Investing During the US-China Trade Conflict: Uncorrelated Equities and Truly Risk-Free Cash
Throughout 2019 the world has suffered from the US-China trade conflict fallout, and while many investors have been inclined to de-risk and wait it out, there are opportunities lost as well by pursuing that strategy. Instead, Hong Kong investment manager Premia Partners believes a more appropriate strategy is to identify the equity winners regardless, minimise correlations, and buy into truly risk-free assets as a hedge for any doomsday scenario. David Lai, Premia Partner & Co-Chief Investment Officer, and Aleksey Mironenko, Partner & Chief Distribution Officer, paired up for a fascinating Workshop at the Hubbis Investment Solutions Forum.
“Whether the trade conflict on both economies will continue,” Lai remarked, “and exactly how much damage it will inflict, nobody knows, but we see that both sides have their own point of view to try to minimise the impact.”
Almost 30% of the world’s investment-grade debt is already negative yield, but buyers are still queuing up for it, meaning they are chronically risk averse in accepting that if they hold to maturity they will receive back less than they paid. And gold is also a major beneficiary of this global risk aversion.
With indicators increasingly pointing to the potential for a recession in the US, and with core inflation in the US about 2.4%, probably a result of tariffs, the combination of slower economic growth and higher inflation is never good for the equity market.
China – despite headwinds, still advancing
Over in Asia, the assumption might be that China would fare badly in this environment. Yet China ‘A’ shares have returned nearly 30% YTD, with China adjusting fiscal policies and therefore reducing debt costs in the corporate world and the economy at large, thereby providing a boost to domestic consumption. Moreover, China has been intent on policy measures to boost consumer activity, in such areas as promoting e-commerce, green/smart home appliances and other measures to help encourage overall consumption. And tax cuts for the corporate and personal/retail markets, with particular knock-on benefits for ‘A’ share listed corporations.
Lai then focused on China old and new economy stocks, highlighting how it is important to be selective, not to view Chinese equities as a whole. “You can see that the China New Economic Index – mainly consumer stocks, healthcare and IT, are growing much faster than the average,” he explained. “Domestic consumption, technological upgrading, urbanisation, infrastructure – the high-innovation end of this, and tech/IT, these sectors are all driving towards stronger growth in the near future.”
Vietnam – a remarkable story
Vietnam is currently a key beneficiary of the China-US trade conflicts. Aside from Vietnam’s core economic fundamentals as it transits from a frontier to an emerging market, the trade wars are delivering a boost from the shifting of China production into Vietnam itself, and at lower costs. Moreover, while the ASEAN currencies such as Thai Baht and Philippine Peso have been robust against the dollar year-to-date, Vietnamese Dong has exhibited very low volatility during the same period of time.
“China’s exports to the US have dropped, but Vietnam’s exports to the US have surged by about 33% in the first half of 2019” said Lai.
It is not only China shifting production. Vietnam offers comparatively appealing labour costs for China and other countries in the region. And the infrastructure is improving rapidly. Moreover, a lot of investors may only focus on the growing trade activities of Vietnam but miss out the consumption potential of the country. With close to 100 million people, most of them still at a very low-income bracket, and with a rapid expansion of manufacturing and general activity, there is markedly faster consumer spending across all segments.
“Vietnam’s spending has been more than 50% centred on food and beverage, in other words, necessities,” he reported, “but a whole range of areas from financial services to healthcare, housing, retailing, and other sectors are now rising rapidly as spending power rises and as more spending is focused on these growth areas. And tourism is growing very rapidly, with the government targeting 10% of GDP from this sector as more Asian and other visitors flood in.”
China New Economy stocks shine bright
Premia thus far has two China ETF strategies and is very bullish on prospects there for equity investors. Mironenko reiterated some of Lai’s observations on China and explained that all of the key developments Lai had talked about will benefit China’s ‘A’ shares market, which is also being propelled by new foreign investment coming in through the Stock Connect programme driven by MSCI inclusion from Q2 in 2018, pulling in more and more foreign investors.
He reiterated how structural change is also central to the uptick in China interest, as the country’s emphasis is on the new economy. Domestic consumption contributed some 37% to GDP growth in the past decade, but it is nearer 80% today. The new economy exposure in the index, including consumption, IT and healthcare, used to be about 20% and today is 32.5%, so new economy exposure in the capital markets is also gaining weight.
The Premia CSI Caixin China New Economy ETF offers access to this universe of China A ‘new economy’ stocks and is tilted toward asset-light, accounting conservative and quality growth stocks and has outperformed comparable alternatives, including ChiNext, since its creation nearly two years ago with less volatility.
Great performance YTD
China New Economy is actually one of the best performing China ‘A’ share ETFs globally year to date, having risen 28% by the end of September.
“The New Economy definition is industries that are skilled talent, advanced technology, asset-light, sustainable growth, and my personal favourite for China, policy supported,” he elucidated. “That is just not our definition, this is the definition of the New Economy PMI that is published in China and what we are simply doing is taking the industry definitions they included in PMI, and we convert them to stock subsectors.”
The problem is that the universe is then still 900 stocks. “So, not only do we focus on new economy stocks, but we then narrow the field down to focus on quality, low debt, efficient inventory management, nimble leadership, targeted, efficient R&D spending and other key factors,” Mironenko explained. “We like asset-light firms, those who are there to benefit from China's long-term transition from the old economy to new economy. We also want low net operating assets and low accruals, because you will be shocked how many companies in China have fantastic earnings and have negative cash flow.”
The universe is thereby trimmed from 900 to 300 stocks. “Financials and real estate don’t feature in new economy,” he reported. “The government is going to use that sector to promote New Economy in our view, meaning net margins will fall. But what we overweight are sectors such as consumer discretionary, healthcare, technology/IT, innovative infrastructure, so for example not the businesses that lay the railroad tracks but the businesses that build the bullet train engines. In other words, high skill, high complexity, high tech industries, and of course robotics, which is far from old economy. All these key areas can be accessed efficiently through the Premia CSI Caixin China New Economy ETF.”
Vietnam – getting into the detail
Mironenko shifted his attention to Vietnam, for which Premia on July 18 listed its Premia MSCI Vietnam ETF (2804 HK/9804 HK), making it easier for investors to access this dynamic and fast-growing market.
Vietnam offers strong economic growth and a young, large and fast-growing workforce. The country is enjoying rising FDI and trade, with increasing inflows and trade value that is overtaking neighbours. The country also enjoys rapid growth of the consumer as Vietnam moves from relative poverty to emulating its ASEAN neighbours such as Thailand or Malaysia. Improved macroeconomic conditions include stable credit growth and monetary policy alongside solid currency control and strengthening reserves. And Vietnam is arguably the biggest beneficiary of the trade war and the resulting review of global supply chains.
The country, therefore, has many key positives, including government support via privatisation to boost the equity market, faster growth than most of ASEAN, conducive liberalisation, and growing foreign investor interest. It also offers a 60% labour cost advantage vs China, a large and willing-to-work population and increasingly improving infrastructure for global supply chains.
With a large and fast-growing population of around 97 million, Vietnam’s story opens the door to investment opportunities in all sorts of key consumption sectors, from retail to education to healthcare and IT.
Growth will be faster than in broader ASEAN. It all means that in the next decade Vietnam will benefit from the growth as high as 7% per year, so for those investors that missed the early years of China’s boom, Vietnam will probably be the next one they should be looking into.
The country offers robust growth in earnings, growing at least at double-digit rates for the next two years. And on the regulatory front, the authorities will remove the foreign ownership limit of most listed companies by early 2020, which might coincide with the upgrade to EM status. And with growth rates of about 7%, they are already growing faster than China,” Lai added.
The equity market size is now only 60% of GDP, but the government has a target to raise that in 2020 to 100% and by 2025 to 120%. Surprisingly, Vietnam has already surpassed Singapore to become the biggest IPO market in any ASEAN country. The stock market should roughly double in size within six years.
A pure Vietnam play
The ETF offers pure Vietnam exposure, as the strategy tracks the MSCI Vietnam Index, which consists of only public Vietnam listed companies and may one day be added to MSCI EM, hopefully, sooner rather than later.
The ETF offers physical replication, in other words direct low-cost access to the Vietnam stock market. It is cost-efficient with ongoing expenses of only 0.75% p.a., vs 1%+ for existing foreign-listed ETFs and 1.5%-3% for active funds.
As it is Hong Kong-listed, and available in USD or HKD, it offers easy access for investors and in the same time zone as the underlying market and without any US withholding taxes.
Borne out of a need
As with every Premia product launch, the Vietnam ETF was borne out of client frustrations, and offers single country exposure that was not available through Premia’s ASEAN ETF, and it improves on what Premia considers other less viable avenues, such as synthetic or US domiciled ETFs, or those that invest in non-Vietnam stocks or even PE.
“Our mission,” Mironenko explained, “is to improve the Asian beta landscape and solve investor challenges into Asia, and with this ETF we offer a low cost, rules-based access, and 100% physical replication strategy to the fast-growing Vietnam market. It is the first ETF tracking MSCI Vietnam index globally and will benefit directly if there is an upgrade from frontier market to emerging market status, which will pull in a lot of foreign interest going forward.”
Putting cash where cash can yield
Lastly, Mironenko focused on another new strategy launched in July in the form of the Premia US Treasury Floating Rate ETF (3077HK/9077HK), which helps investors mitigate trade conflict risks by generating risk-free USD yield.
He highlighted the investment case for US Treasury FRNs. Cash and dry powder are needed, with many investors increasing cash levels as the cycle gets long in the tooth and uncertainties pile up. Bank yields remain low and readily available cash doesn’t pay very much. Cash with risk seems to be the norm - credit risk in money market funds, counterparty risk in repos, timing/duration risk in long-dated deposits. And cash is not operationally straightforward - rolling t-bills and time deposits, identifying the best yielding bank product all takes time away from more important investment thinking.
The Premia solution offers the shortest duration instrument, with only one week of duration with coupon resets weekly. There is no credit or counterparty risk, as there is 100% physical exposure to US treasury obligations only. It offers a high risk-free yield, translating currently to a 2.1% gross yield, higher than all US treasuries up to 10 years.
Mironenko explained why the ETF buys into floating-rate US treasuries, not fixed-rate obligations. “With the Fed Funds at 2.25%,” he reported, “it’s obvious that investors seek out alternatives. But if you buy into money market funds these might typically offer a higher yield of course, but they are run actively and invest in not just Treasuries, but in commercial paper, longer-dated government securities, repos, so there is either credit risk, counterparty risk, or interest rate risk. The fees are also higher. Yes, they are professionally managed and there is nothing wrong in principle with this type of cash management approach. But remember 2008 and just how quickly things can go wrong, as investors fled prime funds to the safety of government-only investments.”
Time deposits, he noted, are also another popular way to invest cash, but have several problems – they need constant rollover and scrutiny for the best rates, the buyer is 100% exposed to the default risk of the bank, retail and institutional rates are different, and the investor is locked in and cannot use or reinvest the cash until the time deposit is finished.
Finally, many investors simply buy t-bills and roll them on a regular basis themselves. But for relatively smaller sizes, this is quite difficult as treasuries typically trade in increments of at least USD100k, and even at that size, the pricing is inefficient.
In short, there’s no perfect solution for cash,” he concluded. “But our US Treasury Floating Rate ETF was borne out of these client frustrations. In our view, floating-rate Treasuries can function as a core alternative for short-term bond exposure with reduced interest rate and credit risk.”
More from David Lai, Premia Partners