The world’s most crowded trade
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!