The Art of War

 

By Barry Lau, Managing Partner & CIO (Private Investments)
August 2018

 

"All warfare is based on deception.”

“If your enemy is superior, evade him.”

“If angry, irritate him. Anger his general and confuse him. Pretend inferiority and encourage his arrogance.”

 

Wise words from a military sage some 2500 years ago.

Not so long ago, back in 2009, different schools of thoughts have emerged in relation to the skewed outcome of QE post GFC. Our view has been that market should be laissez-faire. Intervention would skew asset prices. Unwinding thereof is unprecedented. It's a bit of a gamble and not surprisingly the market has been volatile. Back in 2010, we discussed in one of our newsletters the possibility of a game of chickens, a full-blown currency war on the horizon which never really happened. That said, our analysis was not completely erroneous, large scale depreciation of several G7 currencies have been observed. The contingency impact of Turkish Lira is sending EM currencies all over the place in recent weeks. As recently as last Friday 17 August 2018, Venezuela's proposed peg of their currency to their petro-cryptocurrency would imply a forthcoming 96% depreciation causing shelves in supermarkets across the country to be ransacked and gas stations emptied.

Closer to home, the CNY has continued to weaken; CNYUSD is approaching the 2016 low of 0.144. This weakness is largely the result of the trade war. From the tug of war relating to the currencies, it appears the US is winning. Certainly, that's what President Trump perceives to be the case. His opinion is not misplaced with solid results coming in from the economy at large, low unemployment rate (since 1998, the US added 300k manufacturing jobs on a trailing 12-month basis), equity indices reaching all-time high, the DJ US Railroad Index is trading at an all-time high. The Baltic Dry Index is trading at a multi-year high too. Life is good.

On the other hand, after all, markets do operate in cycles. It will have been 10 years since the GFC and there's got to be a pause in the cycle; it's a matter of when. For all intents and purposes, 2018 appears to exhibit some cracks in the decade-long bull market. Bond yields are on the rise across the board. China has registered the worst performing equity market, money supply appears to be tightening as a result of overall deleveraging of the economy, NPLs are often reported to be the next best bet (we have our reservation), not much positives to report... Our view is that China would like the US to believe China is losing the trade war. With mid-term election coming up, and we do not discuss politics herein, we expect the tempo of the trade war to come to a crescendo but in our opinion the noise will slowly peter out. Many things that have been said would be hard to undo but execution could always be "managed".

China is eager to play a bigger role in the world economy given its apparent stature. China is a fast mover and a ready adopter of new tech, eg it is already the largest EV producer in the world. Elon Musk is building a USD 5bln production plant in Shanghai. China's tech business is booming. Street hawkers have gone cashless. Alibaba and Tencent are generating profits for a sustained and long period of time (contrast them vs Amazon which has become profitable recently but on a market cap adjusted basis, their profitability is not too impressive compared to the Chinese counterparts), albeit for the first time in 13 years Tencent has missed their Q2 estimates sending the tech giant's stock into a territory that would spook global investors.

The above said, China's urbanisation rate remains just north of 50%, comparing that figure with other developed markets (80%) and many other emerging markets (70%), China remains a country of labourers. This means we are sometimes imputing too much into China's current status into the future. China may well be in the middle-income trap, it's unlikely but few emerging markets countries make the break into the higher income bracket as opined by the World Bank. Brazil for example has struggled to break out from this middle-income trap for years and still remains in the trap.

 

 

China's growing middle class has USD 3 trillion of disposable income; there are 100 million globe-trotting Chinese but China is best to be seen as a manufacturing centre than a tertiary industry economy, for now. A weaker CNY is good for China, for now. This plays well into the Make America Great again propaganda.

Our view is that the CNY would continue to be weakened if the trade war is sustained. It is China's way of retaliating in substance. Talks are mere form. A weaker CNY would continue to make its products more competitive and thus (re-) gaining China's market share in the manufacturing position in the world. The question is of all the rhetorics and posturings, at the end of the day, everyone loses in a trade war but if this trade war provides a more sustainable future for the Chinese economy through further valid devaluation of CNY, perhaps China ought to be seen to have the long term upper hand.

 

 

Where do we see opportunities amidst the above? We prefer to stick to our core of providing secured financing to companies with good growth potentials but are temporarily unable to gain access to traditional lenders. We like our space because in China, investors are often focused more on anecdotal and perceived risks than real risks which provide us plenty of room to engage with good companies.

We would caution against the onshore equity markets, notwithstanding from a valuation standpoint, they may be a screaming buy on the surface but could be a value trap. The bet here is that there will be government intervention to boost the markets. We do not buy this argument.

Our experience in the Chinese market has taught us to derive a simple assessment model to test whether government intervention will be implemented. Our litmus test would be in the form of 3 "But For" questions, but-for the government intervening, would adverse impacts occur?

 

  1. to political stability of the Communist Party?
  2. to the Sovereignty of China as a nation?
  3. to the harmonious society of the Chinese people?

 

Testing the above model by applying the onshore stock markets, we conclude that there is a low probability for the government to be motivated to intervene. The negative performance of domestic stock markets will not cause political instability of the Party, nor threaten the Sovereignty of China. The stock markets will cause domestic investors grief; however, it is our opinion that this can be tolerated especially during heightened threats of a full-fledged trade war leading to other calamities.

In conclusion, the current volatility in the markets will unlikely to be resolved in any short period of time and it is not local but a global situation. Our early opinion of a currency war has developed into a trade war beyond mere talks. China's ultimate game plan may well be a weaker CNY to retain its strength as a manufacturer for the world. Like a pair of chess players, an erratic player who's no doubt been soundly

advised will eventually be perturbed by a consistent, measured and calm opponent. China's leadership is well versed in the Art of War by Sun Tsu (a celebrated military treatise dated 5th century BC) and these maneuverings in-form by the US may well be helping China play its strongest hand.

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