Freaking Out About China?

Conclusion: The case for being long Chinese equities continues to strengthen by the day and as Chinese economic data starts to come in less and less bad, we expect shorts to cover on the lack of incremental catalysts and longs to dip their toes back into the water once prices start to confirm. Additionally, we touch upon key TAIL risks and reports of corporate fraud in the report below.

 

Position: Long Chinese Equities (CAF).

From a price and sentiment perspective, buying Chinese equities right now feels akin to catching a falling knife. Thankfully, however, we spend countless hours modeling prices, economic data, and probability-weighting certain scenarios so that we’re prepared to catch them by the handle and not the blade. Still, the overwhelming amount of negative sentiment surrounding China is hard to ignore – even from our typically contrarian seats.

From our vantage point, there are three key issues weighing on the prices of Chinese equities: 

  1. Growth is Slowing;
  2. Inflation is Accelerating; and
  3. Interconnected Risk is Compounding. 

If this sounds familiar it’s because it is the same three-factor setup we introduced in January 2010 when we turned bearish on China via our then-contrarian Chinese Ox in a Box thesis. Since the start of last year, Chinese equities have fallen -19.2% and at one point had lost over a quarter of their value.

Now, we have been sounding the bullish siren as the data supporting each of the three aforementioned factors goes from “bad” to “less bad” on a go-forward basis. What continues to differentiate our models from our sell-side “competition” is the acute focus on slopes rather than absolutes. Understanding that price is set on the margin affords us conviction in our belief that less-negative slopes are leading indicators for positives slopes – be it for prices, economic growth, etc.

So while it’s nice to say that our models suggests China is likely to print Real GDP growth in a range of +9.2% YoY to +10% YoY in 2Q11, the reality of the situation is that we really don’t care what China’s 2Q GDP number is so long as it falls within our range of probable scenarios. A slowdown of -50bps to +9.2% YoY is less than the -160bps decline from 1Q10 to 2Q10. An acceleration to +10% YoY would imply just that – reaccelerating growth. Either way, the outlook for Chinese GDP growth in the near term looks healthy to us. Even a continued deceleration in growth in 2H would auger bullishly should growth continue to slow at a slower rate.

Bottoms, like tops, are processes – not points.

On the inflation side, we have been vocal about two events that are explicitly bearish for Chinese inflation expectations, as well as expectations of further tightening of Chinese monetary policy. The first being our contrarian Macro Theme of Deflating the Inflation, which is supportive of our second theme – the belief that Chinese YoY CPI readings peak in June (itself supported by our models). On a go-forward basis, falling prices across the commodity complex will be a headwind to Chinese inflation statistics. Sure, there will be commodities like corn that may hang in there, but the broader trend throughout this asset class is negative over the intermediate term. The quantitative setup in the CRB confirms this:

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Lastly, from an interconnected risk perspective there doesn’t appear to be much else that could possibly go wrong in China without materially affecting the rest of the world. For example, Narrative Fallacies around the bursting of China’s alleged property bubble and a looming Local Government Financing Vehicle debt crisis are abound in the media.

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Falling prices have a certain way of making the bears loud just as rising prices tend amplify the volume of bullish sentiment.

We have done and will continue to do the work regarding the aforementioned risks and our conclusion remains that they are unlikely to materialize over the intermediate term. That is not to say these risks are to be ignored over the long-term TAIL; we are, however, doing our best to manage the Duration Mismatch associated with the bull and bear case for Chinese equities. Simplistically speaking, any intermediate-to-long-term investor that is using the China blow-up thesis as his or her base case should also find it hard to be long anything equity or commodity related going forward. As the world’s second largest economy and greatest source of incremental demand, a material unwinding of China and/or its banking system will have a substantial negative impact on the global economy. For reference, the Chinese economy is nearly 1.5x the size of all the PIIIGS combined (Portugal, Ireland, Iceland, Italy, Greece, and Spain).

Net-net, if you’re bearish on China on blow-up risk alone, we’d reckon you rethink your entire portfolio.

Additional interconnected risks weighing on both Chinese equity prices and sentiment in recent months are horror stories of fraudulent reverse mergers and outright fraud – particularly in the highly publicized case of Sino-Forest Corporation. Prior to a peak-to-present decline of -92.4% on the Toronto Stock Exchange, Sino-Forest used to be a $6.3 billion commercial forest plantation operator in mainland China. Now, after a painful exposition by Muddy Waters LLC in which the tree operator’s reported acreage was aggressively called into question, TRE.TO is now listed as a $483 million enterprise. The Enron-like plunge certainly raises a few questions about the validity of Chinese corporate earnings broadly, and as such, we agree with the market paying a lower multiple for that.

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Both anecdotal evidence and historical analysis of Chinese listed enterprises confirm that reporting fraud on a broad scale has precedent in China. From 1 when a series of profitability hurdles were implemented to curb the aggregate volume of secondary offerings, the percentage of listed enterprises demonstrating a return on equity greater than the newly required 10% over three years grew +2,140bps or 25.3x to a peak of 28.8% in 1997. A similar trend emerged (albeit to a lesser extent) in 1999 when the reporting requirement was reduced to 6%.

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Net-net, it’s important to know what you own when it comes to China. The same can be said about any exposure an investor chooses to undertake, however. Doing the required due diligence is not a requirement specific to Chinese investments as some would have you believe.

All told, the case for being long Chinese equities continues to strengthen by the day and as Chinese economic data starts to come in less and less bad, we expect shorts to cover on the lack of incremental catalysts and longs to dip their toes back into the water once prices start to confirm.

Lastly, let us leave you with three legendary quotes on investing from three legendary investors. Taken in their entirety best sums up how we feel about our Year of the Chinese Bull thesis. 

  1. “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.”Warren Buffett
  2. “Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.”George Soros
  3. “The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell.”Sir John Marks Templeton 

Buy low; sell high.

Darius Dale

Analyst

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