Horseman Emerging Market Fund March 2016 Letter – China appears to be at the limits of its debt capacityVW Staff
Horseman Emerging Market Fund letter for the month of ended March 31, 2016.
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Horseman Emerging Market Fund performance was hit hard in March as Janet Yellen re-established her dovish credentials, expansive debt policy in China improved economic statistics and investors rapidly covered their short positions. The fund fell 14.71% during the month. MSCI Emerging Markets gained 13%. In spite of the equity rally in March however, I do not believe global economic conditions are consistent with sustainable equity returns, the outlook for growth remains poor in my view.
For decades, credit growth in the world’s major economic zones has been overwhelmingly responsible for growth in GDP. However, debt levels are now too high for credit to add such a benefit and alternative policies offer little compensation in its absence.
In the developed world, Europe and Japan look worst. Both are experiencing acute balance sheet recessions, hence, the private sector has no appetite for fresh debt despite negative interest rates and quantitative easing.
Consequently, nominal economic growth is anaemic and equities (especially financials) are suffering badly.
The US is in a better condition by virtue of greater debt destruction during the financial crisis. Hence, nominal growth is in low single digits. Although still meagre, this is higher than other developed economies as low-level credit demand is still in place.
Horseman Emerging Market Fund – China’s economic slowdown
For its part, China is suffering an economic slowdown because of very high debt levels and diminishing returns on credit itself.
Accordingly, we are in a world of slowing growth in which the US exhibits the best relative economic prospects. Hence, conditions for equities look poor but the dollar remains best supported amongst the major currencies. Historically, this combination is very unfriendly for emerging market equities.
China can no longer rely on additional debt for its growth, but unlike in Europe and Japan it is not because of insufficient credit demand but rather excess credit supply. China appears to be at the limits of its debt capacity for three reasons. Firstly the economy is exhibiting diminishing returns on debt capital, as can be observed from the rate of credit extension necessary to generate even a falling rate of growth. Secondly, China’s debt-servicing capability is almost exhausted, a significant share of fresh credit is necessary to service interest payments on existing debt. Little remains leftover for productive enterprise. Thirdly, banks, which are the principal vehicle for credit extension within the economy, are hitting capital constraints as earnings growth evaporates.
Bank interest income is falling as spreads compress and interest receipts decline in line with actual non-performing loans (“NPL”) (as opposed to the lower ‘reported’ NPLs). Additionally, provisions must grow for recognized non-performing loans in financial statements. This has resulted in earnings barely growing in Q4 versus the same quarter a year ago. Therefore, after dividend payments, retained earnings offer no additional fuel to equity for further loan extensions, which is necessary to roll the growing stock of bad debts. Without external equity raising or an increase in liabilities, the banks will very quickly experience a capital shortage because the economy currently requires at least 16% credit growth a year in order to grow at 6.7%, as the Government desires.
Like much of the world then, China is experiencing difficulty in growing GDP independently of credit. The problem is that with slowing growth and China’s extremely high corporate indebtedness, the economy will rapidly face financial distress as debt comes due. In order to avoid this, and with limited available options, authorities will inevitably and periodically revert to using even more debt as an emergency solution, as it appears they did in January of this year. (The benefits of which are currently flowing through commodity prices and Chinese related equities). Nevertheless, for the reasons cited previously, further debt is not a sustainable policy option. Indeed, Chinese authorities started backing away from such rapid debt deployment from February onwards. I expect this to temper forthcoming growth as a result.
Within the Chinese economy, debt is like the tap in a shower with only one control; turning it on is necessary for it to function but turning the tap also raises the water temperature. Chinese authorities are attempting to lower the temperature without shutting off the water. It is proving impossible to achieve. Given this, authorities must employ other tools as the economy slows down as the credit impulse fades; namely interest rates and currency policy, which, in turn will exert their own pressures on the global economy as previous episodes attest.
The world is experiencing low growth as the major economies are maxed-out on credit. Supportive policies are unable to lift conditions to former levels. Indeed, in most geographies central bank policy measures are not helping whatsoever. China’s recent improved data I think should prove fleeting as the extraordinarily high debt flow, (extended via Total Social Financing in January), passes through the system. Ultimately however, the disbursement is likely to have only contributed to China’s outstanding debt burden. The dollar appears supported thanks to relatively improved conditions in the US versus much of the rest of the world. This leads me to conclude the world is still experiencing a strong dollar and low growth environment. The fund remains net short.