Conclusion: While Chinese equities have recently dropped like a rock on tightening speculation, careful analysis shows those concerns are overblown. Thus, we’re buyers of this dip.
Position: Long the Chinese yuan (CYB); Long Chinese Equities (CAF).
For the fifth day in a row, China’s Shanghai Composite Index closed down. Having fallen (-4.6%) from April 18 in a straight line on rising tightening fears, we welcome further weakness in Chinese equities as a buying opportunity.
As we’ve outlined in our 2Q11 Macro theme titled, “Year of the Chinese Bull”, we think the pace and magnitude of Chinese tightening has peaked and looks to slow on both fronts in the coming months. Further, we think March’s +5.4% YoY CPI reading is at or very near the cyclical top in Chinese reported inflation over the intermediate-term TREND. For the details behind our conviction in these forecasts, refer to our April 18 report titled, “Chinese Exposition” (email us if you need a copy).
It’s comforting to see that neither China’s interbank loan market, interest rate swaps market, nor its currency market are confirming this mini equity-market freak out. Shibor (a measure of interbank liquidity) and 1Y non-deliverable yuan forwards suggest further tightening is on the way, but not at an accelerated pace or increasing magnitude. Further, China’s 1Y interest rate swaps have hardly budged, suggesting that further rate hikes are not imminent (i.e. if China does tighten further, it will likely be through yuan appreciation and higher bank reserve requirement ratios).
We view the recent uptick in bearish sentiment surrounding China’s property market as a classic case of Duration Mismatch and the recent spate of disappointing small-cap earnings is an opportunity for market expectations to be reset. Beat or miss, we think Chinese earnings will look a lot more attractive than US earnings over the next couple of quarters – especially when US GDP growth has a 1-handle on it. If you have to be long equities, the S&P 500 at a cyclical top looks a great deal more risky than the Shanghai Composite, given that much of the bear case is priced into Chinese equities at this juncture. That is in stark contrast to the US, where less than 20% of institutional investors will admit they're bearish.
The major risk we see in holding Chinese equities (or any risk asset) right now is the potential for an expedited down move in the US dollar over the next 2-3 months. A crash in the global reserve currency could potentially lead to a widespread crisis across global financial markets. The overwhelming majority of global liabilities are priced in US dollars, so haircuts on such assets have ability to drive up counterparty risk across the system. To be clear, we’re certainly not calling for the next financial crisis (yet), but the risk is not one to be ignored, given the Indefinitely Dovish direction of The Bernank’s Keynesian monetary policy.