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In the past two weeks, the Chinese equity markets and Hong Kong shares have performed well and are giving signs of pulling out of the bear market in place since 2018.

Besides the indexes themselves, we have an unusually high number of individual stocks that are showing extremely positive configurations, usually the sign that a major bull market may be in the making.

Amongst the positive stocks sectors, banks, insurance, automobiles, and healthcare have been outperforming the indexes and the Trade war “victims” as we called them have risen extremely strongly on short covering.

The renews optimism on Chinese equities has to do with a number of good news relating to the Phase 1 agreement of the Trade War and better economic news across the board in November 2019.

We have been arguing for some time that China would ultimately pull out its mild cyclical slowdown, a slowdown that was magnified by the US Trad War and its global effects on manufacturing and global trade.

The pickup in China’s economy in November added to the optimism from the trade deal announced last week, though plenty of downside risks remain as the nation heads into 2020.

Without the planned December tariff hike, the uptick in domestic activities is likely to last longer. The managed easing policy is also showing in resilient property investment and a probable pick-up in infrastructure construction in the coming months.

Phase-1 Trade Agreement

Last week’s Trade Agreement goes a long way from solving the structural issues that are at the heart of the disagreement between America and China and one of the growing worries we have is how an anti-Chinese sentiment is growing in the USA and in Europe.

As we highlighted in last week’s publication, the THUCYDIDES TRAP is unfolding right before our eyes and a lot of work will be needed on both sides to avoid a full-fledged confrontation in the future.

On Friday, China and the U.S. announced they had come to a preliminary trade agreement, staving off higher tariffs this month. However, the promised reductions in tariffs are unlikely to take effect until February at the earliest and that may postpone the real-world impact.

That phase-one deal has reduced market uncertainty, and China hopes the two sides can work on more to roll back tariffs or even remove all the tariffs in stages, according to Fu Linghui, the National Bureau of Statistics spokesman.

The details of the Trade Agreement agreement have not yet been published and it looks like both Donald Trump and XI Jing Ping are backing away from signing it themselves. A spokesman for China’s Foreign Ministry said Monday that officials remain in contact, and further information will be released in due course.

On the positive sides of the agreement, besides the lifting of the additional US tariffs planned for December 15th that would have had a seriously negative impact on phone and electronic products, the main achievements were an agreement in principle over currency rates, a strong commitment of China to enhance Intellectual Property rights protection and a commitment to buy more US agricultural products and pork/

China’s commitment on agricultural purchases will probably help Chinese policymakers to control the recent pork-driven consumer inflation.

In the long run, it is much more difficult to fathom the real outcome of the Trade war.

It is not really clear what the U.S. is ultimately aiming for, and there is a range of issues that go beyond trade. As many have commented, the relationship between the world’s hegemonic economic power and a rising rival will take years to resolve on even the rosiest scenarios.

And while the issues are real, there are plenty, including ourselves, who believe it was a serious mistake for the U.S. to resort to tariffs in the first place. We always argued that the Trade surplus of China with the US and the rest of the world,d was structural in nature and that only a substantial appreciation of the Chinese currency would solve the problem.

The Currency Conundrum

The foreign exchange rate is therefore probably the best way to measure the success or failure of the agreement and the improving or decreasing quality of the relationship between the two countries.

We have analyzed many times how and why China kept its currency artificially undervalued for three decades and why we had come to the end of that phase.

As the short term chart above shows, the Chinese Yuan had already started appreciating structurally in 2017 and it was very much the launch of Donald Trump’s Trade War in February 2018 that has reversed its course. Since April 2018, the Yuna depreciated by 14 % helping Chinese exporters to mitigate the impact of the US tariffs.

As the long term chart shows, the “artificial pegging” phase ended in 2004 and managed appreciation of the Yuan form 8 to 6 – a 25 % appreciation! – succeeded at keeping the Trade Surplus and foreign exchange reserves stable at high levels.

The 2015 stock market panic led to a phenomenon of capital flight that weakened the currency and it took months of the PBOC to bring things back into control and the appreciation phase resumed until Donald Trump launched his ill-conceived tariffs policy.

Donald Trump’s psychology and professional background made him lean towards “Coercive” negotiation tactics as he has done in other instances, however, in the case of China, it was easily predictable that these tactics would not work as the opposite number of Donald Trump, President Xi Jing Ping, does not have the individual powers that the US President has and that China’s approach to its economy and international affairs is all but transactional.

Imposing tariffs instead of working on currency accord has cost America and the world dearly in the short term, besides the inflationary pressure and the billions paid in compensation to American farmers.

As the following chart shows, US manufacturing collapsed and the world economy lapsed again.

It is unfortunately likely that not much more will be achieved in the future, but if a substantial appreciation of the Yuan starts now, Donald Trump will have done China and the world a great favor.

However, the price paid by America in terms of its standing in the world and access to China’s consumer market may prove to be extremely high in the long run, both economically and strategically.

The Huawei affair will probably stay in history as the tipping point that made China pivot from a cooperative strategy for its economic and technological development to a “Do-it-alone” strategy that will eliminate all levers of the rest of world on what is happening in China,

The yuan rally – and in turn the rally in Chinese assets – will also be fueled by better economic news.

The Chinese economy seems to be pulling out of its contraction

The November activity data showed a decent rebound in production and demand, reflecting effects of supportive policy and favorable seasonal factors.

Industrial output, retail sales both better than expected

Industrial output and private consumption were both much stronger than expected, with production jumping 6.2% from a year earlier and retail sales climbing 8%, data released Monday showed.

The jobless rate was 5.1% in November, about the level it has been all year. There will be more than 13 million new urban jobs created this year, well above the 11 million target for the year, according to the Statistics Bureau

At the same time, fixed-asset investment in the first 11 months of this year grew at 5.2%, the slowest pace since at least 1998. These figures show that China’s transition towards a consumption economy is well advanced and that the prudent policy of gradual stimulus is starting to translate into better economic numbers.

Record Low for Investment

Domestically, policymakers still face questions about the sustainability of debt and rising defaults, but the government has emphasized policy stability and there is little chance of a change until at least March next year, when authorities meet to approve 2020’s broad policy guidelines.

Whether there will be a rebound in sluggish investment will be closely watched going into next year. There was a slight pickup in fixed-asset investment by private companies, according to the November data. But growth was still weaker than expected for state-owned firms, indicating that private companies are still less confident about the economy. This may also reflect the increased difficulty they have in accessing credit.

There are two interesting takes from the above chart, one is that the decline in Manufacturing is certainly linked to the tariffs and that the lifting of tariffs will probably make this metric improve in the coming months and the second is that the sharp decrease in infrastructure investments form 25 % growth to 4 % growth shows that there are reserves of potential growth that can be activated.

To boost growth, the central government is encouraging local governments to sell more bonds earlier in 2020 to pay for infrastructure spending. How effective that will remain to be seen.

For 2020, the nation’s leaders said last week that they want to prioritize stability and keep growth within a “reasonable range.” Fiscal policy should be more proactive and effective, while prudent monetary policy should be “flexible and appropriate,” according to a statement released after the Central Economic Work Conference.

As a result of the Trade War phase 1 agreement, economists from UBS AG and Oxford Economics Ltd. upgraded their forecast for gross domestic product growth in 2020 to 6% from 5.7% after the deal was announced, while saying uncertainties will linger. Citic Securities Co., a leading domestic brokerage house, said they expect the reduced tariffs to lift GDP growth by 0.5 percentage point in 2020 if all the other factors remain unchanged.

Currency markets do matter.

In this first phase agreement the Americans have won something tangible — a weaker dollar — while the Chinese have given something tangible, a stronger yuan.

So we should take the deal seriously.

Moreover, but by giving a better tone to the relationship between the two countries, economic expectations should be better and if the data points continue to improve in China, Chinese equities are way too cheap for the potential.

But what really matters is that IF the Chinese Yuan is to embark on a long term structural appreciation phase following this first-phase agreement, then global investors will increase their exposure to Chinese assets in a durable and substantial way

Moreover, if valuation continues to counsel against buying U.S. stocks, liquidity and valuations are really in favor of buying stocks more or less everywhere else.

It could well be that we are on the eve of a secular bull market in Chinese assets


An interesting way of benefitting from these new trends is the EFG GLOBAL YUAN PORTFOLIO that we have launched in March 2019 and that allows investors to gain exposure to the Chinese Yuan through a diversified portfolio of high-quality Chinese assets in one swiss security denominated in US Dollars offering daily liquidity.

The EFG Global Yuan Portfolio is up + 11.5 % in US Dollars since its inception in March 2019

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