Hugh Hendry, one of the earliest hedge fund managers to point out China's economic structural issues (capital misallocation, financial repression, trade mercantilism), has recently came out in an interview saying that he does not believes that China will devalue the Yuan by 20% because "there is no world after that". He also stated that he believed the depreciation trade would be the correct trade at some later point in time. On the other hand, Kyle Bass states in a recent interview, that he believes the main outlet for China's structural issues would be through the currency via depreciation.
It is interesting that while the two minds view the China issue largely through similar models, i.e. the acceptance of the structural issues; they've come to two disparate conclusions on the short to medium term results for the currency.
A depreciating Chinese currency is diametrically opposed to the rebalancing process of the Chinese economy. Demand for any country is composed of three parts: consumption, investment and net exports. An increase in investment demand necessitates increases in the growth rate of debt. China's growth in debt is out of control largely because they are dependent upon investments to charge the economy. A depreciating currency is supportive of the latter two sources of demand but harms the first. Since investment and net export growth for China is all but completely exhausted, it would be extremely irrational to further punish the required source of demand (consumption) for a self-sustaining economy via currency depreciation.
While the Chinese economy may have structural problems far worse than what the U.S. had prior to the 2008 financial crisis, its lack of a laissez-faire market economy makes the possibility of a dramatic adjustment far less likely. In the American economy, the market takes a life of its own, sometime diverging far away from fundamentals on both the upside and the downside. While the fundamentals of an economy generally move slowly across time, a serious financial crisis may trigger dramatic movement towards or away from the prior path the economy has taken. The response to the crises in the past decades has been the Federal Reserve taking action to rescue the financial markets. For China, you have a fully controlled financial system in almost every aspect of structure from the ownership and management of banks to the controls on the capital account. Capital flows within the economy are under intense scrutiny always within the control of the reigning regime. What this has done is that it has allowed the fundamentals of capital allocation to pursue the wrong path while discouraging the possibility of a dramatic adjustment through tight controls.
Hugh Hendry basically assumes that the situation is under control at least for the time being due to the lack of a proper market financial system and that the government will not deliberately depreciate the currency as it is not to the country's best financial interests to do so. He does not believe China can have its "Minsky moment" in the short term, at least.
The thought process of Kyle Bass is somewhat different from Hugh Hendry in that he thinks about the currency in terms of the all the possible paths China can take and concludes all such paths leads to currency depreciation. Indeed, we can again look at Bass's thinking through our fundamental demand model stated earlier where an economy's demand is composed of consumption, investment and net exports.
China can choose to try to stimulate any three of these sources of demand. If China were to choose to stimulate investment or net exports, depreciating the currency would be a no-brainer. The question Bass then asks is what if China tries to stimulate consumption growth? What actions would lead to such a path? Unfortunately, consumption growth is the most difficult source of demand to stimulate in any heavy handed way. It means that real reforms must take place and the Chinese economy must direct capital away from unprofitable areas of the economy and channel them profitable areas such as private enterprise and household consumption. For a one party regime, this means taking power away from themselves via decreasing the role of or privatizing state owned enterprises (SOEs), and recognizing losses in the banking system which necessitates recapitalizing their larger banks including Bank of China (OTCPK:BACHY), Agricultural Bank of China (OTCPK:ACGBY), Industrial and Commercial Bank of China (OTCPK:IDCBY), China Construction Bank (OTCPK:CICHY) and Bank of Communications (OTCPK:BCMXY).
In summary, Bass believes that all three paths to growth will lead to a depreciating currency with some just being a more direct path than others.
Reconciling the differing views
Of course, both are great minds and I'm vastly oversimplifying the amount of intellectual and statistical rigor these men have put into the process of obtaining conclusions. The fact of the matter is that this is probably the most contentious topic of debate in the economic and financial arena to date. A 20% Yuan depreciation would be disastrous to the rest of the world and would greatly speed up the decline in world trade via protectionism which would be justified in that case.
However, as Bass's case shows, depreciation is almost inevitable at some point if not only a temporary one. Real fundamental reform towards a consumption economy would probably put temporary strains on the financial system via loss recognition by banks, but it would open up the door to sustainable future growth. Continuing on the path of investment stimulus may stave off adjustment costs in the short term, but is almost guaranteed to have an even more deleterious effect on the economy in the future. Finally, stimulating net exports is done through direct currency depreciation. If the communist regime believes the latter two paths to be viable long-term solutions, they are deluding themselves and I don't think they are so foolish as to believe that. Unfortunately, the political implications of the first path are simply unacceptable for the vested interest that have benefited from China's tremendous growth over the past two decades. There is no shortage of historical examples where politics have undermined the long-term development of nations.
How does this affect value investing?
The fundamental issues affecting investors' psyches are two-fold. The first is the path the Federal Reserve desires to take with respect to hiking interest rates. The second is the rather unknown and unpredictable risk in emerging markets and in particular with China. The two issues affect each other in a reflexive manner. Any Federal Reserve rate increase forces up the value of the USD versus all other currencies. Since the Yuan is pegged to the USD, and China does not desire strong currency in the time being, they will continue to weaken their peg and thus export their excess capacity and deflation to the U.S. Due to weak external demand and the import of deflation via the free trade mechanism, the Federal Reserve has no choice but hold off on any significant rate hikes in the short term.
So low interest rates have generally meant bubbles from a historical perspective and we have indeed probably just experienced the slight popping of a bubble in the high yield market after the second half of 2014 with the collapse in commodities prices. But in this case, interest rates were never materially hiked and are continuing to stay at record lows. Yet even at such levels, investment has stayed low in the U.S. due to the lack of price increases to encourage corporate spending. It seems that the only companies that are fetching bubble-like valuations are those that are apparently "disruptive" in that they take away market share from traditional industries i.e. Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), Uber. Quality companies are considered safe havens and while they are very expensive, their valuations aren't outrageous when you put them in the context of our interest rate environment. Such companies include Colgate-Palmolive (NYSE:CL), Alphabet (NASDAQ:GOOG), Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Nike (NYSE:NKE), General Mills (NYSE:GIS) and the list goes on.
Purely in terms of valuation, the greatest areas of interest for value investors in the larger cap arena are those that partially have their fate dependent upon China's economy or perhaps more importantly, how the U.S. will react to China in the near future. Companies that fit this category are General Motors (NYSE:GM), Apple (NASDAQ:AAPL), Caterpillar (NYSE:CAT), Alcoa (NYSE:AA), Ford (NYSE:F), Boeing (NYSE:BA), Aercap (NYSE:AER) and a myriad of other companies. So the ultimate question of whether or not the Yuan will depreciate materially is of great importance not only to this last group of U.S. companies on a fundamental basis, but the result will also heavily influence the future path of Fed rate hikes.
"If you're not a hostage to your errors, your future is rather promising." - Hugh Hendry
I don't make bets on the macro economy through currencies or derivatives and largely make my investment decisions based upon the fundamentals of a company. However, the situation has gotten so interesting that I just couldn't help but take a closer look on my spare time.
The problem with China when it comes down to it, in my opinion, is that it is a hostage to its own errors. The binge on investments and dependency on exports has left the country with very little runway left to continue its growth under the current model. Since China's economic and political model is not conducive towards making an adjustment from an investment led growth model to a consumption led model, it is being held hostage on its current path. Unfortunately, this current path means overcapacity in the world economy and exporting deflation when major economies are at record low interest rates and desiring a pick-up in inflation.
General free trade ideology and mercantilist behavior from surplus countries holds trade deficit countries hostage to lower GDP growth rates, deflationary pressures and stagnant wages. The lynchpin to the current reflexive patterns in the global economy is global free trade. Take this away and China cannot legitimately grow its domestic money supply by expanding its balance sheet while keeping a stable currency. Without totally free trade, the U.S. is free to impose tariffs which will result in price inflation and an increase in domestic investments allowing interest rates to rise. Kyle Bass's views will probably play out in full force when key countries begin to abandon the notion of completely free international trade. In the meantime, Hendry will probably be more correct in that we will not see a very dramatic depreciation in the Yuan because it is not within the interest of China to do so at the moment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.