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Philippe Jabre

China needs a significant currency devaluation

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Jabre Capital Partners is one of the industry's best-known hedge funds. Established by Philippe Jabre (pictured) in 2006, the Geneva-based hedge fund runs a variety of strategies that include: Multi-strategy, Equity Long/Short, Convertible Bonds, Emerging Markets and Event Driven. 

With respect to its Emerging Markets strategy, Jabre Capital combines a top down global macro view with bottom up fundamental stock selection to build positions in a diversified portfolio. 

Such has been the level of volatility coming out of emerging market economies, principally China, that finding the right investment opportunities and trying to time the right entry and exit points has been a mighty challenge. In Jabre's view, the world economy is in a period of decelerating growth; Japan has resorted to a negative interest rate policy, non-farm payroll figures in the US rose less than expected in January (151,000 jobs compared with expectations of 190,000), and the Eurozone is showing no signs of hitting its inflation targets, recording a 0.2 per cent contraction in February. 

Such an environment of declining growth creates lower multiples on earnings. "If you have 2.5 per cent GDP growth in the US, as we had on 31st December 2015, it deserves a 15.7x P/E multiple. However, if growth drops to 1 per cent in 2016, then it will deserve only a 14x P/E multiple. If growth is 0 per cent, it will be a 12x P/E multiple," says Jabre. 

Some economists, such as Nouriel Roubini, Chairman, Roubini Global Economics, argue that the risk of a global bear market is rising daily. Asked whether the world is on the brink of another global recession, Jabre is reluctant to go that far. 

"Recession, no recession? Nobody knows. It's a function of probability. A recent Morgan Stanley report highlighted that US clients were convinced that there would be a hard landing in China, and a sudden, rather than gradual devaluation of the currency. If China has a hard landing then it will result in global recession but the definition of a recession is two consecutive quarters of negative growth. 

"We are still very far away from that. In the US, we are still seeing growth of 1 per cent to 1.2 per cent growth. It would take a countrywide collapse to produce two quarters of negative growth. There is a possibility of that happening, but in my view it remains an extreme one," says Jabre.

The situation in China has become more serious over the last 12 months and there is much fear mongering in the West, terrified at the prospect of the China economic juggernaut running out of steam. 

The mood in China among fund managers is far different, however. Jabre relates that an analyst recently visited China and came back in a bullish mood, recommending a number of stocks. 

"I had to calm him down because I simply didn't share his optimism. He said that the mood among Chinese fund managers was very bullish and my response was, `There is a time to invest in China, but it's not right now'," says Jabre, who continues:

"Let's talk facts. China experienced slower growth in 2015 and cut interest rates three or four times. The people who moved their RMB into international currency were the local Chinese, not foreign investors. When these reached large amounts, the global investor community took notice and decided there was a problem. Those who were bearish on China before were largely ignored because China's growth was fine, the economic numbers still looked strong."

Logic would suggest that at some point China's currency will need to depreciate to better reflect the reality of the situation: namely, that RMB outflows have decelerated in tandem with declining growth. 

"If you look at the recent data on monthly money outflows in China, it was approximately USD30-40bn per month when people started getting worried last summer. In December and January that figure had risen to USD100bn a month, against reserves of USD3.2tn (down from USD4tn as at December 31, 2014). 

"Moreover, of that USD3.2tn, at least half is not readily available because it is invested in illiquid assets. The perception of the world is that China cannot continue like this, wasting its precious reserves in dollars. Eventually, my view is that we will have a similar phenomenon to that which occurred in Russia 18 months ago; Russia stopped supporting the ruble at around the 35 level. Now it is trading at close to 80 on the dollar," comments Jabre. 

Much of this currency weakness is structural, having been driven down by the collapse in the price of crude oil.

One possible explanation for why China doesn't want to head down a similar path to Russia might be the fact that significant Chinese corporate debt is held in US dollars. As such, any weakening of the RMB will exacerbate the debt issue and inflate it when it comes to repayment schedules. 

When the US first introduced quantitative easing the USD fell, it prompted emerging market corporates, including Chinese corporates, to borrow dollars, with banks happy to extend their credit lines. Now the fear is that with a rising greenback, the credit situation in China could become serious. Indeed, some commentators think that non-performing loan default rates could rise from 1 per cent to 1.5 per cent in 2016. 

"They have started to experience declining cash flows over the last 12 months yet they still have to repay their USD debts and it's not going to improve it the RMB weakens. There is apparently USD300-400bn of Chinese corporate debt held in US dollars. Petrobras in Brazil alone holds USD120bn of USD-denominated debt and the Brazilian government recently announced that it would not bail out the flailing state-owned oil company because it doesn't have the reserves to do so. 

"As long as emerging markets have growth and healthy cash flows, everything is fine. Now, suddenly, we have a situation where EM corporates are holding a lot of USD debt whilst at the same time experiencing lower growth and lower cash flows," says Jabre.

One obvious investment trade in such an environment is to short the RMB. Unfortunately, this is very limited. There is only approximately USD150bn in Hong Kong's offshore RMB market that foreign investors can short. 

"That said, it is possible to take a bearish short position on China by shorting global companies that do business on the mainland e.g. German or Japanese car manufacturers. There are many derivatives to shorting China that are both liquid and, in our view, too expensive. We do hold some outright short positions on Hong Kong-listed China H shares but the market has now dropped to a significant discount rate. One trade that has been working well in our portfolio is relative value, holding China A-shares and H-shares," confirms Jabre. 

Looking ahead for the rest of 2016, China cannot realistically cut interest rates again as this will lead to more currency outflows. Something has to give. 

"I don't think at this rate they will be capable of facing the macro headwinds, especially if Japan cuts rates further, and the ECB also moves to a negative interest rate policy. That will put even more pressure on them. The solution is to let their currency better reflect the value of the markets. The problem if they do that is that they will curb China's economic growth, but that cannot be a surprise to people now," adds Jabre.

Some hedge fund managers such as Mark L. Hart III, Chairman and CIO of Corriente Advisors LLC, a Texas-based hedge fund manager, have forecast that the RMB could devalue by 50 per cent when foreign investors divest their positions in China. 

"It's hard to evaluate what is necessary, but rather than have everyone looking to short the RMB, the Chinese authorities should perhaps engage in one major devaluation exercise. That will at least appease the markets and curb people's expectations that its currency will fall even more. 

"This is hard to call though. Some think a 50 per cent depreciation, others think a 10 to 20 per cent depreciation. But what will be the trigger?" asks Jabre in conclusion

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