Conclusion: It’s increasingly likely that slowing growth and additional tightening may be priced in, thus Chinese equities look poised to benefit in an inflationary or disinflationary environment.
Position: Long Chinese equities via the etf CAF.
On Friday, we opened a position in Chinese equities within the Hedgeye Virtual Portfolio for the first time since closing a long position in late September of last year. The recent weakness in the wake of Japan’s crisis provided a buying opportunity, as the Shanghai Composite remains bullish from an intermediate-term TREND perspective:
“Why buy China?” one might ask, given our outlook for the Chinese economy remains “growth slowing as inflation accelerates”. Simply, put, the answer to that question is a question in and of itself: “What price does one pay for slowing growth?”
With a handful of sell-side firms following the Chinese government in revising down their 1H11 Chinese growth assumptions, we are inclined to believe the bear case on China is getting increasingly priced in. In fact, we were among the few to be appropriately bearish on Chinese equities in early 2010 and since we introduced our bearish Chinese Ox in a Box thesis on Jan 16, 2010, China’s Shanghai Composite Index is down nearly ten percent (-9.8%), including a peak-to-trough decline of (-26.7%) recorded on July 5th.
We get the bear case on China, so naturally, our next risk management tasks are to figure out whether that’s fully priced in and if the market is leading us to a reacceleration in Chinese growth. Addressing the latter point specifically, there are signs that China is indeed entering a bottoming process from a growth perspective.
YoY growth in Chinese Exports, Retail Sales, and Money Supply (M2) all slowed to multi-year lows in February (in part due to the timing of the Lunar New Year). While there may be further downside in these series in the coming months, the intermediate-term risk/reward setup is skewed to the upside for the first time in several quarters.
From a financial market perspective, we see that China’s 12-month interest rate swap contract (which exchanges fixed payments for the seven-day repurchase rate) backed off its high of 4.04% on Feb 21 to 3.4% today. The key takeaway here is that the Chinese bond market’s expectations for additional tightening have receded. While still elevated relative to the 1.99% we saw on Aug 25, the slope of this trend remains positive for Chinese growth expectations on the margin. Whether today’s +18bps gain is the start of a newfound trend of expectations for incremental tightening relative to current projections remains to be seen. For now, the trend is moving in the right direction.
We’d be remiss to not mention the impact of inflation on Chinese equities. Prior to the current rally which began on Jan 25, Chinese equities had sold off from their Nov 8 cyclical peak on fears of accelerating inflation leading to aggressive tightening of monetary policy. With three interest rate hikes and six announced reserve requirement hikes since late October, a great deal of tightening may indeed be in the rear view. This opens the door for those Chinese stocks which benefit from higher levels of inflation to outperform. An analysis of industry contributions to the Shanghai Composite’s current +8.7% rally confirms this:
- Coal (+1.2%) – energy inflation;
- Mining (+0.9%) – precious metals reflation;
- Chemicals (+0.6%) – energy inflation pass-through;
- Banks (+0.5%) – widening yield curve; and
- Oil & Gas (+0.5%) – energy inflation;
Buying China here is certainly not without risk, however. Given that the current rally is highly levered to accelerating inflation, any disinflation in real-time commodity prices (via USD strength) may prove detrimental. Consider the following correlations to the Shanghai Composite Index over the past two months:
- Brent Crude Oil: r = +0.86, r² = 0.74;
- Gold: r = +0.89, r² = 0.79;
- Silver: r = +0.93, r² = 0.87;
- Chinese Yield Spread (10Y sovereign yield less 1Y Benchmark Lending Rate): r = +0.82, r² = 0.67; and
- US Dollar Index: r = (-0.66), r² = 0.43.
What could also happen in a disinflationary scenario, however, is that the outperformance shifts from inflation-positive names to consumer and industrial stocks, keeping a bid under the market at large – particularly because many investors have likely chosen to remain on the sidelines due to the current round of tightening. At any rate, given that it’s increasingly likely that slowing growth and additional tightening may be priced in, Chinese equities look poised to benefit in an inflationary or disinflationary environment.