China: Getting More Constructive...

With the Chinese stock market down almost 70% peak to trough, and articles beginning to appear in the consensus press discussing a slowing China, we are naturally starting to get more constructive on being long China via the iShares FTSE Xinhua China 25 ETF, FXI. Classic contrarian indicators are supported by a number of fundamental factors – capitalism, commodities, and currency.

The Chinese stock market is becoming more capitalistic as markets around the globe, including the United States, are becoming less capitalistic. Notably, as we mentioned in the “Early Look” on September 26, 2008, the Chinese government signed off on a plan to “allow margin lending and short selling” four days ago. Ironically, this Communist regime is providing investors more investing “freedom” as governments around the globe, led by the United States, have been banning short selling. Simply, we like to invest in markets where capitalism is expanding.

The CRB Commodities index, which is a compilation of 19 major commodities, reported its single largest down day since 1956 yesterday. This is deflationary. The steady decline of global commodity prices since their May / June 2008 peak has also been deflationary. Clearly, the roughly 70% decline in the Chinese market since its peak is already reflective of a slowing growth outlook, which has now morphed into consensus (see “Beijing Slowdown” in the Wall Street Journal today). We believe the second derivative of this slowing growth, commodity deflation, will serve as a positive catalyst for the Chinese market.

Finally, the Chinese Yuan appears to have put in a top in mid July 2008 versus many major currencies, in particular the US Dollar. As a country whose competitive advantage is cost to produce goods (labor) versus the rest of the world, the lower its costs are in its currency versus the currencies of its major customers, the more appealing its export outlook will become. The Chinese Yuan should only continue to decline as China has signaled a willingness to cut rates with its first easing in 6 years earlier this month. Chinese interest rates have a lot further to fall versus rates in the U.S. (Chinese benchmark rate is currently at 7.2% versus 2.0% in the United States).

Daryl Jones
Managing Director

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