The next global financial crisis is likely to spring from China’s severely imbalanced economy, according to FE Alpha Manager James Thomson, but he says investors can still find attractive returns by focusing purely on developed market equities. 
Thomson is one of the highest returning and most consistent managers in the IA Global sector and his £590m Rathbone Global Opportunities has got off to a flying start to 2015 with its top decile returns of 9.77 per cent.
He says one of the major drivers of those returns has actually been his decision to avoid emerging markets, an asset class which has had a very turbulent year due to falling commodity prices, weakening currencies and major concerns surrounding the future of China’s economy.
Thomson admits that he tends to avoid emerging markets generally in his portfolio as he feels he would be unable to add a huge amount of value from those regions. However, the other major reason is because he firmly believes a crisis is brewing in the developing world.
“There has been a number of emerging market ‘canary in the coal mine’ warnings about their dangerous imbalances, particular in China, over recent years. Worryingly, they seem to be getting worse,” Thomson (pictured) said.
“In my opinion, China will be the source of the next financial crisis. Slowing economic growth, over-capacity and excessive leverage is a lethal cocktail. I can’t say when a crisis would start, but all investors need to tread with caution when it comes to China.”
Concerns about the state of the Chinese economy have been an ever-present threat to global markets for a number of years now, as investors have worried about the country’s changing economy from an investment-led model to consumption driven one, its over heating property market and murky shadow banking sector.
However, while those headwinds have continued, Chinese equities had acted as if all is extremely well.
According to FE Analytics, between June 2014 and June 2015 the Shanghai Stock Exchange Composite delivered gains of 180 per cent compared to 12 per cent rise in the MSCI AC World Index.
Performance of indices between June 2014 and June 2015
Source: FE Analytics
A number of factors contributed to those remarkable gains such as the Shanghai-Hong Kong Stock Connect, easing from the Chinese central bank and investors’ anticipation of further central bank liquidity-boosting measures to stave off slowing growth.
However, as investors will now be well-aware, the Chinese market has seen a significant change in fortune since June. As the graph below shows, the index is now down close to 30 per cent over that time.
Performance of index since June 2015
Source: FE Analytics
While some have described recent events as deflation of the ‘A’ (or domestic) shares bubble, but others warn it is sign of worse to come.
The Chinese authorities have already stepped in a number of times since the initial falls to try and stop the rot, including suspending new share offerings, ordering brokerages to buy shares and promising to provide liquidity.
They also took the bold decision to devalue the yuan earlier this week by 2 per cent, making its exports cheaper and its domestic firms more attractive to compared to foreign importers. Again, though some say this is a signal to buy into the market (such as Psigma’s Thomas Becket), Thomson is far from optimistic.
“Yes, I think [the devaluation] is another warning sign that growth is deteriorating faster than we think,” Thomson said.
His thoughts are echoed by David Madden, analyst at IG, who recently told FE Trustnet that the authorities’ decisions shows the world’s second largest economy is clearly on the rocks.
“Since Beijing is very protective of the yuan it is a clear sign that it is running out of ideas. China is trying to portray an image of a gentle slowdown, but in reality it is trying frantically behind the scenes to keep its levels high, and traders aren’t buying it,” Madden said.
Thomson says that for investors to fully understand China’s predicament, they need to review the phenomenal economic growth that made its equity market so profitable in the first place.
Performance of indices since May 2003
Source: FE Analytics
“You have to look at the growth miracle in China to see why the current imbalances are so dangerous,” Thomson explained.
“It was predicated on rampant investment spending. Some 48 per cent of GDP was investment spending which was the highest in the world. The reason China has been so addicted to it is because it adds more capacity and therefore creates a lot of jobs.”
“Jobs are how you cement your political power. What’s interesting though is that for every £1m of investment spending you create 12 jobs but for every £1m worth of consumption you create just four jobs.”
“Invariably, if they want to change their economic model, they are going to create unemployment.”
“When you match that with excess capacity (there are 95 Empire State Building’s worth of empty office space in China), nothing to absorb it but just more investment spending which isn’t adding value and then throw in excessive leverage – that’s dangerous.”
He added: “Of course, none of this is new to the Chinese authorities and they do have a lot of firepower at their disposal to counteract this, so I wouldn’t say investors should expect China to walk of a cliff just yet.”
Thomson has managed his Rathbone Global Opportunities fund since November 2003.
According to FE Analytics, it has been a top decile performer in the IA Global sector over that time with gains of 384.7 per cent, beating the MSCI AC World index by more than 190 percentage points in the process.
Performance of fund versus sector and index under Thomson
Source: FE Analytics
It is also top quartile, and beating the index, over one, three, five and 10 year periods. This is largely due to the consistency of the fund’s returns as Thomson has beaten the sector in nine out of the last 10 calendar years and has beaten the index in seven of those years.
Rathbone Global Opportunities is highly-rated within the industry and currently sits on the FE Select 100 due to Thomson’s stock-picking abilities.
The FE Research team note how the manager also learned from his mistakes during the financial crisis (his fund lost 40 per cent, twice the amount of the index, during the financial crisis) and therefore now avoids leveraged companies to protect his investors.
“The manager has developed an approach which limits the damage to the fund when markets fall. Nonetheless, it is still very much a fund that is likely to do best when the economy is improving and stock-markets are rising,” they said.
While Thomson is clearly bearish on China, he says investors shouldn’t automatically run to the hills as there are still plenty of opportunities within a global remit.
“I think you can still make good money in global stock markets, particularly in developed markets where growth is improving,” Thomson said.
“In fact, the likes of the US are likely to benefit from China’s slowdown as falling food and energy prices will act as a big boost to the consumer. In the absence of a complete unravelling in China, the current trend is good for developed markets.”
The manager had been renowned for keeping relatively high levels of cash a number of years ago due to his cautious outlook, Rathbone Global Opportunities is now fully-invested and Thomson says he is has more opportunities than cash in the current environment.
Therefore, while he accepts that volatility may increase as the US looks to raise interest rates, he is positive on developed market equities over the medium term.
Thomson currently holds 54 stocks in his Global Opportunities fund and his largest regional allocations are to the US (58 per cent), the UK (25 per cent) and Europe ex UK (13 per cent). The fund has a clean ongoing charges figure of 0.8 per cent.
