Conclusion: We remain bullish on Chinese equities over the intermediate-term TREND and strongly believe that China represents the greatest upside potential among the world’s most liquid equity markets over that duration.
Overnight, China’s Shanghai Composite Index flashed a positive divergence relative to the other major equity markets in Asia:
- China’s Shanghai Composite: +0.2%
- Hong Kong’s Hang Seng Index: -1.7%
- Japan’s Nikkei 225 Index: -0.7%
- India’s BSE Sensex 30 Index: -0.7%
- South Korea’s Kospi Index: -1.1%
- Indonesia’s Jakarta Composite Index: -0.2%
- Australia’s All Ordinaries Index: -1.5%
- Singapore’s FTSE Straits Times Index: -1.1%
- Thailand’s Stock Exchange of Thai Index: -1%
Analyzing both inter and intra-market divergences is one of the key tools we have at our disposal to determine whether or not a particular data point(s) and/or thesis is priced in. Specifically regarding our own Year of the Chinese Bull storytelling, we believe today’s positive divergence supports our view that our bearish thesis on China (which we authored in January 2010) is fully priced in.
What isn’t priced in yet is our bullish thesis on China and we continue to favor Chinese equities over all others over the intermediate-term TREND. The research supporting this thesis can be found in the following research notes (email us for copies):
- 3/21: Buying China
- 4/18: Chinese Exposition
- 5/13: Chinese Bull Riding
- 6/9: China’s TARP
- 6/21: Freaking Out About China
- 6/24: Early Look – Chinese Cowboy
Chinese Inflation Is Peaking
Over the weekend, China reported a +90bps sequential acceleration in its June YoY CPI reading (+6.6%). This was largely driven by a pickup in the rate of Food Inflation, which accelerated to +14.4% on a YoY basis. Though the headline number exceeded analyst estimates, the measured acceleration was largely expected and, going forward, we see Chinese headline inflation on the downtrend over the intermediate term.
The slope of that line is supported by the current downtrend in China’s Input Prices PMI (less cost increases to pass through the supply chain to Chinese consumers):
Our outlook for Chinese CPI is largely a function of our once-contrarian Deflating the Inflation thesis (bullish on the USD; bearish on commodities). Simply put, as the US Dollar strengthens and puts downward pressure on food, energy, and raw materials markets, price increases on the ground in China won’t have enough velocity to surmount increasingly tough comparisons and continue their upward trend in 2H. This will allow the PBOC to relax, on the margin, its tightening bias on a go-forward basis.
We’re bullish on the US Dollar from a research perspective primarily because we’re bearish on the Euro (57.6% of the DXY basket). The following bullets summarize our bearish EURUSD thesis, which we outlined in a research note on 6/24 titled: “Emerging vs. Developed Markets: Aggressively Framing Up the Debate”:
- The end of QE2 means the growth of the Fed’s Balance Sheet will no longer be a headwind (positive on the margin);
- We don’t believe QE3 is in the cards, but assuming that consensus will clamor for more “stimulus”, the timing of any hint from the Fed is likely six-plus months away (refer to our Indefinitely Dovish and What’s Next for the Fed? presentations for more details);
- A shift on the margin towards fiscal sobriety in Washington, D.C. via a Debt Ceiling Compromise is also a bullish catalyst for America’s currency;
- Slowing growth in the Eurozone will have the FX market pricing in less and less hawkishness out of the ECB relative to the Fed on a go-forward basis (don’t forget that the socialist Mario Draghi takes over in November and that the Europeans have a full 150bps of potential interest rates to cut).
Monetary Policy Is Becoming Supportive Of Growth on the Margin
As mentioned prior, as the slope of inflation in China starts to trend down, Chinese policy makers will be able to ease off the economic brakes. Our bearish thesis on Chinese CPI leads us to believe that the PBOC is done raising interest rates in this tightening cycle, though we wouldn’t be surprised by one more hike if July CPI surprises to the upside as well. Nevertheless, we believe the go-forward outlook for Chinese monetary policy is one of marginal dovishness and we find that to be a bullish catalyst for Chinese equities – which have been struggling as a result of expectations surrounding tighter policy since early 2010. Chinese equities are down -13.1% since we introduced our Chinese Ox in a Box thesis on January 15th of last year and at one point had lost over a quarter of their value.
Recent commentary out of PBOC Governor Zhou Xiaochuan supports our outlook for Chinese monetary policy:
“China can’t adopt inflation as [its] only monetary policy target… the central bank also has to maintain economic growth and consider employment.”
- Zhou Xiaochuan, July 8, 2011
Regarding growth specifically, Governor Xiaochuan is approaching a critical juncture as it relates to the slope of both the Chinese economy and the global economy. Simply put, Chinese growth can’t go much lower from here without having a meaningful negative impact on the global economy (itself included). That is why we continue to state, “If you’re incrementally bearish on China from here, you should be going to cash.”
China’s 50.9 June Manufacturing PMI reading shows just how close one major segment of the Chinese economy is from contracting on a sequential basis. The following chart illustrates how strong the relationship is between Chinese manufacturing and global growth.
Four out of the five [reported] months YTD show negative Chinese Loan Growth on a YoY basis. That’s an explicitly bearish data point for an economy that relies on Fixed Investment for 45-50% of GDP.
All told, we don’t think Zhou and company will crash the Chinese economy. In fact, we think Chinese growth could potentially accelerate in 2H from current levels supported by a widening Trade Balance (lower import costs; more fixed export prices) and easy comparisons. We’re not necessarily making that call right here and now, but it does appear to be an upside risk we should consider. Both Chinese equities (bullish TAIL) and Dr. Copper (bullish TREND) are signaling to us to this scenario is worth considering. Interestingly, June was the first month in the last three where growth in China’s copper imports was positive on a MoM basis (+10%).
Net-net, we remain bullish on Chinese equities over the intermediate-term TREND and strongly believe that China represents the greatest upside potential among the world’s most liquid equity markets over that duration. Fear surrounding a potential housing bubble (which we do not buy into) and a potential banking crisis (Duration Mismatch at best) has made Chinese growth cheap on both a relative and absolute basis. As such, we’ll continue to heed the following advice from three legendary investors as it relates to China.
- “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
- “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
- “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.