IS CHINA BACK?: EVERYTHING YOU NEED TO KNOW AND HOW TO PLAY IT

Takeaway: While consensus believes the Chinese economy has reached a critical inflection point, the data would suggest this view is a bit aggressive.

SUMMARY BULLETS:

 

  • On balance, reported Chinese GROWTH data is inconclusive at best and not supportive of the view that broader economic growth has bottomed in China. Looking to the PRICE data, Chinese financial markets are signaling that the outlook for economic growth in China remains tepid at best.
  • Looking forward, our best advice on what to do with China from here would be to wait and watch for actual confirmation from both PRICE and GROWTH data rather than succumbing to encouragement by the Manic Media to chase the asset prices of pro-cyclical sectors any higher. Sure, there is risk that you underperform for a few weeks or a couple of months, but that’s a lot less negative than buying “risk assets” hand-over-fist at what appears to be another cyclical top – especially considering how binary the election, fiscal cliff and debt ceiling scenarios are.
  • According to both our predictive tracking algorithms and Chinese Premier Wen Jiabao, Chinese GROWTH appears to be “stabilizing”, though the ratty PRICE data suggests downside economic scenarios are still very much in playAnd, relative to expectations, China sequentially slowing from here might feel like an outright recession for the consensus "China is back" crowd. 
  • All that being said, if this is, in fact, a bottom in Chinese GROWTH, that does not at all mean that it’s time to party like it’s 2009. As we wrote on Monday: “Where our call [on China] has differentiated from the Street is that we have not anticipated any substantial stimulus efforts, and therefore are not expecting a meaningful acceleration in Chinese growth from here.”
  • For anyone looking to dip their toes in on the long side of Chinese equities (they are “cheap” – whatever that means), we would recommend doing so only after being reasonably certain that unreasonable consensus expectations for POLICY-based reflation and a return to persistent 8-12% real GDP growth continue to dissipate. Judging by preliminary indications, they are beginning to: “China Comfortable With Weaker Growth”.

 

HAS CHINESE GROWTH BOTTOMED?

 According to the Manic Media, it certainly has. While that’s hardly supportive enough to justify putting real capital to work, we would agree that investors certainly have to start asking themselves whether or not Chinese growth has bottomed and if their portfolio is positioned for it.

 

From our vantage point, the Chinese economy is near a bottom; our forecasting models have Chinese real GDP growth coming at +7.2-7.7% YoY in 4Q12E with probable downside to +7.0% in a worst-case scenario. In 1Q13E (subject to change pending the 4Q12 figures), we’re at +7.4%-7.6% with probable downside to +6.9% in a worst-case scenario. Our updated GIP model for China is outlined in the chart below; note the ranges in the GDP estimates:

 

IS CHINA BACK?: EVERYTHING YOU NEED TO KNOW AND HOW TO PLAY IT - CHINA

 

Rather than celebrating a sequential slowdown to +7.4% (the slowest rate of YoY economic growth in China since 1Q09), we think it’s critical to debate the following two questions before claiming that China is “back”:

 

  1. Does the evidence suggest China’s economy is at a bottom? Real GDP growth continued to slow, so what are the headlines anchoring on as signs of “the bottom”?
  2. Even if this is a bottom, what is the outlook for the Chinese economy from here? Should investors and corporations anticipate meaningful upside, or is +7.5% give-or-take ~20bps-30bps a “new normal” as it relates to Chinese GDP growth?

 

DATA DEPENDENCY: WHAT DOES THE EVIDENCE SUGGEST?

Given China’s importance to the Global Macro landscape (China has accounted for 43.9% of global real GDP growth since 2008, after only accounting for 15.9% in the five years prior) we routinely track a lot of Chinese economic data, understanding that some figures more important than others. Below we simply demarcate all of the major GROWTH indicators we think are worth tracking:

 

  • Trending Positively (slope sequentially accelerating in at least two of the last three periods, including SEP/3Q):
    • Retail Sales
    • M2 Money Supply
    • Sources of Funds for Fixed Assets Investment – State Budget
    • Sources of Funds for Fixed Assets Investment – Domestic Loans
    • Manufacturing PMI – Backlogs of Orders
    • Manufacturing PMI – Imports
    • Trade Balance
    • Exports
    • Exports to US
    • Exports to EU
    • Cement Production
    • Processing of Crude Oil
    • Fuel Oil Production
    • Total Sales of Buildings
    • Floor Space of Buildings Sold
    • Sources of Funds in Real Estate Development – Total Funds
    • Sources of Funds in Real Estate Development – Domestic Loans
    • Sources of Funds in Real Estate Development – Deposit & Advanced Payments
    • Financial System – Total Funds Raised
    • Financial System – Trust Loans
  • Trending Negatively (slope sequentially decelerating in at least two of the last three periods, including SEP/3Q):
    • Real GDP
    • Quarterly Business Climate Index
    • Financial System – New Bank Loans
    • Financial System – Equity Issuance
    • Fixed Assets Investment – Real Estate Development
    • Fixed Assets Investment – Manufacturing
    • Fixed Assets Investment – Construction
    • Fixed Assets Investment – Mining
    • Foreign Direct Investment
    • Manufacturing PMI – Employment
    • Non-Manufacturing PMI
    • Total Freight Traffic Volume
    • Freight Traffic Volume – Railways
    • Freight Traffic Volume – Highways
    • Freight Traffic Volume – Waterways
    • Crude Steel Production
    • Iron Ore Production
    • Refined Copper Production
    • Copper Products Production
    • Financial Institutions FX Positions
    • Floor Space Under Construction
    • Floor Space of Buildings Completed
    • Land Areas Purchased
    • Sources of Funds in Real Estate Development – Foreign PDI
    • Real Estate Climate Index
  • Inconclusive (mixed; “(+)” = latest data point was a sequential acceleration in the slope and “(-)” if the latest data point was a sequential deceleration in the slope):
    • Industrial Production (+)
    • Total Fixed Assets Investment (+)
    • Fixed Assets Investment – Real Estate (+)
    • Sources of Funds for Fixed Assets Investment – Foreign Investment (-)
    • Manufacturing PMI (+)
    • Manufacturing PMI – New Orders (+)
    • Manufacturing PMI – New Export Orders (+)
    • Manufacturing PMI – Output (+)
    • Imports (+)
    • Steel Products Production (+)
    • Electricity Production (-)
    • Housing Starts (+)
    • Financial System – Corporate Debt Issuance (-)

 

As outlined above, reported Chinese GROWTH data is inconclusive at best and not supportive of the view that broader economic growth has bottomed in China. Looking to PRICE data, markets on the mainland (assuming what we all learned in school about markets discounting future economic scenarios is accurate) are not pricing  in a recovery in Chinese growth. That could obviously change with more data, but, for now, Chinese financial markets are signaling that the outlook for economic growth in China remains tepid at best:

 

  • Stocks (-): The Shanghai Composite Index is bullish on our immediate-term TRADE duration and bearish on our intermediate-term TREND and long-term TAIL durations (the latter demonstrably so, as long-term expectations for the Chinese economy remain under pressure). We’d like to see a confirmed breakout above our TREND line of 2,141 to accept any “China is back” sentiment as reasonable.
  • Bonds (-):  Since mid-JUL, China’s sovereign yield curve (10yr-2yr; a rough proxy for GROWTH expectations) has completely pancaked, compressing by over 40bps to 59bps wide. While it’s making higher-lows on an intermediate-term basis, it’s still making lower-highs on  a long-term basis. QE3 has complexly priced out easing expectations on the short end of the curve.
  • FX (-): The FX market in general is definitively not participating in the “China is back” hype, with the CNH price spread to the CNY flat; it’s typically at a premium when Chinese growth is accelerating, as international demand for Chinese assets outpace liquidity. Moreover, the NDF market continues to price in material weakness over the NTM (CNY -1.8% discount; CNH -2.5% discount) – a disturbing setup given the recent trend of CNY strength in the spot market (at a ~19yr high).
  • Steel (-): We look at China’s domestic steel prices – rebar and hot rolled steel in particular – because of the importance of construction activity to broader economic growth (Fixed Capital Formation = 46.2% of GDP). Rebar prices have bounced +10.5% off their early-SEP lows; hot rolled steel prices have jumped +14.8% off their early-SEP lows. These recent moves are indeed supportive for “China is back” speculation, though we are not encouraged that both series are still making lower-highs and lower-lows on both an intermediate and long term basis. Furthermore, the rebar futures curve remains in backwardation; we’d like to see a steepening/normal curve if Chinese growth were, in fact, bottoming out.
  • Property Prices (+): The lone dissenter, the slope of growth in Chinese property prices (per our proprietary 20-city nominal price index) has accelerated for two consecutive months on a YoY basis and three consecutive months on a MoM basis. The +1.9% MoM reading in SEP is the fastest pace of sequential growth since JUN ’11. Interestingly, this data point can be interpreted as somewhat negative as accelerating property prices increases the probability of incremental macroprudential tightening, on the margin.

 

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In addition to the GROWTH and PRICE data, we think it’s very important to keep track of the rhetoric emanating from Chinese policymakers. POLICY data is paramount in China because it remains a command economy with pre-determined targets for economic activity. Additionally, Chinese policymakers are the architects of the current slowdown; at any point in time, they can ease off the brakes and accelerate – though our call continues to be that they have no intention to do so (refer to our note from Monday titled, “CHINA IS BORING, AGAIN… WILL THAT BE ENOUGH SAVE GLOBAL GROWTH?” for more details).

 

Below is a collection of official statements from just this week (as an aside, we generally publish any relevant commentary with each note we write on China, so we are deliberately being brief here; email us for a more comprehensive collection of POLICY rhetoric):

 

  • Premier Wen Jiabao: “China’s economic growth has started to stabilize. The government is confident of achieving annual targets and the economy will continue to show positive changes.”
  • PBOC Vice Governor Yi Gang: “That the most important job for the central bank is to control inflation… While this year's inflation rate is fine and may be +2.7% for the full year, longer-term threats are from agricultural costs and prices for imported raw materials, commodities and energy, which can be driven by global monetary easing… China's fiscal and monetary stimulus will be appropriate to counter the country's economic slowdown and avoid any negative fallout. The stimulus package, I think, this time will be appropriate in terms of size. When I say appropriate in terms of size, that is large enough to stabilize growth, but not too large to cause some further negative impact, or negative problems in the future."
  • PBOC Governor Zhou Xiaochuan: “Quantitative easing policies worldwide could cause inflationary risks… Central banks should consider draining excessive liquidity injected into the market and eliminate inflationary pressure in the long-term."
  • PBOC Secretary of Discipline Wang Huaqing: “The central bank is putting more emphasis on price-based tools to manage monetary policy and strengthening macro prudential rules to shield the country's financial sector from systemic risk. [The PBOC] was putting greater stress on price-based tools and stepping back from direct control on liquidity.” (i.e. reverse repos)
  • PBOC Advisor Song Guoqing: “China’s government won’t provide big economic stimulus and a strong rebound in growth is unlikely. Local-government investment plans probably won’t materialize quickly because they’re reliant on the central government and banks for funding.”

 

On balance, the aforementioned rhetoric would suggest that Chinese policymakers anticipate that domestic economic growth is at or near a bottom, but the marginally hawkish lean of central bank officials (including the direct warning from Song Guoqing on growth expectations) leaves us expecting subdued upside in Chinese economic activity over the intermediate term.

 

STORYTELLING SUMMIT: WHERE DO WE GO FROM HERE?

Who knows? All we can do is continue to highlight proactively predictable risk ranges, deltas and inflections, all the while measuring them against the slope of expectations. Speaking of, we continue to think the slope of Chinese GROWTH expectations over the NTM are a bit aggressive in the absence of any meaningful monetary or fiscal stimulus (our base case scenario) – stimulus that could include reversing curbs on the property market, for instance.

 

IS CHINA BACK?: EVERYTHING YOU NEED TO KNOW AND HOW TO PLAY IT - 8

 

Our best advice on what to do with China from here would be to wait and watch for actual confirmation from both PRICE and GROWTH data rather than succumbing to encouragement by the Manic Media to chase the asset prices of pro-cyclical sectors any higher. Sure, there is risk that you underperform for a few weeks or a couple of months, but that’s a lot less negative than buying “risk assets” hand-over-fist at what appears to be another cyclical top – especially considering how binary the election, fiscal cliff and debt ceiling scenarios are.

 

According to both our predictive tracking algorithms and Chinese Premier Wen Jiabao, Chinese GROWTH appears to be “stabilizing”, though the ratty PRICE data suggests downside economic scenarios are still very much in play. And, relative to expectations, China sequentially slowing from here might feel like an outright recession for the consensus "China is back" crowd. 

 

All that being said, if this is, in fact, a bottom in Chinese GROWTH, that does not at all mean that it’s time to party like it’s 2009. As we wrote on Monday: “Where our call [on China] has differentiated from the Street is that we have not anticipated any substantial stimulus efforts, and therefore are not expecting a meaningful acceleration in Chinese growth from here.”

 

For anyone looking to dip their toes in on the long side of Chinese equities (they are “cheap” – whatever that means), we would recommend doing so only after being reasonably certain that unreasonable consensus expectations for POLICY-based reflation and a return to persistent 8-12% real GDP growth continue to dissipate. Judging by preliminary indications, they are beginning to: “China Comfortable With Weaker Growth”. Now that’s progress.

 

Have a great weekend,

 

Darius Dale

Senior Analyst


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