The world’s most crowded trade

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Mar­kets are made at the mar­gin. As a re­sult, the key driver of prices for a given as­set is the ques­tion of where the mar­ginal buyer (or seller) comes from. This is why very crowded trades can prove danger­ous: by the time ev­ery one and their dog is con­vinced that (i) the euro can only go down (early 2015), (ii) be­ing short long-dated bonds is the sin­gle best trade out there (early 2014), (iii) un­der­weight­ing Euro­pean eq­ui­ties is the eas­i­est path to out­per­for­mance (early 2013) or, (iv) gold will pro­vide good di­ver­si­fier against wide­spread cur­rency de­base­ment (early 2012), then the mar­ginal flows start to dry up and as­set prices can move rapidly against the con­sen­sus. Our point is not to re­it­er­ate re­cent ar­gu­ments we have made in favour of the euro. It is to state a sim­ple truth that,

Over the past few years, we have re­peat­edly high­lighted what we be­lieve to be the sin­gle most im­por­tant longterm fi­nan­cial devel­op­ment, namely, the in­ter­na­tion­al­i­sa­tion of the ren­minbi. This process is now go­ing into over­drive with an es­pe­cially im­por­tant marker be­ing a vote of the In­ter­na­tional Mon­e­tary Fund be­fore the end of the year for the ren­minbi to be­come a spe­cial drawing rights cur­rency. This event draws par­al­lels to Ja­pan’s cur­rency lib­er­al­i­sa­tion af­ter 1980, when the yen was freed-up and made con­vert­ible. This led to an up­grade of Ja­pan in most global eq­uity in­dices. Very quickly, global eq­uity and bond in­vestors were chas­ing their own tails, push­ing up the value of the yen to­gether with Ja­panese eq­uity and bond val­u­a­tions to regular new highs; a decade­long bull mar­ket ended once Ja­pan had be­come 45% of the World MSCI and seven of the top ten com­pa­nies by mar­ket value were Ja­panese banks.

Fast for­ward to to­day and what do we know? On the one hand, a re­cent Citibank sur­vey of the top 72 cen­tral banks showed that by 2025, they plan to move roughly 10% of their re­serves into ren­minbi. At cur­rent lev­els of re­serves, that is roughly $760 bln of bond pur­chases (to put things in per­spec­tive, the cur­rent size of the dim-sum bond mar­ket is roughly $110 bln—so the Chi­nese gov­ern­ment bet­ter start is­su­ing debt fast!). On the other hand, we also know that China is cur­rently 0% of the World MSCI and 1.7% of the MSCI All-Coun­tries in­dex. Who is to say where the num­ber will set­tle once MSCI starts to ad­justs China’s weight for the re­al­ity of a more freely float­ing cur­rency?

To­day, China ac­counts for 15% of global GDP and about the same share in terms of global eq­uity vol­ume and mar­ket cap­i­tal­i­sa­tion. Ren­minbi us­age has grown rapidly over the past five years to the point where it is the fifth most used cur­rency in SWIFT set­tle­ments. And yet, how many large pen­sion funds, in­sur­ance com­pa­nies, global eq­uity in­vestors, or en­dow­ments have 10% of their as­sets in China to­day? Or even 5%? We would ven­ture not more than a hand­ful; and this for an ob­vi­ous rea­son: China re­mains an in­con­se­quen­tial part of most peo­ple’s bench­mark. But will this still be the case in a few years’ time?

To­day, it is fash­ion­able to make fun of China’s roar­ing eq­uity bull mar­ket by high­light­ing that it is driven by re­tail pun­ters who care lit­tle for val­u­a­tions, busi­ness strate­gies or man­age­ment qual­ity. But how much will in­dex funds and bench­mark hug­gers care about th­ese is­sues once China’s true eco­nomic and fi­nan­cial im­por­tance starts to be se­ri­ously re­flected in the world’s main in­dices? Such in­vestors helped drive Ja­panese val­u­a­tions to crazy lev­els in the mid- to late1980s, de­spite Ja­panese cor­po­rates hardly be­ing paragons of value-cre­ation. Much more im­por­tantly, back in the 1980s, in­dex funds and other “dumb money” ac­counted for a rel­a­tively small part of the global eq­uity pie. To­day, the pre­cise op­po­site is true.

Hence, if China does em­brace cur­rency dereg­u­la­tion, and if as a re­sult all in­dex providers are forced to up­grade China’s weight in global in­dices, the wave of “forced buy­ing” of Chi­nese eq­ui­ties could end up be­ing a ti­dal wave which sweeps away the very idea of in­dex in­vest­ing. A dis­tinct pos­si­bil­ity which brings us to the ti­tle of this piece: the sin­gle big­gest anom­aly in the world to­day is how al­most ev­ery in­vestor around the world has safely ig­nored a dou­bling of the Shang­hai stock mar­ket over the past year. In essence, out­side of a few Chi­nese re­tail in­vestors, ev­ery­one is “short/mas­sively un­der­weight China”, or at the very least will be once global bond and eq­uity in­dices start to re­flect the re­al­ity of a China more open to for­eign in­vest­ment flows. And not only is this un­der­weight China po­si­tion the most crowded trade amongst all in­sti­tu­tions; but al­most no-one re­alises that they, along with all their friends, have it on!

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