China’s ‘Chicken Little’ investors benefit from over-indebtedness

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China could be described as a Chicken Little game for stock market investors. Whenever sovereign debt default fears rise – the market’s equivalent of the falling sky – investors flock to sell stocks.

The correlation has been so strong since mid-2015 that credit default swap spreads for Chinese sovereign bonds – which measure default risks – have been a near-infallible indicator for stock prices on the Hong stock market. Kong.

But these days, the perceived risks of collapsing skies are receding, giving investors room to buy China’s Great Economic Transition.

” In decline CDS means a lower perception of default risks, which means less macro risk overall and a higher risk appetite for Chinese equities,” says Maarten-Jan Bakkum, senior emerging markets strategist at NN Investment Partners. , a Dutch asset manager. “I expect that to continue.”

To be clear, Chinese debt risks have not gone away. A recent JPMorgan report puts total debt at 268% of gross domestic product in the second quarter of this year, down slightly from 269% in the first quarter.

But it was still a huge leap from levels of less than 150% a decade ago. Standard & Poor’s downgraded China’s sovereign rating this month – the first time since 1999 – and the International Monetary Fund warned in August that Beijing’s reluctance to curb its borrowing was “dangerous”.

But with CDS spreads low, investors feel freed to seek opportunities during a transition period for China.

Thomas Gatley of Gavekal Dragonomics, a research firm, says data shows that this transition from China’s “old” to “new” economies is on track. At the start of 2011, old-economy sectors such as energy, materials, industrials, utilities and real estate accounted for 75% of non-financial industry profits. New economy sectors such as consumer, technology and healthcare took the remaining 25%.

Today, the split is 60-40 in favor of the old economy, revealing the considerable progress made by the new economy. As the housing sector slows, the momentum driving much of the old economy will also wane, Gatley said.

However, bets that the new economy will drive Chinese corporate earnings are likely to be tempered by expectations of an intensification of state-owned enterprise reform following the Communist Party Congress in October.

james.kynge@ft.com

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