China (contd): the argument for disaster insurance

This week, I’m going to conclude my musings on China with two very different takes on how to profit from the economic superpower.

One of the most eloquent China bears at the moment is Hugh Hendry – the boss at hedge fund managers Eclectica. Earlier in the year at an event in London, Hendry very articulately took up Professor Michael Pettis’s argument (summed up in this column a couple of weeks ago) that China was prioritising an increase in output over an increase in real wealth. Hendry’s view was that output growth as a political end within a fixed currency regime was bound to lead to asset bubbles and ensuing price crashes.

But what Hendry didn’t tell the audience was that he’s made a big bet on this eventuality – one that’s soon to be spun off into a separate, potentially high return fund.

He figures that, as China keeps digging more roads and building more factories, the frenzied activity will have an entirely predictable effect on output, accompanied by a collapse in net margins for all parties. That spells corporate bankruptcy in the next few years for lots of companies in commoditised sectors of the Asian regional economy.

So, how do you make money on this over- capacity trade?

Hendry has lit upon a familiar weapon of mass destruction: credit default swaps (CDS) – in which a counterparty sells what is, in effect, bankruptcy insurance on underlying corporate debt.

Electica has found a peculiar bunch of investors who are willing to sell CDS products on corporate bonds for key industrial sectors likely to be hit by this over-capacity trade. Hendry’s hedge fund only has to pay a few pence in the pound to buy these CDS but, rather like those who speculated on mortgage securities in the US, his return will be many times greater if the “unthinkable” happens and bond-issuing companies go belly up. In essence, his new fund will be a form of disaster insurance. If
China keeps on unsettling the global terms of trade and pulverises its competition, his investors will make many times their money back.

What’s curious to me is why anyone would want to sell Hendry these risky CDS options. The answer, of course, lurks in the low returns from most investments in the past decade and the desperate scramble for yield enhancement. Eclectica hasn’t completely closed all its trades in this space yet, so I can’t say exactly which countries and which managers are selling this protection – but the logic on their side is simple, if possibly suicidal.

They think a little extra money from selling deep out-of-the-money swaps is a handy stream of income – especially if you believe that hedge fund managers are making daft bets against national champions who will never go bust because their governments will bail them out.

But for the hedge fund manager – and for the patient investor – this is an imaginative investment. If you’re willing to wager a small sum of money, it might pay off very handsomely – or maybe not if the issuers of the CDS products are right and the worst doesn’t happen.

But, more generally, I wouldn’t want to be long any big Asian equity sector or stock likely to be hit by this massive wave of margin destruction as the Chinese rollercoaster eliminates everything in its path. The beauty of Hendry’s trade, though, is timing – he can afford to bide his time and sit tight and wait for the fat
pay-off ensuing from others’ distress.

That patience could be useful if you take the medium-term view of the China bulls. I can certainly see their point. In fact, I’d repeat my observation from last week that, based on 2011 earnings, some Chinese markets are trading at reasonable levels. And if one casts the net wider, one could even argue that some Chinese stocks are trading at bargain levels. That’s certainly the argument of bulls such as Russell Cleveland, boss of UK Listed investment trust US Growth Investment Trust.

I can’t wait to get him in a room with Hugh Hendry.

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