This note was originally published at 8am on May 13, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“If you do not change direction, you may end up where you are heading.”
Lao Tzu, born in the sixth century B.C., is known as the founder of Taoism and the author of Tao Te Ching. In this book, Lao Tzu describes the Tao “as the mystical source and ideal of all existence”. Interestingly, in some legends he was born after being in the womb for 62 years – as a grown man with a grey beard and long ear lobes (a sign of wisdom).
The quote above from the founder of Taoism is apropos as it relates our investment views of China over the past couple of years. Early last year we introduced the Chinese Ox in a Box theme, which encapsulated our view that Chinese central banking authorities would be forced to raise interest rates due to broad measures of inflation, which would lead to a negative delta in Chinese growth and the likely underperformance of Chinese equities.
This theme played out according to plan as China led the world in tightening monetary policy and the Chinese stock market was one of the worst performers last year, finishing down -14.3%. Of course, markets trade on future expectations, not trailing facts. With China’s dismal equity performance in the rearview mirror, it is now time to focus on those future expectations. Our view is that those expectations are sufficiently low versus the potential upside in Chinese equities. That is, we see asymmetric risk / reward in being long of China.
This “change in direction”, has also led to change in theme name, which we introduced in April on our Q2 Theme Call as Year of the Chinese Bull. That’s right, the hockey heads in New Haven are all bulled up on China. Giddy up! On a serious note, as our subscribers well know, we are far from being cowboys when it comes to managing risk and making recommendations. In fact, there is an omnipresent sense of accountability standing behind all of our research at Hedgeye. As such, the key tenets of our latest thesis on China are outlined below and predicated on a lengthy research trip that Analyst Darius Dale took to Asia last fall.
Firstly, expectations are subdued for Chinese equities. This is reflected in two measures, the performance of the Chinese equity market last year and the valuation, broadly speaking, of Chinese equities. Last year the Shanghai Composite was down -14.3%, which was a negative outlier amongst the world’s largest economies. Despite this, China continued to grow, and so did the earnings of Chinese companies. As a result of lower prices and higher earnings, the Chinese stock market, based on the Shanghai Composite, is trading at roughly14x NTM earnings, which is at the bottom of its long run valuation range.
Second, China is at an inflection point in growth versus global growth more broadly. After five quarters of Chinese growth narrowing versus global growth, Chinese growth bottomed on comparative basis in Q3 2010 and is now reaccelerating versus the rest of the world. In our view, this will primarily come from global growth slowing, as seen in the United States last quarter, versus Chinese growth necessarily accelerating. Even so, as global growth slows, Chinese growth will become much more attractive on a relative basis. In the Chart of the Day below, we highlight this graphically.
Finally, we believe both of the key factors of monetary policy and inflation will begin to work to benefit equities. On the first point, China is not starting to tighten monetarily, but in fact is likely closer to the end of its tightening regime. In fact, as of yesterday’s increase, Chinese banks’ reserve requirement ratios are now at an all-time high of 21.5%, with some exceptions. In addition, China has been raising rates steadily since October 2010. The impact of this proactive tightening can be seen in declining money supply growth in China. Not surprisingly then, our models see tightening being reflected in a gradual decline in the year-over-year growth rates of Chinese CPI.
Now we certainly get that there are risks to being long of China, but on our factors of growth, monetary policy, and inflation, the Chinese equity outlook looks promising over intermediate term. The obvious pushback we get on this thesis relates to our willingness to be long of a Communist nation that formally utilizes central planning. We get that, but also get that things aren’t all that different in many Western nations as it relates to governments trying to influence the economy. In fact we stumbled upon the following quote in our morning grind this morning:
“I absolutely see a continuation of QE2 in some form; the economy certainly isn’t strong enough to survive on its own.”
This quote came from Keith Springer, president of Springer Financial Advisors. Now we don’t know Mr. Springer, so we’ll leave it at that, but admittedly we do find it sad that this nation has gotten to a place where investors legitimately believe the “economy can’t survive” without another dose of Keynesian Kryptonite. Last time I checked my Yale history books, the economy of this great republic has survived – and thrived – over the 230+ years that preceded The Quantitative Easing.
As you head off into the weekend, I’ll leave you with a quote from Confucius to contemplate:
“Men's natures are alike; it is their habits that carry them far apart.”
Or in hockey speak: back check, fore check, pay check.
Enjoy the weekend with your friends and family,
Daryl G. Jones