Conclusion: We remain bullish on Chinese equities as the bulk of Chinese and global economic data continues to come in in-line with our estimates. In the note below, we expand our comments from the Early Look today and dig deeper into our investment theme, Year of the Chinese Bull.
Position: Sold our Chinese equity exposure (CAF) on 5/10 due to it being immediate-term TRADE overbought; looking to buy it back on sale. Long the Chinese yuan (CYB).
Inclusive of today’s +1% move, Chinese equities are down -6.1% since reaching a cyclical peak on April 18. While we are not currently long China, as we booked a gain in the Virtual Portfolio on our long CAF position on 5/10, we’d much rather have the Chinese equity market validate our research by outperforming and continue to believe that over the course of 2011 it will do so.
Obviously, though, markets never do exactly what they are supposed to do – irrespective of our modeling outputs, forecasts, and analysis of sentiment. “Markets wait for no one”, Keith likes to say. As such, we thought we’d take the opportunity to highlight one of, if not the most, important skills risk managers must possess in these highly volatile times – the ability to separate the IDEA (research output) from the INVESTMENT (the price you pay to express the research output). Being married to an idea at every price is among the greatest mistakes many investors make; as such, timing and price remain the dominant factors in our models.
We like Chinese equities on the long side. That’s our IDEA, which is being driven by a muti-factor thesis that is best summed up as follows:
1. Chinese growth, while slowing, is slowing at a decelerating rate. In our models, the bottoming of the economic cycle is equally as bullish as the topping process is bearish.
As we called for at the beginning of 2010 via our Chinese Ox in a Box thesis, the rate of China’s YoY GDP growth has slowed from +11.9% in 1Q10 to +9.8% in 4Q10, marking a -210bps slowdown. Even with adopting our model’s most bearish scenario, we see Chinese GDP slowing at only three-quarters of that rate. Within our models, the bottoming of growth rates is a key indicator to increase long exposure to certain economies – a factor which gave us conviction to get long US equities in early March ’09.
2. On a relative basis, Chinese growth rates will widen vs. the rest of the world, creating the illusion of incremental value to growth investors – value we think the market will pay a higher premium for.
From 4Q10 to 1Q11, Chinese YoY GDP growth slowed -10bps. The rate of US YoY GDP growth, on the other hand, slowed by a factor of 5x that of China’s. We’ve been appropriately bearish on US economic growth since the start of the year and we see the current trend of weak domestic growth data continuing over the intermediate term at a magnitude that exceeds China’s own slowdown. Moreover, the US is not alone in this regard – we maintain that growth in the EU, Japan, Brazil, India, and other key emerging markets will slow at a rate greater than China’s over the intermediate term. As China prepares to exit the economic “penalty box”, the large majority of the world’s economies are on their way in.
3. Valuation is supportive; relative to their own historic ranges, Chinese equities are truly cheap.
The last time Chinese growth was accelerating on a relative basis to the rest of the world (2009), the Shanghai Composite peaked at 26x NTM Earnings. Today, they closed at roughly half that (13.2x). While we certainly aren’t making the call that they are going to return to the “bubbly” valuations of 2007 (38x), we do see upside here from a valuation perspective, although valuation is never a catalyst.
4. Mean reversion (to the upside) remains a supportive factor in our quantitative models when factoring in last year’s weakness (down -14.3% in 2010).
The Shanghai Composite finished 2010 down -14.3% and at one point was down -27.9% intra-year. We continue to flag mean reversion as supportive here, as the bear case (slowing growth, accelerating inflation, rate hikes, etc.) continues its transition from “on the horizon” to “in the rear view mirror”. Accordingly, in the latest Bloomberg Global Investor Poll Survey, the percentage of respondents identifying China as the “Market Offering Investors the Worst Opportunity Over the Next Year” dropped -400bps to 16% from January to May. As the bear case becomes fully priced in, we expect this trend to continue in our favor.
5. The net result of the PBOC’s proactive tightening is that we’re very likely to see Chinese domestic inflation peak in the very near term and begin an elongated trend of deceleration, which would alleviate market fears for further tightening.
In line with our forecast, Chinese CPI and PPI slowed in April to +5.3% YoY and +6.8% YoY respectively. In our recent work on China, we have been calling for the start of an elongated down-trend in Chinese reported inflation. As a result, we continue to maintain our view that China is near the end of the tightening cycle, with any additional measures likely coming in the form of less-malignant reserve requirement hikes and currency appreciation.
To the latter point, the PBOC increased reserve requirements yesterday +50bps – the fifth such measure YTD (vs. only two rate hikes). Meanwhile, the Chinese yuan continues to trade within 10-20bps of its all-time high (CNYUSD) and we see the uptrend continuing over the intermediate and long term. If China’s April trade balance shows us anything ($11.4B vs. $3.2B consensus), it’s that Chinese exporters are perhaps more resilient than consensus and/or the Chinese government believes. As such, we should continue to see additional yuan appreciation as the government gets increasingly comfortable with its impact (or lack thereof) on the Chinese economy.
Net-net, recent action in China’s interest rate swaps market (lower-highs), its interbank loan market (lower-highs), and its currency forwards market (higher-highs) is supportive of our view that the pace of Chinese rate hikes has slowed dramatically and that vast majority additional tightening will be expressed via the currency market and reserve requirement ratios.
From an INVESTMENT perspective, the data is supportive of us remaining bullish on Chinese equities and we will continue to manage risk around this exposure. With this summer’s Global Macro backdrop shaping up to be particularly ominous, we will likely continue to keep this and many of our other long ideas on a short leash.