Conclusion: Below we’ve compiled our take on several key discussion points which have arisen in the wake of our 2Q Key Macro Themes Call, specifically as it relates to our Year of the Chinese Bull theme (email us if you need the replay podcast and presentation materials).
Position: Long Chinese equities (CAF); Long Chinese yuan (CYB)
Q: In the U.S. a tightening cycle is usually not great for equities. Why are you not more concerned about Chinese equities given that the Chinese government is tightening in an effort to deal with inflationary pressures?
A: The point we we’re attempting to make on slide 16 in the presentation is that the bulk of the Shanghai Composite’s earnings either benefit from, or are insulated from tightening. In fact, if you look back to the last period of Chinese tightening back in 2006-07, we saw that China’s equity market put on an over +200% move to the upside. Obviously no two periods of time are the same and we certainly aren’t making the case for a similar move, but, as the graph below shows, Chinese equities can indeed work amid a tightening cycle.
One of the key tenets to the call we are making now is for Chinese CPI to top out and decelerate in the coming months – and Friday’s +5.4% CPI reading could indeed be a cycle top. That would potentially allow the PBOC to ease off the brakes and allow the growth premium to return to China’s long-term interest rates. A widening yield spread is explicitly bullish for nearly one-third of the index’s earnings and higher growth expectations are good for the majority of the rest of the market. Further, China’s yield curve is now at/near pre-financial crisis, pre-recovery levels. A higher spread from here would be bullish for Chinese bank earnings, while a lower spread would likely be an ominous signal for the global economy.
If we’re wrong and China’s CPI continues to rip to the upside like it did in early ’08, we still have mean reversion (bear case is a known-known), accelerating relative growth vs. slowing US/EU growth, and cheap valuations relative to their own historical range. This three-factor setup alone makes Chinese equities interesting from an institutional fund flow perspective –remember Chinese equities went no-bid for nearly 2/3rds of last year.
If we’re really wrong on the slope of Chinese inflation and it causes the PBOC to either: a) significantly tighten far beyond any current expectations, or b) revalue the yuan significantly in an expedited manner, the resultant effects of scenario “a)” would be very negative for global growth and a significant, expedited appreciation of the yuan as outlined in scenario “b)” would bring about many unwelcome consequences for the global supply chain – particularly from an import price perspective in China’s export markets. Such a scenario would be bad for anything equity-related, in our opinion.
As we pointed out in a research note on 2/16/11 titled “China: Stuck Between a Rock and a Hard Place”, political consensus’ demands for China to quickly revalue the yuan are misguided at best. It would likely take most companies 2-3 years to offset the resultant lack of price competitiveness from a higher FX rate by installing manufacturing capacity in other markets. Near to intermediate-term, a major yuan revaluation would likely result in an import price shock in China’s export markets.
Addressing the “relative” aspect of the question, with regard to the U.S., China is not nearly as sensitive to interest rates in one direction or the other. China’s gross national savings rate is north of 50% of GDP and consumption still hovers around 35-38% of GDP – about half of what it is in the U.S. What this means is that as interest rates increase, Chinese consumers and corporations actually have more income from which to consume given their already high savings rate.
From a investment perspective, rising interest rates don’t have quite the same impact in China because the hurdle rate for capital expenditures is much lower than in the U.S., given China’s historically elevated economic growth rates. Essentially, China’s robust growth profile creates a wide spread between expected returns on capital projects and the project’s weighted average cost of capital. Therefore, China has a lot of hay to bale from an interest rate hike perspective if they are going to have a meaningful impact on slowing the growth of capital expenditures.
In China, a great deal of household wealth sits in a shoebox in the family plot (not kidding). Relative to the massive oversupply of savings, China’s bond market (~$3T) isn’t quite liquid enough to accommodate that kind of an influx of funds out of its ~$6T equity market or the ~$6T economy, so net-net, more attractive rates of return don’t have nearly the same flow of funds impact in China than they do in a more advanced economy such as the U.S. Moreover, with China’s household consumption as a percent of the overall economy at about half of the U.S. rate and with Chinese consumers being significantly less levered than their U.S. counterparts, rate hikes simply don’t have the same impact of slowing aggregate growth by deterring consumption in China as they do in the U.S.
Q: What is your call on falling inflation in China predicated on? I guess the argument could be made that as the government allows the currency to appreciate quicker, that will naturally put the brakes on inflation, but does that fully offset rising labor costs associated with urbanization and normalization of salaries or commodity pressures (esp. oil) which when combined make up more than 1/3 of headline inflation?
A: The projections on slide 14 are the outputs of a quantitative model we use to forecast the slope and amplitude of a YoY economic data series. While it back-tests with an r² greater than 0.8-0.85, we do understand that it is purely a mathematical exercise and not to be fully trusted without quantifiable catalysts. Understanding that, our confidence in the slopes of those lines is derived from on a confluence of factors that stem from China’s proactive response to inflationary pressures.
While much of the media has been focused on China’s four rate hikes since October, the reality is that China’s been tightening since last January and recent moves by the PBOC to force banks to bring off-balance sheet assets back onto their balance sheets will make China’s ten reserve requirement ratios since Jan. ’10 start to actually have some measurable effects. In all, Chinese banks’ reserve requirements have increased +500bps in the last 15 months. We’re already seeing the effects of that in the form of slower Money Supply growth, slower Credit growth, and negative YoY Total National Financing growth in 1Q11.
The yuan has and will continue to be used as a tool to combat inflation – perhaps even more so than before, judging by PBOC governor Zho Xiaochuan’s commentary this past weekend. The yuan has risen +4.5% vs. the USD since it was de-pegged last June and his latest commentary was that the PBOC has grown increasingly concerned about the spread of Chinese rates vs. U.S./global rates. The spread between China’s 1Y Deposit Rate and the Fed Funds Target Rate and the ECB Main Policy Rate is now at levels last seen since just before the Asian Financial Crisis of 1997-98. They are legitimately concerned about the potential for destabilizing capital inflows and that will likely shift their policy stance towards favoring additional yuan appreciation and reserve requirement hikes for now – at least on the margin.
Lastly, to the extent the confluence of China’s tightening measures fully offset recent and anticipated wage growth does indeed remain to be seen. At this point, that remains one of the key risks to the thesis – accelerating inflation perpetuated by consumer demand – and no longer just monetary expansion. That would, however, be bullish for China’s near-term consumption figures and incrementally positive for overall Chinese growth in the near-term. And, as we’ve seen with WMT recently, China has the power to limit and/or outright deny price hikes for finished goods. It’s food and energy prices that makes the PBOC’s fight difficult; so to the extent we continue to see higher-highs in food and oil prices, we’ll likely see elevated levels of Chinese CPI and incremental yuan strength.
At the end of the day, it is important to remember that Chinese CPI itself is a mathematical series that is subject to: a) the Chinese government making up the number (like we do domestically); and b) its own base of comparison. We’d have to see an acceleration in the velocity of food and energy price increases for Chinese CPI to “comp the comps” and that’s not something we have in our forecasts for 2H11 – the dollar can and will be burnt only to a point before it snaps fervently off its lows. For now, that’s something we see as a 2Q/ early 3Q phenomenon.
Q: Also as a follow-up, we have seen more and more automation in China as more of a LT solution to rising wages. In 2011, I think more and more companies will be taking that route. The break-even point between manual and automation may be 3 years, but the first year or so the cash costs from implementing automation is much greater than running the business on manual labor. Is there a possibility this may serve as a ST positive inflation shock, as these costs have to get passed through somehow?
A: Great point and to be honest, we haven’t done the work here specifically so we’ll hold off for now. The only thing we’d say is that from a probability weighting perspective, this would rest more on the tails rather than in the heart of the bell curve of probable scenarios. From our vantage point, there’s more lower-hanging fruit to analyze when attempting to forecast Chinese CPI over the next 6-9 months.