Conclusion: If you have to be long something equity-related, we continue to side with the market and stand by our view that Chinese equities are your best bet on a relative basis. As China begins to fire up more strategic growth initiatives, we expect the delta in performance between Chinese shares and U.S./E.U. shares to widen even more dramatically that what we’ve already seen over the last few months.
Position: Long Chinese equities (CAF).
At Hedgeye we place a significant emphasis on timing and duration in both our research and risk management (expression of said research). From a timing perspective, our signal to buy Chinese equities on June 16thhasn’t been our best call on an absolute basis (the CAF is -2.2% against us in our Virtual Portfolio). On a relative basis however, the Shanghai Composite Index has held up marvelously amid the recent global sell-off in equities:
A recent mainstay on our Hedgeye Alpha (a daily compendium of our firm’s 12 best L/S ideas), our Chinese Cowboys thesis continues gain traction as the research supporting the call comes in as expected:
- Real economic growth basing;
- Inflation is peaking; and
- Rate hikes stop and central bank becomes dovish on the margin.
As we have said many times throughout our bullish bias on Chinese equities, we’re not calling for a reacceleration in Chinese economic growth. We’re merely calling for it to slow at a decelerating rate over the intermediate term – rather than fall off a cliff as the May/June China-bears wrongfully believed.
Over the last few weeks, we’ve received some (slight) bullish catalysts that we think are worth compiling:
- The State Council reported that Chinese officials intend for the construction of 10 million units of low-income housing to have begun by the end of November (as part of a larger initiative to build 36 million by 2015). We’re not big on China’s current “build it and they will come” growth model, but we can’t deny the impact of such a large-scale initiative will likely have on the Chinese economy over the intermediate term (~48% of GDP is Fixed Asset Investment).
- China’s Finance Ministry drafted a preliminary plan that would allow the country’s municipal governments to issue bonds to investors. This is helpful because it would allow cash-strapped local government financing vehicles to smooth out their liabilities over a longer duration vs. the current credit structure consisting of ~80% bank loans and ~70% of the aggregate debt burden coming due in over the next five years. A successful follow-through of this plan removes major TAIL risk from the Chinese banking system.
- The National People’s Congress recently finalized revisions to the personal income tax law, raising the minimum income tax threshold +75% to 3,500 yuan and also lowering the mill rate for lowest taxable income bracket. The former maneuver is expected to exempt an incremental 60 million Chinese consumers from paying income taxes. The changes take effect at the start of next month and we expect it to be incrementally bullish for Chinese consumption growth, which is already being buoyed by per capita disposable income growth accelerating to +14.1% YoY in 2Q.
- The absence of tightening: China has held off from raising interest rates and banks’ reserve requirement ratios since July 5thand June 20th, respectively, with the latter hold being the longest in the current tightening cycle (beginning in Jan. ’10) since China held RRR’s flat from May through November of last year. The lack of tightening and shift in bank expectations away from further hawkishness has facilitated a -108bps peak-to-current decline in 3mo Shibor, an aggregated measure of interbank funding costs out of the National Interbank Funding Center in Shanghai. As banks start to pay less and less for funding, we expect the current credit crunch hampering the operations of many small-to-medium-sized enterprises to recede on the margin. This is a big deal, as SMEs employ ~80% of Chinese workers, generate 2/3rds of industrial output, and pay half of all tax revenues per China’s Ministry of Industry and Information Technology.
- Perhaps the largest (and most speculative) bullish catalyst we could potentially see in the next 3-6 months is a widespread relaxation of fiscal spending and a broad easing of monetary policy in “some sectors”, as reported today by the China Securities Journal. Though largely an unsubstantiated rumor at this point, it is an important catalyst to keep an eye out for over the coming months – especially as our calls for Slowing Global Growth and Deflating the Inflation continue to play out in spades.
All told, we continue to like Chinese financial and consumer stocks as China begins to fire up more strategic growth initiatives favoring these sectors. This will likely come at a time when developed markets, such as the U.S., have little to no bullets left on the monetary policy front and no headroom left at all on the fiscal front to attempt to stimulate growth. In such an event, we expect the delta in performance between Chinese shares and U.S./E.U. shares to widen even more dramatically that what we’ve already seen over the last few months.
We realize that it’s difficult for the Chinese economy to hum along while global growth slows broadly – especially considering weakness in important economies like the U.S., Japan, Germany, France, U.K., Brazil, etc. That said, however, if you have to be long something equity-related, we continue to side with the market and stand by our view that Chinese equities are your best bet on a relative basis.