Fifty Shades of Gray

Get your mind out of the gutter; this isn’t that kind of commentary. Today we are going to discuss operating in the gray area that exists in financial markets.

It’s interesting to watch my teenage daughter navigate life with a very black and white view of the world. Things for her are either right or wrong, up or down. She doesn’t yet appreciate that it’s the nuances of life that make it simultaneously worth living and challenging to navigate.

The gray is the reason life isn’t straightforward, and it’s also the reason markets are difficult to evaluate for risks and opportunities. The investing landscape is home to mostly elephants (the gray kind, not the pink) and very few zebras.

Most of your investing decisions will be made using incomplete and often contradictory information. This, my friends, is the gray area.

Right now, the conditions surrounding Chinese equities are as gray as a shallow sea.

 

Disclaimer

It’s no secret that most people believe the Chinese government makes up their data. The truth is that most governments manipulate data at one time or another. Here in the U.S., we’ve had several different calculations for Consumer Price Inflation (CPI) since the Clinton administration. What was so wrong with how we tracked inflation in the 90s?

That said, the Chinese have taken data “procurement” to the next level. For instance, annual GDP growth for the Chinese economy in 2016 was exactly 6.7% for quarters 1, 2 and 3. For both of the first two quarters of this year, the Chinese economy reportedly grew at exactly a 6.9% rate. Folks, getting the exact same GDP growth rate for two straight quarters, much less three, is as likely as landing an An-225 cargo jet on your front lawn.

I can’t confirm that China creates the data they want to share, but I’m fairly certain there is no bigger fan of Microsoft Excel’s goal seek function. It’s important to keep this caveat in mind as we traverse through a couple of Chinese data sets.

 

The Black

The Chinese economy has been accelerating, along with most economies around the globe, for the better part of a year. However, recently a chink opened in its economic armor.

It started a couple of months ago with the latest data set that I call the “Big 3:” retail sales, industrial production and fixed-asset investment.

Both retail sales and industrial production have slowed for two consecutive months, which means that if there’s one more month of slowing data, they are officially in a downtrend.

Fixed asset investment is one measure of capital spending and refers to any investment in physical assets, such as real estate, infrastructure or machinery. Chinese fixed asset investment has now slowed for five consecutive months.

It won’t shock you to find out that the latest service sector data from Caixin, a private media company based in Beijing, showed the slowest pace of growth in almost two years. In contrast, the official government-released service sector data showed the highest reading since 2014. Goal seek, anyone?

The slowdown is widespread and is reflected in the composite PMI, which is a wholistic measure of the Chinese economy. This composite index is currently sitting just above the lowest readings in the last twelve months.

Not only is the economic data trending the wrong way, but banking liquidity has been drying up since January. This liquidity reduction has been purposeful, as the People’s Bank of China (PBOC) tries to slow down speculation in both the stock and housing markets.

Contracting liquidity, coupled with slowing economic data, is not a conducive environment for risk assets in general, or equities specifically. The current economic environment seems pretty black and white for a bearish bias, right?

 

The White

My entire framework is built on the belief that the two most important variables impacting asset prices are: (1) economic conditions and (2) how central banks respond to those conditions. Well, whether the data is as fake as Lisa Rinna’s lips or not, the PBOC’s behavior indicates the economy is riding the struggle bus.

Two weeks ago, the PBOC said it would cut the reserve requirement ratio (RRR) for lending to small businesses and the agricultural sector. As a reminder, the RRR is the amount of cash, as a percentage of deposits, that banks must park with the PBOC. This is the first rate cut of its kind since February 2016, and it’s the PBOC’s attempt to reinvigorate a sluggish economy.

This central bank response to slowing economic conditions should clear the path for further gains in Chinese equities. When the PBOC cut the RRR last year, the iShares China Large Cap ETF (FXI), the U.S.-based proxy for Chinese equities, gained 24% in the subsequent eight months with just a 7% drawdown. If my math is right, that’s over three times as much upside gain as downside risk.

This type of skewed return and risk for an asset class shouldn’t surprise you given that when a central bank juices liquidity, it typically creates a very conducive environment for equities. The PBOC’s current policy stance seems pretty black and white for a bullish bias, right?

 

The Gray

We have slowing economic data, which is typically bearish for equities, and we have a central bank increasing liquidity, which is typically bullish for equities. But if that mixture isn’t gray enough for you, there is one more piece of data that places the circumstances surrounding Chinese equities right in the middle of the black to white spectrum.

In the eight months leading up to the last RRR cut, the iShares China Large Cap ETF (FXI) had declined 45% from its post-crisis high in April 2015.

This time around, FXI has gained 28% in the last eight months, and is currently sitting back within 7% of that same April 2015 high.

The current quantitative set-up for Chinese equities is dramatically different than it was at the beginning of 2016. Is the picture for Chinese equities as clear as mud to you?

 

The Bottom Line

Chinese equities are faced with several economic headwinds and the PBOC knows it, which is why they’re again turning on the liquidity tap.

However, the question remains: will the PBOC’s actions goose Chinese equity returns even further? Only time will tell what the true color of this currently gray picture will turn out to be.

If you want to be a consistently successful investor, you must embrace the fact you’ll make decisions from a gray area much more often than from an area of black and white. As in life, very few things in financial markets are black and white. The best you can hope for is to find markets whose color leans either towards the lighter gainsboro gray or more towards the darker slate gray.