The Dividend Cafe - SPECIAL EDITION: Investing in China

Episode Date: August 6, 2021

We are going to do something unique this week – a deep dive into the massive country that is China. From stocks to bonds to history to currency to geopolitics, this is a big topic, and we do it this week with the sole aim of determining where there may be investment opportunity for our clients, and where there may not be. It is a topic that reveals deep passions and emotions out of many people. Our goal is to remove passion and emotion, and be fiduciary investment managers with a burden for optimizing solutions on behalf of our clients. This has serious implications when you look at Chinese stocks, or U.S. bonds. I could make this introduction a full article if I wanted to, but let me resist the temptation to keep bloviating and ask you to dive right in. I believe it is a thought-provoking and useful summary of a few investment considerations in the fastest growing economic region in human history. And we want to get this right. DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to a special edition of the Dividend Cafe. I am going to be talking to you all on this podcast and in this video for the next, I don't know, 15, 20 minutes, all about the subject of China and particularly about opportunities for U.S. investors in China. And maybe the answer is non-opportunities. Maybe it is lovely opportunities. Maybe it's somewhere in between, but we want to unpack a lot of that it's a project i've been working on for quite some time uh and probably the thousand plus pages of research i've already devoted to the topic received another few hundred pages of attention in the last

week in in preparation for this particular dividend Cafe. And there's much more to be done, as you'll see in a moment. But some months ago, I became convinced that some economists who I follow closely, who I value, who I respect to their point of view, and have developed a relationship with. We're on to something about capital flows, that there were regions of the world, economic regions that were going to see less capital come in, and there were regions that were going to see more capital come in. This is a story of history. It's a story of economics. It has a lot to do with tax policy, trade policy, and the fundamentals of economic

growth that drive capital into different parts of the world and drive capital away from parts of the world. And there's no question that China is a place that is right now a net recipient of foreign capital. And a lot of that has to do with fundamental reasons that make capital want to go to China. And, of course, a lot of it has to do with the fact that the newness of it, the novelty of this is a newer reality for a country

that has been around for thousands of years and has such a rich dynastic history. The fact of the matter is that a lot of these things playing out on the world stage right now are brand new. Many of them less than 25 years old, and some, to be quite honest, about five years old. So there's a lot we're going to kind of unpack a bit historically here today as well. So there's a lot we're going to kind of unpack a bit historically here today as well. But something has happened more recently than when I first began wondering if there was an opportunity for me to invest client capital from their safe money bucket, from their what we call boring bonds bucket, where we want a lot of principal protection, a lot of capital preservation, low volatility focus, and yet we would like to get paid something.

And where the U.S. bond market that has mostly offered something in that vein for the better part of 100 years really no longer does. And as we have, through fiscal and monetary policy decisions, pushed our yield curve down to the lower bound, on the short end to the zero bound. And it's my position that we'll probably be there for quite some time. And therefore, the pursuit of other opportunities that may diversify the risk and reward mix is interesting to me. And that's what we've been kind of pursuing for some time. I think it's been maybe four months or so I've been playing around with this, gathering information, talking to people slowly but diligently, and I think intelligently trying to go about the process to figure out the cost-benefits analysis.

Well, in the last few weeks, something has happened that I think is quite interesting to the overall pursuit, and that is an absolutely wild, I mean, pretty unprecedented intervention into the equity markets in China that have done great damage. Certain sectors, particularly their education space, has gotten totally pummeled. Other areas, not totally pummeled, but rather significantly impacted, some down 5%, some down 25%. But I mean, in short order, some down 5%, some down 25%, but I mean in short order, in a time when global risk assets have all done really quite well. And you're talking about, if you look at the US market and how we have kind of a major social media company, we have a major search engine company, we have a major e-commerce company, we have major software. China kind of has the same

thing. They're sort of counterparts, competitors to what a lot of the FANG names are in the United States. And a lot of these are the names that have gotten hit. And then other names that maybe would be like kind of one tier below that have gotten hit even worse. And these are mostly self-inflicted wounds. And yet I'll argue not accidentally, okay? It's very much within the Chinese authorities' priority there. And so what I guess you could say over the last couple weeks is that one could be forgiven for wondering if our thesis about foreign capital going into China is still in place and would a government

that is able to come in with really draconian interventions of regulation, in some cases of quasi-nationalizing an entire sector and wiping out a lot of equity value. There's a host of things that have taken place that are somewhat particular case by case. I don't want to go through all of them. So let's just say they all have this in common, an intervention from the Communist Chinese Party that has done damage to equity holders. And it is my thesis that those things are legitimately concerning to the risk profile of Chinese equity investors, those who would take an interest in the Chinese stock market, the Chinese tech market, the growth markets. They have an upside.

They have a thesis for where the return, the risk premia, would come from. And yet the risk levels have been intensified from a kind of erratic and wild and yet I think strategically intentional decision-making process from the CCP. And why in the world would the CCP want to damage the equity value of some of their darling stalwart companies? Well, part of it is because they were darling stalwart companies. I do believe that there's a sort of symbolic importance to this that the Chinese government does not want a celebrification of their corporate leaders. They do not want to cult status on some of the major players that are behind some of these big companies that are big

Chinese companies, but certainly big global companies as well. But far more important than that, I think, is their strategic imperative to not become reliant on Western capital. And so this is something I write about a lot in Dividend Cafe today, and I want to be able to kind of go through it quickly here with you. I want to be able to kind of go through it quickly here with you. I think that there is a symbolic message. I also have a joke in Diving Cafe about the, you know, life doesn't change that much for adults versus high school. I guess for a lot of people that's literally true. I would like it to be kind of less true for the grownups that I associate myself with. the grown-ups that I associate myself with. But there's always that, these kind of things that define the social structure of high school life and that old joke of you can't break up with me

because I'm breaking up with you, you know, or trying to break up with somebody first. There's no question that the United States has, over the last year, taken a lot of measures towards regulating or preparing to regulate further the listing of Chinese companies in the U.S. I think some of this is preemptive that China's wanting to kind of do it first if you will but this I want to read this from the different cafe I think that more important than sending a signal to the business class in China than sending a signal to the business class in China. More important than fortifying intellectual and capital resources for more pressing national needs is that China does not want to be dependent on foreign capital. And it actually even transcends reliance on foreign capital,

has everything to do with a broad reliance on the West. Capital, customers, technology. China's very aware strategically of the advantages they've enjoyed by nature of the West's reliance on them. And what I mean by that, how has the West been relying on China for the last 20 to 30 years? The customers, the cheap exporting of product that has become a huge part of this export-import relationship, and the ability of China to finance Western deficits by nature of that trade deficit. And so there's a heavy benefit that China's had from reliance on the West, and I think the last thing China wants is for the shoe to be on the other foot. Okay. And so it, to me, is perfectly consistent with strategic imperatives of the CCP for them to be doing this damage to Chinese equities. Now, I am totally open to the argument

that that's baked in the cake, that they're still rapidly growing companies, highly profitable companies, and that, you know, existentially, they're probably not going to kill these things off. And there may just be a great long term opportunity for investors who want to buy some of those Chinese tech, internet growth companies. My view is I cannot wrap my arms around that risk reward trade-off. There may be particular companies within a very small position of a portfolio that is heavily vetted and diligence to buy outside money managers. But no, as far as that representing a really attractive risk reward trade-off, I think it amounts to kind of hope as the strategy that it is not just that the Chinese government is willing to intervene

and do great damage to the equity holders, to the rights of the equity holders, to the profit participation of the equity holders. They are willing to do all these things that are damaging, but it is also potentially continually in their best interest to do so. And that is a very bad formula, a very bad combination of circumstances. So then the question becomes, what about the bond market? Because that's really where our interest level began.

And the bond market's an entirely different story. Now you're talking about a different part of a client portfolio, a different objective. You're not trying to get organic growth and organic growth of income. income. You're not trying to participate in private enterprise forces, in the organic human action that stimulates that economic activity per se. This is often driven by liquidity needs, safety needs. It's a different drawer in the cupboard. And I think that when it comes to the fixed income world, the pursuit of this inquiry, the very possibility of this consideration is driven by U.S. decisions. It was the U.S. fiscal and monetary authorities that chose to put us now down near the zero bound, that has offered to pay savers and conservative investors a negative real rate of return

in exchange for them loaning them their own hard-earned money. The deficit levels at which we live, the national debt tally that has been accumulated under both party administrations, and the economic reality of our country that I've talked about ad nauseum all year long as to how we got into this position, and the philosophical belief from both the monetary side of the house, the Fed, and the fiscal side, both the monetary side of the house, the Fed, and the fiscal side, that it is the job of the regulators to do more of the things that have put us into this position, that the medicine needs to then kind of multiply on itself as it ends up basically providing a diminishing return over time. And so you have an environment in which people that previously could have relied upon the United States Treasury bond market, the high-grade corporate bond market, to provide a

certain part of their retirement savings and retirement income no longer have that, or at least not in the same classification. Now, of course, it very well could be that other alternatives carry on other risks or other complications that are just simply not worth it. But my point is, why even look elsewhere, let alone look to a communist country who is a geopolitical enemy of the United States. Why in the world would these opportunities in other regions like that even be attractive or potentially attractive to a U.S. investor? And the reason is not because of anything those other countries have done,

not the foreign entities themselves, but because U.S. bond investors are frustrated by U.S. bond conditions. So then we have to get to the point of actually arriving at a decision that is rooted in the proper amount of investigation, consideration, etc. And this is what has been a really quite informative and frankly fascinating study for me is walking through the realities of the Chinese bond market. There's a lot of charts at Dividend Cafe this week. I have every confidence that you will go online at dividendcafe.com and look at them because you really ought to. But let me just give you kind of a nutshell. The five-year

treasury in the United States is right now paying about 0.7%. And the 10-year, as you know, is paying about 1.2%. In China, you're north of 2.5% in the five-year, closer to 3% on the 10-year. So basically, whether it's a five-year to five-year or a 10-year to 10-year, apples to apples, you're talking right around a triple, right around three times the yield that you would get in Chinese sovereign debt versus United States sovereign debt. That's a pretty significant pickup and premium. And yet, we know that we have this problem I talked about earlier, which is the willingness of the Chinese government to intervene with equity investors.

And my argument is that there is a willingness to do so with equity that is combined with an advantage or an alignment or a motivation, an incentive to do so, yet on the bond side it is the exact opposite. I'm quite sure there's a willingness for them to do any number of things that would be damaging to foreign investors, yet their incentive is actually quite the opposite. That the one strategic advantage, the one Western reliance that trumps all the rest is the reserve currency status of the United States dollar. And to the extent China is able to continually denominate more of their own debt,

they're practically to 100% now in their own currency, and get other nations around the world to denominate their debt in Chinese currency or hold some of their reserves in Chinese currency. As they continue to want to grow on the global stage as a legitimate, developed global player, the stability of their bond market, the stability of their currency, the liquidity of their bond market are all paramount strategic imperatives for China. And therefore, the very factors that are working against Chinese equity investors are working for Chinese bond investors. Well, what about the size of the bond market? Is this an interesting hypothesis, but we're just simply dealing with too small of a situation for it to feel stable scalable etc the chinese bond market is now the second largest bond market in the world

you may say yeah well it's you know the first or second largest economic country in the world by population it is the largest country in the world okay okay? But this is the thing. They didn't even have a bond market until 1981. They really didn't even have a bond market until the last decade. There were no bonds issued at all throughout Mao's Cultural Revolution. They began issuing some sovereign debt in 1981, but you basically,

when you look at the chart of the issuance, started about 10 years ago, and then in the last five years is where it's really ramped up. Their sovereign debt is the third highest in the whole world, U.S. than Japan. Japan obviously has significantly more debt than China, but their total bond market is larger even than Japan's, which is staggering. But this is the thing. Much like the U.S.'s little nuance with Fannie and Freddie,

which were kind of corporate, non-governmental debt with a governmental implicit guarantee that now became a more explicit guarantee out of the conservatorship and the financial crisis. China has a significant amount of quasi-government debt that makes for a very robust and diversified bond market because they have banks that are nationalized and so their debt is under the purview with an explicit guarantee of the Chinese government. And then unlike a water bond in Milwaukee, Wisconsin, the municipal or local debt in China is backed by their central authority. in China is backed by their central authority. And so it's not a perfect analogy, but it would be sort of like if the municipal bond market in the United States became a direct obligation of the United States government. So they have other asset classes in their fixed income market that could fit under the quasi-government backing. So it makes for a very interesting bond

market that is new, that is large, that is diversified, and then out of that is providing a lot of opportunity for investors with yield premium, with liquidity, with diversification, with liquidity, with diversification, etc. And so here's the kind of summary I would say to you. China is an emerging market in the sense that hundreds of millions of people in its population are still in poverty. China is a classic developed market and is one of the fastest growing economies in the world that has achieved more civilizational progress in terms of technology, economic opportunity, GDP growth than any country ever. of its entrance into WTO decades ago and its more prominent acceptance of its currency. It's a clear globally developed competitive player,

for good or for bad, by the way. And yet you basically have a yield that would suggest that it's in the sweet spot where it's much higher than these developed countries like U.S. and Italy and Germany, Japan, but much less than the risk and instability and chaos of Thailand and South Africa and Turkey and things like that. And so I believe that this is sort of the summary of what we're dealing with here. An arbitrage, I'm reading from Diving Cafe, being made available to fixed income investors over this sort of dual classification, China as a developed economy and an emerging economy. And when you look Japan at 225, 250% debt to GDP, the United States 125% debt to GDP, and China only at 50%,

you have kind of the advantages of a more conservative structure. But then the market is well aware that China has those other quasi-governmental debt obligations that push it up more to like 100% to 125% debt to GDP. So that reality keeps its credit rating as good but not great. And yet it, in all practical purposes, is very serviceable, very liquid, very functioning, very stable debt. Well, you know, I don't really care what the risk agencies go attach it. You call something a AAA, the U.S. is a AAA, and I'm getting paid 1% for 10-year. I'm going to lose 1% per year to inflation to own a 10-year bond.

Rating agencies call China debt A1. So it's not junk debt. It's highly rated, but it's lower. But then you're going to get paid that higher yield premium. It's fascinating. But it's because of China being in this kind of position that may very well represent a sweet spot for debt investors. But from a volatility standpoint, there's a chart at Dividend Cafe. This doesn't seem to have become problematic. It's quite the opposite. You have dramatically lower volatility, up and down movements in Chinese sovereign debt than any other country emerging. That's not a surprise, but even other developing

nations. So you have a lower volatility profile. You have a huge yield premium pickup. You have much more favorable debt to GDP characteristics. You have the newness of it, attractiveness of more foreign capital coming in, providing greater and greater liquidity still because obviously their bond market in present state is not as liquid as United States Treasuries or trillions of dollars trading a day.

But you have this well-liquified marketplace that is getting more and more liquid through time as it continues to grow and democratize its investor base. And you have a strategic objective from China to want a stable and healthy bond market and a stable and healthy currency. And then you have the fact that their bond market is not nearly as influenced or impacted by their central bank as almost every other bond market is, certainly the Federal Reserve in the United States, certainly the European Central Bank and EU nations, certainly the BOJ in Japan, which basically is their bond market. And I think that makes for a healthier environment as well.

So what's the problem? Isn't this our answer? Well, it's not quite that simple. Because even though I really do believe my hypothesis makes a lot of sense, the willingness of China is a problem no matter what, but the alignment and incentives are far more favorable on the bond side than they are on the equity side where I think it's the opposite. We still have to ask ourselves, first of all, is this worth it? Is it worth it? Is it more trouble than it's worth? Is finding a three times yield premium on boring bonds worth it? It may not be. It may very well be. It may just be not only that it's worth it, but it's our duty to do so on behalf of clients if we were to get there through the research of this endeavor. But then I also think beyond the kind of worthwhileness of the whole thing,

there's a moral conundrum. I feel that I've vetted this a little bit further than I'm letting on in Dividend Cafe today. But yeah, I'm a pretty staunch anti-communist. Do I want to buy the debt of a communist country? It's a legitimate question. Now, of course, if we dig deeper into that subject, we'll realize it's a little different than may meet the eye. And by buying United States Treasury debt that is then sold to China, people might not be fully comfortable with the complexity of all these things in an actual global economy anyways. But at least superficially, prima facieie it's a pretty fair question is there something that we want to investigate about that but i'm right now approaching this as any fiduciary would which is what is best for our clients and these are the conclusions we've come to so i can

wrap up this podcast and and let you get back to the more exciting things in your life we have a bias against direct chinese equity ownership right now due to the unpredictability and the risk from the Chinese government, which has strategic objectives that currently desire less reliance on Western capital, technology, social structures, etc. The same incentives that work to cause Chinese authorities, number two, to damage their own equity markets, also work to cause them to support and stabilize their bond markets. Number three, their bond market is a

new phenomenon in modern global capital markets. It's a large, liquid, robust market. It offers a sizable premium to U.S. bond markets in yield and income. Number four, that premium is a byproduct of China straddling the line between a developed and an emerging economy. Number five, we are thoroughly vetting the economic assumptions, the risk reward trade-offs, and the moral and political aspects to decide if sovereign exposure and boring bonds would be in the best interest of our clients. And so the various setup and structure that I've laid out for you premiums are what they are, the various characteristics of the bond market, the historical realities, and the future structure, etc. We've done a lot of this groundwork. We've done a lot of this investigation.

So now we have to go test the thesis and we have to find people that disagree and hear them out. So I have a lot of meetings set in New York in the months ahead. I want to continue hearing from the people that are bullish on Chinese bonds, people bearish on it, and be able to vet those arguments and considerations. But those conclusions lay out the kind of sequence of premises that lead in our thinking and will obviously keep your breasts as to where we're headed. My intention here is to avoid major disruptions. There's enough intense uncertainty that exists for all investors at all times. And as I talk about all the time with the Fed, my desire is that there be less intensity to the uncertainty of capital markets.

And yet that uncertainty, that fragility, that unpredictability is intensified by policymakers. Current monetary policy, all of the interventions from central banks, both in the U.S. and abroad, the constantly living above one's means in terms of the debt levels of most developed countries on planet Earth. All of these things produce enough uncertainty as it is, not to mention the uncertainty that just is inerrant in the equity side of our portfolio because capitalism is itself a dynamic thing. As companies go about competing, there's ups, there's downs,

there's a business cycle. And so all of those things are already baked into the life of a portfolio, to the life of an investor. The last thing I want is to invite additional intensity to that risk, that uncertainty, that unpredictability. However, I didn't invite it into the U.S. bond market. Someone else did. And it's my job to go look at what alternatives may exist to that. And we may come back to this thing and say, no dice. It doesn't make sense. We may come back and say, yeah, we like the idea of Asian bond exposure, but it's not going to be China. It's going to be Malaysia or something like that. There's a lot of places this can go. I'm spreading a wide net here. But I guess as I leave you this week in the Dividend Cafe, what I want to say is

this is a project that does warrant our intellectual inquiry because our objective is to get this right for clients. And there is a need to have that component, that asset class represented in a portfolio, and it may very well be that there is an opportunity there in the Chinese fixed income sovereign debt market that we'll end up concluding we want to invest in. That's where we are with the process. I hope this has been helpful. I hope I've walked you through it. helpful. I've walked you through it. I really would love for you to read The Divin Cafe as well, not only because I've kind of gone quickly here through this podcast and video, but also because of those charts that might help bring you point by point through my thinking on it. Reach out with any questions anytime and share this with anyone else that you think might be

interested. Share it with people you think are going to hate it, people you think are going to love it. It doesn't matter to us. But in the meantime, do have yourself a wonderful weekend. And we thank you, as always, for listening to and watching The Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, and with Hightower Advisors LLC, a registered investment Thank you. or investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research

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