China Is Boring

Conclusion:  While China looks to have limited downside from an economic growth perspective over the intermediate term, the same can be argued with regards to China’s upside growth potential over the long term, making the country uncharacteristically boring from a fundamental perspective.

 

As the world’s second-largest economy and arguably the single-most important source of global demand for raw materials (copper ~46%; aluminum ~42%; etc.), China matters a great deal to the Global Macro Universe. This is especially true on days where China is rumored to be: A) easing monetary and fiscal policy; B) bailing out the Eurozone; or C) falling off a cliff from an economic growth perspective.

 

On most other trading days, China has really taken on a reduced role in the calculus of the consensus fundamental outlook – which intuitively makes sense to us, given the consensus bullish bias within the U.S. financial newsmedia community and the fact that China's GROWTH/INFLATION/POLICY trends have largely been deteriorating for 2+ years now.

 

While almost trivial, we can’t help but remind clients that Chinese equities (via the Shanghai Composite Index) have been down quite a bit each of the past two years (2010: -14.3%; 2011: -21.7%) – underperforming U.S. equities (via the S&P 500) by a wide margin. The trend in Chinese equities is akin to the long-term decline in rates of Chinese economic growth.

 

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Again, while the more newsy headlines out of China and other countries have dominated the intermediate-term tops and bottoms of global equity, commodity, currency and bond markets in recent years, we always find it important to contextualize and handicap the trailing and future trends in Chinese growth, inflation and policy data. In doing so, we have created a process that helps us get ahead of the aforementioned headline risk.

 

China’s Multi-Duration Growth/Inflation/Policy Outlook:

 

TRADE: 3wks or less

At some not-yet-specified point over the next 48 hours, China will release its monthly New Loans and Money Supply data for the month of MAR. On APR 12, we’ll also receive China’s 1Q12 GDP report along with its MAR Industrial Production, Retail Sales, and Fixed Asset Investment figures. That will be followed by China’s [purposefully vague] Property Price statistics on APR 17. Most growth rates are forecasted by Bloomberg Consensus to be flat-to-down relative to the prior month/quarter.

 

Rather than pretend like we have any edge in modeling [likely] made-up statistics, we defer to the quant to get a real-time read on what these data points are likely to look like. Chinese equities, which recently snapped their immediate-term TRADE line, are still bullish from an intermediate-term TREND perspective. This setup tells us two things:

  1. The risk of a downside surprise in the data is much greater than the risk of an upside surprise; and
  2. The trend in reported Chinese growth data is likely to continue on its secular downtrend without a measured acceleration (to the downside) at the upcoming reporting juncture.

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In support of the latter claim, we point to the tug-of-war between China’s sequentially-improving MAR PMI reports and China’s sequentially-deteriorating MAR Trade data (particularly on the import side).

 

On the PMI front, China’s Manufacturing Index ticked up in MAR (alongside every subcomponent) to 53.1 from 51 prior; the new seasonally-adjusted Services Index ticked up to 58 from 57.3 prior.

 

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On the trade front, Chinese Export growth accelerated in MAR to +8.9% YoY from a +6.8% pace in the JAN-FEB period. Accelerating U.S. demand for Chinese goods (+14% YoY) overshadowed waning demand from the E.U. (-3.1% YoY). Chinese Import growth slowed in MAR to +5.4% YoY from an +8.2% pace in the JAN-FEB period; +5.4% YoY is the slowest pace of Chinese import demand growth since OCT ’09.

 

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TREND: 3mos or more

As highlighted in our recent work, we remain of the view that Chinese policymakers are unlikely to come out with any dramatic policy easing measures in the immediate-term. Rather, we expect Premier Jiabao’s to continue making good on his repeated promises of policy “fine tuning”, such as the recent increase in QFII quotas, SME bond pilot program development, RRR cuts, CNY15 billion SME credit facility, and relaxing of SME loan capital requirements.

 

Taken collectively, these and a growing list of other measures are supportive of Chinese growth on the margin; for example, SMEs account for 2/3rds of industrial output and employ 4/5ths of Chinese workers. That said, however, we remain convinced that China is unlikely to move the dial on its growth trajectory in a material way absent an implementation of the following two steps:

  1. Lowering interest rates; and
  2. Removing the curbs on real estate speculation.

Regarding step #1, we think China is indeed inching closer to cutting rates based on a combination of a dramatic decline in inflation/inflationary pressures, as well as a priced-in easing bias in China’s interest rate and FX markets. While the MAR CPI figure did accelerate to +3.6% YoY, our proprietary models and the Chinese yuan’s sustained outperformance of global food and energy prices (due to its now-convenient peg to the USD) both point to lower-highs in China’s reported inflation figures over the intermediate term.

 

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Regarding step #2, we continue to hold the belief that this China isn’t even in the area code of taking their foot off the brakes of their property market. Both rhetorically and actively – in the form of eschewing a signaling of a broader policy reversal in favor of “fine tuning” – Chinese policymakers remain committed to achieving their long-held goal of deflating the property market in an orderly fashion.

 

Further, it is unlikely that China will embark on such a dramatic inflection in policy so late in the leadership of the 17th  Politburo (its term concludes in MAR ’13), in our opinion. The ill-effects of the 2008-09 stimulus package haven’t yet truly come home to roost in China’s banking system – which extended CNY10.4 trillion ($1.7T) in credit in span of just 12 months through NOV ‘09. For China to move away from tight policy at the current juncture would be far from “prudent”, which both the PBOC and State Council have pledged to maintain in the policy arena as recently as last month.

 

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TAIL: 3yrs or less

Perhaps the most important conclusion we can stress is that if both of the aforementioned steps (#1 and #2) are not implemented largely in conjunction, we don’t see meaningful upside in China’s long-term economic growth potential. 

 

Much like valuation remains is not a catalyst to invest in a company, rate cuts are rarely a bullish catalyst for a country’s equity market if a positive inflection in economic growth (which, in theory, would be slowing during a rate cut cycle) is not within reach. Overlaying Chinese interest rates with the CRB Commodities Index or the Fed Funds Rate with the S&P 500 from 4Q07-1Q09 speaks volumes to this point. It remains prudent to avoid the classic consensus mistake of buying the dip the entire way down on monetary easing alone.

 

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Turning our attention back to China, we maintain our view that Chinese policymakers are well aware of the risk that being over-levered to investment – particularly real estate investment – poses to their economic growth potential. Specifically, at 48.6% of GDP, China’s ratio of “I” to GDP is greater now than the corresponding ratios of any of the countries that were most affected by the 1997-98 Asian Financial Crisis from a capital outflow perspective leading up to and through that event.

 

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To mitigate the risk of destabilizing capital outflows and a corresponding banking crisis over the long term, the State Council has called for a structural downshift in the rate of Chinese economic growth to +7.5% per annum, as well as a rebalancing towards increased household consumption in lieu of further investment. While mean reversion in the aforementioned GDP expenditure ratios seems likely over the long term, it remains to be seen whether or not Chinese policymakers have enough savvy and firepower to ensure an orderly transition over the long-term TAIL. History would suggest China’s odds of a structural “soft landing” are not favorable.

 

Looking to China’s property market, which is the primary beneficiary of high rates of domestic investment, the latest supply and demand data suggests real estate prices are quite likely to be headed lower on a sustained basis.

 

In the JAN-FEB period, the growth rate of completed supply accelerated to an all-time high of +45.2% YoY as seen in the Floor Space of Buildings Completed series. From a pending supply perspective, growth in Floor Space of Buildings Under Construction accelerated to +35.5% YoY in the JAN-FEB period – good for the second-highest rate on record. The State Council’s goal of building 36 million units of affordable housing from 2011-2015 is a key policy initiative affecting the underlying trends in supply.

 

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From a demand perspective, growth in Total Sales of Buildings slowed in JAN-FEB to an all-time low rate of -20.8% YoY. Moreover, growth in Floor Space of Buildings Sold and Floor Space of Residential Buildings Sold have each slowed to multi-year lows of -14% YoY and -15.9% YoY, respectively.

 

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Looking at the investment climate, the one positive data point we’d highlight is that growth in domestic financing for real estate investment accelerated to +16.3% YoY in JAN-FEB, which is the fastest rate of growth since NOV ’10. That said, however, China Economic Network’s Real Estate Climate Index ticked down to a 32-month low of 97.89 in the JAN-FEB period; the index’s YoY growth rate of -4.9% is the slowest rate since JUN ’09.

 

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With supply increasing at much higher rate than any measure of demand, continued price declines seem likely and may be poised to accelerate. Our financials team, led by Josh Steiner, has shown that demand leads U.S. housing prices by one full year. While certainly not an apples-to-apples case study, one would expect Chinese property prices to continue trending lower over the long-term TAIL given the current and [likely] future supply and demand imbalance – a setup which doesn’t look to inflect in a meaningful way absent the implementation of the aforementioned steps “#1” and “#2”.

 

The one bright spot we’d point to that lets us know that the Chinese property market isn’t quite falling off a cliff – at least not yet – is growth in China’s raw materials demand (consumption), which has largely trended sideways over the last 18 months. Even amid the Great Recession/Global Financial Crisis, Chinese demand for raw materials only briefly went moderately negative from a YoY perspective, suggesting to us that any sustained declines here would be quite an ominous signal for China’s Fixed Assets Investment Growth.

 

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All told, while China looks to have limited downside from an economic growth perspective over the intermediate term, the same can be argued with regards to China’s upside growth potential over the long term, making the country uncharacteristically boring from a fundamental perspective. Further, while not a great thesis, playing for mean reversion on the long side of Chinese equities in a strong-dollar environment is about all that an investor can hope for at the current juncture.

 

Darius Dale

Senior Analyst


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