Conclusion: We don’t think it pays to freak out about China’s manufacturing data just yet. The Chinese economy is progressing right along and we think broad-based concerns ranging from a sharp downturn in growth to a potential banking crisis are overblown. Moreover, a holding above our key risk management level would lead us to believe such consensus apprehension is close to being priced in.
Position: Long Chinese equities (CAF).
Overnight, a sub-50 reading (48.9) in HSBC’s preliminary July Purchasing Manager Index helped send Chinese equities down a full percent. Make no mistake; this was a very negative data point indeed. While it would be easy for us interpret today’s one-off data point in conjunction with today’s bearish WSJ article highlighting the “trouble” ahead for Chinese small-cap banks as a reason for us to book the gain on our long position in Chinese equities within our Virtual Portfolio, we prefer to apply a more rigorous process to risk management.
The quantitative setup for China remains favorable and we would expect Chinese equities to hold their TRADE line of support at 2,727. Should that line break and confirm itself, our models aren’t signaling any meaningful support below.
Regarding the economic data, we’ve been clear and consistent with our call for Chinese growth to “slow at a slower pace”. We continue to think Chinese growth continues to decelerate over the intermediate-term TREND. Both the market and the Chinese officials in charge of making up the data have been telling us that for over 18 months. The Shanghai Composite Index is down -14.2% since we introduced our bearish Chinese Ox in a Box thesis on January 15th of last year. Moreover, at 8% and 7% respectively, both the NDRC and the Politburo via its latest 5yr plan agree with our view of slowing Chinese economic growth – at least directionally (we don’t think China grows anywhere in the area code of 7-8% in 2011; we’re closer to 9-9.3%).
Of course, picking stocks (or in this case, markets) isn’t all about internalizing one’s own research. A great risk manger must also understand the other side of the trade – perhaps more so than their own. We get that the Chinese banking system could indeed face substantial headwinds over the long-term TAIL from a credit quality perspective. Though we do not agree with the prevailing belief, we fully understand the risks associated with a potential Chinese property market bubble.
According to Reuters calculations from official data, Chinese property price growth accelerated to +4.2% YoY in June, though down substantially from their peak growth rate of +12.8% in April ’10. We welcome the significantly less inflationary effects of mid-to-low single digits growth in Chinese property prices and do not think Chinese officials will tolerate a sustained breakdown below current growth rates over the intermediate-term TREND. This view is supported by the recent uptick in pro-growth commentary out of various Chinese officials. Rebalancing the world’s second-largest economy doesn’t happen overnight.
To the earlier point about a potential Chinese banking crisis, we are quick to point out that the loudest source making noise about China’s local government financing vehicle paper is noise in and of itself (Moody's). Ratings agencies are rarely leading indicators for anything of consequence. In fact, their poor track records and oft-late conclusions afford us much conviction that the risks associated with 10.7 trillion yuan of LGFV debt aren’t nearly as bad as Moody’s thinks they are. We would be remiss to pretend there aren’t any skeletons in the closet, but it seems rather aggressive to suggest that NPLs could grow to as much as 12% of total credit in the Chinese banking system.
Taking the other side of our bullish Chinese Cowboys thesis for a moment, we think the chart of China’s 5yr CDS is quite alarming and, given that 70% of LGFV debt matures within the next five years, we think this is a key duration to pay attention to. Still, there are a bevy of reasons we feel China’s pending “banking crisis” is likely to pass without any material damage – not the least of which is the likelihood that the central government relaxes its controls on LGFV bond issuance. Granting any ailing local government the ability to issue long-term paper will help the Chinese economy at large by smoothing out any potential asset/liability mismatch.
Elsewhere, we see that China’s money market rates are indeed breaking out to the upside. Both three-month shibor and one-year swaps rates are making higher all-time highs of late. Whether this is a leading indicator for another Chinese rate hike or just indicative of the general tightness we’ve been seeing throughout the Chinese banking system remains to be seen. On one hand, our models suggest that Chinese YoY CPI has one more month of sequential acceleration left and that should get the market right freaked out about another - and most likely the final - rate hike. On the other hand, only 963 billion yuan of central bank bills and repurchase agreements mature in 3Q (vs. 2.1 trillion in 2Q), which means that in the third quarter the Chinese banking system will be as tight as it has been since 2008 from an incremental liquidity perspective (per China Merchants Bank Co.). Regardless, both outcomes are supportive of our call for Chinese inflation to decelerate on a sustainable basis in 2H.
All told, we don’t think it pays to freak out about China’s manufacturing data just yet. The Chinese economy is progressing right along and we think broad-based concerns ranging from a sharp downturn in growth to a potential banking crisis are overblown. Moreover, a holding above our key risk management level would lead us to believe such consensus apprehension is close to being priced in.