The Great Wall and The Big Short
Have you ever heard of Howie Hubler? If you are a Michael Lewis reader, the answer might be ‘yes’. Hubler was a former trader at Morgan Stanley, famous for making the second largest trading loss in history. And it was all the more ironic that his analysis on US mortgage securities was 90% right.
What went wrong? As defaults on US mortages were rising, Hubler believed that it would be profitable to short CDO BB tranches, financing the trade by selling credit default swaps on ‘high quality’ AAA tranches. It could have been a great strategy… but only if Huber had made the opposite trade!
When the macro picture deteriorates, financial risk lies in instruments that are priced as ‘risk-free’ assets. Actually, high yield tranches were already regarded as risky by investors, while AAA tranches were said to be a safe haven. And this is why we got the 2008 financial crisis.
Let’s go back to the present. Today when you read the headlines you might feel very concerned about China. And not just about China as a long-term technological challenger for the US, but also about a potential economic ‘hard landing’.
Somehow investors seem to turn bipolar when it comes to China. On the one hand people believe that Chinese economy is about to collapse, because of overdue debts and a crashing stock market. But on the other hand, they still buy the ‘bad news is good news’ idea, expecting a massive stimulus plan by Chinese authorities to save the economy.
The thing is that almost everyone in the West has been cautious on China during the past decade. Global emerging funds have underweighted China for years and Asia ex Japan equity markets are already trading at distressed multiples
Investors have long seen Chinese economy as a risk. But so have Chinese officials.
Xi Jinping and his clan are definitely aware of China’s structural imbalances. Supported by the Princelings, Chinese president has started to empower painful but necessary economic reforms so as to avoid a deeper crisis. His predecessor Hu Jintao got public disgrace because he was held responsible for the rise of corruption among the country and the emergence of a big financial risk. And the current administration is likely to act differently.
For almost 30 years, PRC had quietly followed the economic path of Deng Xiaoping, evolving from a poor rural economy to the world biggest exporter. But this strategy was no longer sustainable and China had to change to prepare for the future. In a sense, Xi Jinping might become the third ‘Mao emperor’, by first rejecting all the excess of his predecessors, like Mao and Deng did before him, and then paving the way for a long term transformation of the country.
If I am right, then it means lower growth rates and the end of traditional engines such as heavy construction plans and overproduction. And traditional stimulus plans, like those we’ve seen between 2009 and 2016, might not occur. Authorities are cleaning up the economy and they might be more selective when trying to help corporates from collapsing, now that priority has clearly been given to ‘quality’ rather than ‘quantity’.
So the key question for us in the West is: are we prepared for that? If most of US or Europe investors don’t own many assets in Hong Kong or China, then where does the actual risk lie?
Think of Howie Hulber’s trade. In the global financial system, almost everyone already regards China as a high yield risky bet or even worse. So what are the overpriced AAA assets?
This article was originally published on LinkedIn January 26, 2019.