Monday digest

Posted 2 August 2021

Overview: Growth slows and highlights the tension between yields and earnings
Despite the government’s ‘Freedom day’ last week, things are only slowly returning to normal. Google’s mobility data shows the flow of Britons back into offices is still weak relative to the beginning of 2020 – though the UK had more centralised working in its major cities than other European nations. Some of this will undoubtedly be down to seasonal effects – with the summer holidays in full swing and workers enjoying the (sporadic) sunshine. The good mood has spread to markets too, with UK assets outperforming global peers and sterling gaining against other currencies.

Even so, Britain’s retail and recreation sectors appear to be lagging European counterparts, despite nearing population-wide vaccination rates. Meanwhile, Eurozone growth is continuing its recovery from the pandemic trough, with growth levels matching the US. JPMorgan noted that economic sentiment in Europe has jumped in July to the highest level since data collection began in 1985. This backs up recent impressive sentiment surveys which recorded high levels of business and consumer confidence.

Over in the US, the world’s largest economy is now running at a more reasonable pace, coming down from the stratospheric levels we saw earlier in its recovery. This slowing of US growth has impacted bond markets, with investors now putting less upward pressure on yields. This normalisation will give the US Federal Reserve (Fed) some leeway in pulling back its bond purchases. The July meeting showed Fed members inching towards this process, but August will likely see more firm proposals floated. The slowing of growth expectations – together with the Fed’s continued bond purchases – is having a huge impact on real (inflation-adjusted) yields. US Treasury yields have sunk to new depths in real terms, and their impact is spreading to other inflation-linked bond markets. Real yields are a vital piece of the puzzle for any investment outlook, helping set expected returns relative to risk and having a big impact on price-to-earnings ratios. Equity markets are therefore being supported by the fall in real yields, despite what was a lacklustre quarterly earnings season compared to the last three quarters.

However, as was the case in 2013, those low yields give the Fed licence to act, and it can taper its policy measures in the expectation that real yields may rise but remain negative. Of course, this would be less supportive for equity markets, so the Fed will have to be careful the rise does not become ‘disorderly’. Should it manage this well, earnings growth will remain intact, offsetting the yield rise. Nonetheless, it could mean tougher times ahead for equity markets, and they may spend the summer months treading water.

China’s risks could bring greater reward
The well-worn cliché that the Chinese word for crisis is composed of symbols for both danger and opportunity might be a mistranslation, but it usually holds true for investors, with China often presenting both danger and opportunity in equal measure.  The commotion in the Chinese education sector towards the end of July again highlighted the risk and reward pairing, but for the wrong reasons.

Private education has been one of China’s biggest growth stories of the last few years, and that has attracted swathes of investors, especially from overseas. The sector was also one of the pandemic’s big beneficiaries, with vast growth in online teaching and after-school tutoring propelling valuations of edu-tech firms. That changed after Bloomberg published a leaked report ahead of last weekend’s announcement of sweeping reforms from Beijing. The reforms will bar companies that teach the school curriculum from making profits, raising capital or going public. The authorities say the move is designed to overhaul an education system that has been “hijacked by capital”. Affected firms have all publicly supported the government’s decision, but there is no doubt how devastating the change is for the $100 billion industry. Authorities say the move ease the burden on children and parents, address growing inequality and Share prices for the three largest US-listed education companies – TAL Education, New Oriental Education and Gaotu Techedu – have all plummeted since the report was published. More concerningly, the sell-off spread to China’s big tech companies – many of whom are heavily invested in education and have faced their own confrontations with regulators.

Judging from media and market reaction, international investors are clearly in panic mode. Fears are centred on a particular legal structure that foreigners use to invest in Chinese companies, known as Variable Interest Entities (VIEs). These are essentially contracts between domestic Chinese firms and specially created offshore shell companies, whereby the latter agrees to reflect the former’s books. Since foreigners are often not allowed to own certain Chinese companies outright, these provide a loophole for international capital to flow into corporate China. Access to VIEs is precisely what Beijing has banned for education firms, prompting concerns of a wider backlash against companies using them. There are two deeper anxieties underlying the story. First, markets are concerned that Beijing is attacking VIEs as part of a wider campaign of financial decoupling – that China wants to boot out foreign capital and go its own way. Second, investors are worried that the education clampdown marks a return of hard-line Maoism. That is, investors fear that the Communist Party is turning against private property itself.

We have not seen anything to suggest these fears are justified. It is true that Beijing has stepped up its regulatory action this year, with a particular focus on large tech companies like Tencent and Alibaba. Moreover, it is almost certain this is being driven by the government’s distaste of powerful private entities, and Xi Jinping’s desire for tighter central control. But there is a world of difference between those aims and wholesale isolationism – let alone a rejection of profit altogether. Profitability and the encouragement of foreign capital is still important to Beijing. If policymakers can increase profits while maintaining the government’s broad policy goals, they will do so.

China is pushing hard and fast for regulatory reform. The process is scaring international investors and some of that fear is a justified re-evaluation of the underlying risks. But this should not detract from the long-term story of Chinese growth, which may indeed be helped by the government’s reforms. As such, the more pessimistic that markets feel about China, the more its assets may present an opportunity. Investing in Chinese equities right now would justifiably feel very risky. But the lower that China’s valuations sink, the higher the potential reward. For investors, crisis might well mean danger and opportunity after all.

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