Investors cannot stop worrying about debt. And this is the case no matter whether it is Southern European sovereign debt, Fannie and Freddie’s US mortgage obligations, or the upcoming aftermath of China’s lending binge last year. I can’t tell you for sure exactly how many, or which potential parts of this moving jigsaw puzzle are factored into expectations – and neither can anyone else. But there are a few interesting things to point out.

Remarkably, a Greek default and significant further weakness amounting to an effective “double dip” are now already factored into many managers’ “base case” scenarios. For instance, in recent surveys no less than 80% of fund managers expect a Greek default or restructuring some time in the next couple years, as well as bank recapitalizations in Spain, and serious problems in most of the rest of Europe. Investors have firmly embraced the notion that if we are having a recovery, it sure isn’t a normal one.

Asian markets have sold off (partially as “growth proxies”) and China continues to face a barrage of negative sentiment whether its accelerating, slowing or sitting still. And some of the street economists whose forecasts for Chinese growth were higher than the mean have finally recognized that Chinese growth has decelerated in the wake of stricter lending controls and a pretty serious property market crackdown and downgraded their forecasts for GDP growth this year. But if you’re looking for clear signs of a huge problem in Asia or China, the evidence is weak, to say the least. The deceleration in economic indicators is natural, given that a large part of the previous acceleration was off of a very low base and in many cases, such as bank lending and money supply, we expect a re-acceleration in the second half of the year. In the property sector, fears of future bad news are firmly embedded in investors’ expectations. However, the potential for anything disorderly looks remote, given that neither property developers nor consumers’ balance sheets are stretched. While forward looking indicators such as PMIs have decelerated, they remain firmly expansionary while Eurozone concerns have kept policy on hold. In short, we are hard pressed to find anything clearly indicating the onset of a double dip. We see a slower, but self-sustaining recovery. And as long as investors can start to believe in growth again, they can set aside, at least temporarily, fears about debt.

In the meantime, policy has firmly moved away from tightening towards “neutral”. This can be seen from the fact that the Chinese media seems to be going out of its way to telegraph the fact that there are no further tightening measures scheduled. While some of the motivation for this may have come from a property-led slowdown in China, we suspect that the more powerful incentive has been the increasingly obvious problems in Europe, which Chinese policymakers have been cautious on for some time already.

However, armed with June data showing a slowdown in exports, further slowdown in loan growth and monetary aggregates, the possibility of something more than merely “no more new tightening” begins to increase. And while it would seem slightly odd to have a complete reversal in property tightening measures when in most places in China (apart from Beijing) property prices have hardly fallen, stranger things have happened. It is now beginning to be possible to make a case that the “property prices only ever go up in China” mentality has faded away and this should help Chinese policymakers to stop worrying that hot money inflows are causing a property market bubble. As long as these pressures remain subdued, a sharp reduction in “braking activity” could set this sector alight again.

Regular readers will know that we have held an unambiguously positive outlook out China generally, and we have been willing to position the portfolio accordingly. Over the past two months, we have had the misfortune to have some of our exposure in two areas where the numbers have continued to come in better than expected, where investors are overly bearish, and where the stocks have nonetheless been indiscriminately sold down.

One part was Macau gaming where revenues from Chinese tourists continue to increase in the range of 50-70% year on year. Add to this the fact that most investors have been bearish on the sector, valuations are low, and we correctly anticipated that numbers would surprise on the upside, in most cases quite substantially, and we felt comfortable putting money to work here. Another area was the solar sector, where, despite concerns about European subsidies, the Chinese solar companies continued to increase market share and profits well ahead of investor expectations. But as bearish sentiment on the world in general, and China’s guilt by association continued to play out, we “risk managed” out of the positions at a loss. Our concentrations here hurt us and this is a mistake we are unlikely to repeat.

We still believe investors are over-discounting the possibility of a double-dip, or even a serious slowdown in growth, and that the risk/reward of holding long positions is good. However, we acknowledge that tail risks remain, and we can still manage to find a few shorts where expectations are stretched. The volatility profile of the fund is now much lower, and, in this context, we will do our best to capture some portion of the snapback in investor expectations that we expect, while guarding against the risks of the false sense of confidence any such snapback might engender.

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