 2.80’s now where it was 3.10 plus just seven or eight trading days ago?

Michael Power: I think what has happened is that everyone will be affected, China included, but China will probably be least affected or affected by the buffeting that we are all going to face in the next few months and, when we are out of this on the other side come 2020 or whenever, China’s relative position will have jumped up even further. By my estimation, we are only eight years away from China overtaking the United States to become the largest economy in the world and maybe this whole experience we are about to go through over a couple of years will speed up that process. I don’t see China as being unaffected by this but I don’t see it in any way being knocked over.

Lindsay Williams: What do you mean by experience? Please put it in black and white for a layman like myself. Have the last two days been a precursor to something more meaningful and more lengthy?

Michael Power: Yeah, look, the name of the game at the moment is a giant game of chicken between the optimists and pessimists as to when the next downturn/ recession is coming, with the optimists (who generally look at the world through American glasses) holding out for 2020 and the pessimists (who are increasingly looking at the world through Japanese or European glasses) now calling 2019. It is only a question of probably an argument over six months as to who is right.
So the thing that I am suggesting at the moment – that events like Italy and possibly Turkey, Argentina and various other possible accidents that could happen could pull the timeframe closer towards the pessimistics’ perspective. So we could see something happening, like a recession, in 2019.

Lindsay Williams: I spent a very lazy Saturday afternoon a couple of weeks ago watching a film called “The Perfect Storm” with George Clooney and Mark Wahlberg I think.  This little boat kept on rising above these giant waves that were buffeting it, etc., and at one stage the skies cleared and you thought they were going to get back with their load of tuna or whatever fish they were catching and then suddenly the storm came back again and this massive wave, in the end, got them. Is this a massive wave now and is the little boat, with George Clooney as its skipper, the emerging market world?

Michael Power: Gosh, I like the analogy but I don’t like the implications. Look, I think that this could be a rather – I think if Italy is – and we are just talking about the Italian boat here – I mean Italy is facing some sort of reckoning in the next few years.  It hasn’t seen its wages rise since 2000. The size of the economy hasn’t risen since 2000. Productivity is bad. Demographics are the worst in Europe; unfunded pension liability at 350% of GDP; bad debt ratios in the banks around 20%.

You know, there is a lot in Italy that needs to be tidied up and I don’t think it is going to be done, to be perfectly honest, within the confines of the Euro. As much as I think that in abstract it is probably a good thing for them to stay within the Eurozone, I think that this could just break the structure and I am not sure how much the northerners, who truly found it very difficult to bail out Greece, are going to look towards Italy and say: can we bail out Italy? The Financial Times summarised it by saying that Italy was too big to fail and too big to bail, which I don’t quite know what the consequences of that combination is.

Lindsay Williams: South Africa, where do we fit in?

Michael Power: Probably a makeweight in the emerging market fraternity. South Africa is often what I call a bad news overweight, which means that, unless it is somehow precipitating the problem itself, it, generally speaking, doesn’t do so badly on a relative basis in a downturn like this. However, that doesn’t mean that it doesn’t suffer on an absolute basis. It will come down but perhaps not as much as some of the others that are even more exposed than we are.

Lindsay Williams: Are you a little bit scared, Michael Power?

Michael Power: Not if I look at the world as a whole. Not if I look at the world that includes China and emerging Asia and, indeed, India. No but, if I just put on my western glasses, yes, I probably am.

Lindsay Williams: Fascinating stuff and intriguing and also a little bit scary to me anyway. Michael Power, thank you very much for your time this evening. That is Michael Power, Investment Strategist at Investec Asset Management [sometimes] in Cape Town. 


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