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CHINESE EQUITIES RALLY SUSTAINABLE?

Takeaway: We don't think the recent strength in the Chinese equity market is sustainable, as China’s second-half growth outlook appears dicey at best.

This note was originally published May 17, 2013 at 12:26 in Macro

SUMMARY BULLETS:

 

  • On positive headlines largely surrounding economic and financial system reform(s), speculative capital continues to flow into the Chinese economy. According to PBOC data, growth in Chinese banks’ accumulated purchases of forex accelerated to +6.9% year-on-year (YoY) from +5.5% prior (+1.1% month-on-month). The issuance of new RMB in this process is a tailwind for money supply in the Chinese economy.  
  • On these increased inflows of “hot money” the Shanghai COmposite closed up +1.6% WoW on good volume into a bullish TRADE/TREND/TAIL setup, so there is little-to-no sense in fighting the tide here – especially given the positive outlook for China's consumer economy (real wage growth accelerated +30bps in 2012 to +9.3% YoY for SOEs and +160bps to +14.4% YoY for private enterprises).
  • Given the precarious nature of financial sector reform, however (as identified by our April 29 expert call on the Chinese Financial System), we’re not sure how much can actually be done to truly liberalize interest rates in China. Not to mention, ending financial repression by promoting higher real rates of return in traditional bank deposits would likely put an end to the country’s fixed assets investment bubble.
  • All told, we think the recent “hot money” inflows into the Chinese economy are a sign that Chinese enterprises levered to FAI are attempting to get ahead of what is likely to be the “rug” being pulled out from underneath them from a financing perspective. An exaggerated trend of export goosing and aggressive USD debt issuance (issuers on the mainland and in Hong Kong have sold $18.8B worth of bonds so far this year, more than six times the total for the same period last year) suggest that this is likely the case. Trends in the FX market are supportive of this view.
  • We do not, however, think the recent strength in the Chinese equity market is sustainable in the sense that FAI is what drives the growth boat in China; fixed capital formation accounts for ~46% of Chinese GDP. That will slow when the capital flows slow, as they should in the coming months post the very recent regulatory crackdowns. Moreover, China does not yet have the social safety net infrastructure in place to ensure a smooth handoff to domestic consumption at the current juncture. That could change come OCT, but, for now, the outlook for Chinese growth in 2H12 appears dicey at best.

 

According to Chinese local press, President Xi Jinping has taken charge of developing an aggressive reform agenda to help restructure the Chinese economy. It is widely speculated that he will present the reforms at the third plenum of the 18th Central Committee of the Communist Party, likely in October. Those reforms, which are likely to be met with resistance from vested interests throughout the Party, may include further liberalization of interest rates, an overhaul of local government finance and Hukou reform.

 

On these positive headlines, speculative capital continues to flow into the Chinese economy. According to PBOC data, growth in Chinese banks’ accumulated purchases of forex accelerated to +6.9% YoY from +5.5% prior (+1.1% MoM). The issuance of new RMB in this process is a tailwind for money supply in the Chinese economy.  

 

 CHINESE EQUITIES RALLY SUSTAINABLE? - 1

 

Given the precarious nature of financial sector reform, as identified by our 4/29 expert call on the Chinese Financial System, we’re not sure how much can actually be done to truly liberalize interest rates in China. Not to mention, ending financial repression by promoting higher real rates of return in traditional bank deposits would likely put an end to the country’s fixed assets investment bubble.

 

Regarding FAI specifically, Total Fixed Assets Investment is growing only marginally faster than its decade-low growth rate of +20.4% YoY. Growth in New Construction FAI has been slowing precipitously since OCT, while growth in Real Estate FAI had been accelerating since then, though well off prior peaks. It’s worth noting that this TREND-duration acceleration in Real Estate FAI is precisely why Chinese officials haven’t responded to their economic growth slowdown w/ any monetary easing measures.

 

 CHINESE EQUITIES RALLY SUSTAINABLE? - 2

 

From here, we think FAI is poised to continue slowing over both the intermediate-term and long-term durations, as:

 

  1. Incremental tightening measures by the PBOC and CBRC slow the rate of credit expansion (see: YTD repo activity and the recent resumption of PBOC bill issuance); and
  2. The Chinese Communist Party’s economic rebalancing agenda is accelerated in accordance with the aforementioned expectations.

 

Additionally, the stimulus package of 2009-10 has soured Chinese state bank balance sheets (where ~89% of all outstanding corporate loans and bonds are held – to maturity, nonetheless) with not-yet-reported NPLs. In addition to tighter regulation of LGFVs and WMPs, this cultural “extend and pretend” phenomenon (NPLs were perpetually rolled over from the late 80s until the late 90s/early 2000s bank recapitalization) will slow the rate of new credit growth in the Chinese economy, at the margins, by slowing the flow of incremental liquidity within the system.

 

Another headwind for growth of incremental liquidity within the Chinese banking system is a perpetually-dwindling current account surplus. China’s gross national savings (~50% of GDP) have been buoyed over the past 10 years by China’s entry into the WTO – a one-time, rear-view stimulus that is not likely to reoccur in the foreseeable future. Moreover, it is no longer politically palatable within the int’l arena for China to continue taking market share in global trade.

 

 CHINESE EQUITIES RALLY SUSTAINABLE? - 3

 

 CHINESE EQUITIES RALLY SUSTAINABLE? - 4

 

Net-net, both factors translate to less currency coming into China via the current account, at the margins. As an aside, this is precisely why Chinese exporters have been goosing export figures as of late (i.e. they are “importing liquidity” via mislabeled capital flows).

 

Slower growth in current account flows directly translate into slower bank deposit growth, at the margins. And, since we know the Chinese economy is merely just one, large experiment w/ politicized financial repression, that ultimately translates into less speculation in fixed assets. The law of large numbers means that China actually needs to be accelerating this activity if it wants to maintain its trend GDP growth rates, not allowing said activity to slow (as dictated by the Party’s politicized push for “socially inclusive growth” and environmental reform).

 

All told, we think the recent “hot money” inflows into the Chinese economy are a sign that Chinese enterprises levered to FAI are attempting to get ahead of what is likely to be the “rug” being pulled out from underneath them from a financing perspective. An exaggerated trend of export goosing and aggressive USD debt issuance (issuers on the mainland and in Hong Kong have sold $18.8B worth of bonds so far this year, more than six times the total for the same period last year) suggest that this is likely the case. Trends in the FX market are supportive of this view.

 

 CHINESE EQUITIES RALLY SUSTAINABLE? - 7

 

On these increased inflows of “hot money” the Shanghai Composite closed up +1.6% week-on-week on good volume into a bullish TRADE/TREND/TAIL setup, so there is little-to-no sense in fighting the tide here – especially given the positive outlook for China’s consumer economy (real wage growth accelerated +30bps in 2012 to +9.3% YoY for state owned enterprises and +160bps to +14.4% YoY for private enterprises).

 

 CHINESE EQUITIES RALLY SUSTAINABLE? - 5

 

We do not, however, think the recent strength in the Chinese equity market is sustainable in the sense that FAI is what drives the growth boat in China; fixed capital formation accounts for ~46% of Chinese GDP. That will slow when the capital flows slow, as they should in the coming months post the very recent regulatory crackdowns. Moreover, China does not yet have the social safety net infrastructure in place to ensure a smooth handoff to domestic consumption at the current juncture. That could change come October, but, for now, the outlook for Chinese growth in second half 2012 appears dicey at best.

 

 CHINESE EQUITIES RALLY SUSTAINABLE? - 6


IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE?

Takeaway: We do not think the recent strength in the Chinese equity market is sustainable, as China’s 2H13 growth outlook appears dicey at best.

SUMMARY BULLETS:

 

  • On positive headlines largely surrounding economic and financial system reform(s), speculative capital continues to flow into the Chinese economy. According to PBOC data, growth in Chinese banks’ accumulated purchases of forex accelerated to +6.9% YoY from +5.5% prior (+1.1% MoM). The issuance of new RMB in this process is a tailwind for money supply in the Chinese economy.  
  • On these increased inflows of “hot money” the SHCOMP closed up +1.6% WoW on good volume into a bullish TRADE/TREND/TAIL setup, so there is little-to-no sense in fighting the tide here – especially given the positive outlook for China’s consumer economy (real wage growth accelerated +30bps in 2012 to +9.3% YoY for SOEs and +160bps to +14.4% YoY for private enterprises).
  • Given the precarious nature of financial sector reform, however (as identified by our 4/29 expert call on the Chinese Financial System), we’re not sure how much can actually be done to truly liberalize interest rates in China. Not to mention, ending financial repression by promoting higher real rates of return in traditional bank deposits would likely put an end to the country’s fixed assets investment bubble.
  • All told, we think the recent “hot money” inflows into the Chinese economy are a sign that Chinese enterprises levered to FAI are attempting to get ahead of what is likely to be the “rug” being pulled out from underneath them from a financing perspective. An exaggerated trend of export goosing and aggressive USD debt issuance (issuers on the mainland and in Hong Kong have sold $18.8B worth of bonds so far this year, more than six times the total for the same period last year) suggest that this is likely the case. Trends in the FX market are supportive of this view.
  • We do not, however, think the recent strength in the Chinese equity market is sustainable in the sense that FAI is what drives the growth boat in China; fixed capital formation accounts for ~46% of Chinese GDP. That will slow when the capital flows slow, as they should in the coming months post the very recent regulatory crackdowns. Moreover, China does not yet have the social safety net infrastructure in place to ensure a smooth handoff to domestic consumption at the current juncture. That could change come OCT, but, for now, the outlook for Chinese growth in 2H13 appears dicey at best.

 

According to Chinese local press, President Xi Jinping has taken charge of developing an aggressive reform agenda to help restructure the Chinese economy. It is widely speculated that he will present the reforms at the third plenum of the 18th Central Committee of the Communist Party, likely in October. Those reforms, which are likely to be met with resistance from vested interests throughout the Party, may include further liberalization of interest rates, an overhaul of local government finance and Hukou reform.

 

On these positive headlines, speculative capital continues to flow into the Chinese economy. According to PBOC data, growth in Chinese banks’ accumulated purchases of forex accelerated to +6.9% YoY from +5.5% prior (+1.1% MoM). The issuance of new RMB in this process is a tailwind for money supply in the Chinese economy.  

 

IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? - 1

 

Given the precarious nature of financial sector reform, as identified by our 4/29 expert call on the Chinese Financial System, we’re not sure how much can actually be done to truly liberalize interest rates in China. Not to mention, ending financial repression by promoting higher real rates of return in traditional bank deposits would likely put an end to the country’s fixed assets investment bubble.

 

Regarding FAI specifically, Total Fixed Assets Investment is growing only marginally faster than its decade-low growth rate of +20.4% YoY. Growth in New Construction FAI has been slowing precipitously since OCT, while growth in Real Estate FAI had been accelerating since then, though well off prior peaks. It’s worth noting that this TREND-duration acceleration in Real Estate FAI is precisely why Chinese officials haven’t responded to their economic growth slowdown w/ any monetary easing measures.

 

IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? - 2

 

From here, we think FAI is poised to continue slowing over both the intermediate-term and long-term durations, as:

 

  1. Incremental tightening measures by the PBOC and CBRC slow the rate of credit expansion (see: YTD repo activity and the recent resumption of PBOC bill issuance); and
  2. The Chinese Communist Party’s economic rebalancing agenda is accelerated in accordance with the aforementioned expectations.

 

Additionally, the stimulus package of 2009-10 has soured Chinese state bank balance sheets (where ~89% of all outstanding corporate loans and bonds are held – to maturity, nonetheless) with not-yet-reported NPLs. In addition to tighter regulation of LGFVs and WMPs, this cultural “extend and pretend” phenomenon (NPLs were perpetually rolled over from the late 80s until the late 90s/early 2000s bank recapitalization) will slow the rate of new credit growth in the Chinese economy, at the margins, by slowing the flow of incremental liquidity within the system.

 

Another headwind for growth of incremental liquidity within the Chinese banking system is a perpetually-dwindling current account surplus. China’s gross national savings (~50% of GDP) have been buoyed over the past 10 years by China’s entry into the WTO – a one-time, rear-view stimulus that is not likely to reoccur in the foreseeable future. Moreover, it is no longer politically palatable within the int’l arena for China to continue taking market share in global trade.

 

IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? - 3

 

IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? - 4

 

Net-net, both factors translate to less currency coming into China via the current account, at the margins. As an aside, this is precisely why Chinese exporters have been goosing export figures as of late (i.e. they are “importing liquidity” via mislabeled capital flows).

 

Slower growth in current account flows directly translate into slower bank deposit growth, at the margins. And, since we know the Chinese economy is merely just one, large experiment w/ politicized financial repression, that ultimately translates into less speculation in fixed assets. The law of large numbers means that China actually needs to be accelerating this activity if it wants to maintain its trend GDP growth rates, not allowing said activity to slow (as dictated by the Party’s politicized push for “socially inclusive growth” and environmental reform).

 

All told, we think the recent “hot money” inflows into the Chinese economy are a sign that Chinese enterprises levered to FAI are attempting to get ahead of what is likely to be the “rug” being pulled out from underneath them from a financing perspective. An exaggerated trend of export goosing and aggressive USD debt issuance (issuers on the mainland and in Hong Kong have sold $18.8B worth of bonds so far this year, more than six times the total for the same period last year) suggest that this is likely the case. Trends in the FX market are supportive of this view.

 

IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? - 7

 

On these increased inflows of “hot money” the SHCOMP closed up +1.6% WoW on good volume into a bullish TRADE/TREND/TAIL setup, so there is little-to-no sense in fighting the tide here – especially given the positive outlook for China’s consumer economy (real wage growth accelerated +30bps in 2012 to +9.3% YoY for SOEs and +160bps to +14.4% YoY for private enterprises).

 

IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? - 5

 

We do not, however, think the recent strength in the Chinese equity market is sustainable in the sense that FAI is what drives the growth boat in China; fixed capital formation accounts for ~46% of Chinese GDP. That will slow when the capital flows slow, as they should in the coming months post the very recent regulatory crackdowns. Moreover, China does not yet have the social safety net infrastructure in place to ensure a smooth handoff to domestic consumption at the current juncture. That could change come OCT, but, for now, the outlook for Chinese growth in 2H13 appears dicey at best.

 

IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? - 6

 

Email us if you’d like to discuss China further. For your convenience, we’ve put together a compendium of our recent work on this topic(s) below.

 

Have a great weekend,

 

Darius Dale

Senior Analyst

 

  • IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? (3/28): Systemic risks are present across China’s financial sector – as is the political will and fiscal firepower needed to avert a crisis.
  • REPLAY: EMERGING MARKET CRISES (4/23): We currently see a pervasive level of risk across the emerging market space at the country level and have quantified which countries are most vulnerable. China is particularly vulnerable to experiencing a financial crisis.
  • CAN CHINA AVOID FINANCIAL CRISIS? (4/26): The risk of a Chinese financial crisis is heightened to the extent that financial sector reforms are not appropriately managed.
  • REPLAY: Will China Break? (4/30): The Party’s use of state owned banks to drive economic growth through fixed asset investment has left the financial system loaded with bad assets.  The bad assets mirror bad investments in the real economy.  They also can limit the ability of Chinese banks to make new loans.  Following the financial crisis, the Chinese government pushed too hard on the FAI growth lever, building infrastructure projects “for the next 10 years.” It has also left the banking sector choked with bad debts that may limit future lending.  Those factors should slow Chinese FAI growth and slower Chinese FAI growth should be negative for commodity prices and resource-related profits, all else equal.
  • TWO CHINAS? (5/1): Financial system headwinds continue to outweigh consumption tailwinds within the Chinese economy.
  • WHY IS CHINA GOOSING ITS EXPORT FIGURES AND HOW MUCH LONGER WILL IT CONTINUE? (5/8): Chinese firms are goosing exports to drive incremental liquidity into the banking system – a phenomenon that appears set to slow from here.

DF - Sayonara to the S&P 500

Yesterday evening, Standard & Poor’s announced that Kansas City Southern will be replacing Dean Foods in the S&P 500 while DF will take KSU’s places in the S&P Midcap 400.  This little bit of index musical chairs will take place after the close on May 23rd, coincidental with DF’s distribution of WWAV shares to DF holders.



We wrote about this earlier in the week, and while we expect that index funds have likely gotten ahead of this change, we still may see some selling pressure.  Any weakness in DF (or DF when issued, for those folks that can buy it) represents an opportunity, in our view.

 

We are also going to take this opportunity to provide some more granularity with respect to the current values of the various moving parts of this situation.  We continue to see material upside to the EV/EBITDA multiple covering the fluid milk business at DF.

 

DF - Sayonara to the S&P 500 - DF math

 

Call with questions,

 

Rob

 


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Department Stores: JCPenney Winning?

Takeaway: After the noise around earnings relative to expectations, JCPenney looks good compared to its peers, at least on one metric.

This note was originally published May 17, 2013 at 11:03 in Retail

 

 

Performance in the department store group (JCPenney, Kohl's, Macy's, Nordstrom) this quarter diverged as meaningfully as we've seen in recent memory. We don't think its appropriate to simply look at where the companies came in relative to the Street, i.e., guidance. The best thing for us to do is triangulate the sales/inventory/margin performance for each of the four major department stores, and see how they have changed over the past four quarters relative to one another.

 

Bigger picture, each department store has a point where inventories are intersecting with margins.  None of those points are within a stones throw of one another. Not even close. The trends are becoming more divergent as to the other way around.

 

  • Kohl's (KSS): Widely viewed to be a positive print, margins headed back to zero-barrier (even with last year) but inventories slid the most out of the group -- so mush that we had to readjust the vertical axis on the chart.

 

  • Nordstrom (JWN): Conversely, viewed as the biggest disappointment of the group. Yes, margins eroded sequentially, but JWN also showed proportionally the best improvement in inventories out of the group. In another two quarters, compares get much easier for JWN, and it's on a trend of improving inventories.

 

  • Macy's (M): The steady performer in the group, but proportionally showed the worst inventory move aside from KSS. This is more of a concern for M given that it has been in the upper right hand quadrant for five-quarters and margins remain positive. In other words, it has more to lose.

 

  • JCPenney (JCP): Lastly, JCP is in its own little cycle. Earnings-per-share were a disaster this quarter, and both inventory and margins are triangulating with sales in the dangerous lower left quadrant of this analysis (inventories up, margins down). But it is the only company that sequentially posted a moved headed up and to the right. When evaluating stock price movements, it does not matter as much which quadrant a company is in, but rather which one it is pointed toward.  Ironically enough, out of all four, JCP comes out ahead in the 'incremental rate of change' contest.

 

Department Stores: JCPenney Winning? - department store sigma


JCP/KSS/M/JWN: JCP Winning?

Takeaway: After the noise around EPS relative to expectations, we see that of all four, JCP comes out ahead in the 'rate of change' contest.

 

 

 

Performance in the department store group this quarter diverged as meaningfully as we've seen in recent memory. We don't think its appropriate to simply look at where the companies came in relative to the Street (ie guidance). The best thing for us to do is triangulate the sales/inventory/margin performance for each of the four major department stores, and see how they have changed over the past four quarters relative to one another.

 

Bigger picture, each department store has a point where inventories are intersecting with margins.  None of those points are within a stones throw of one another. Not even close. The trends are becoming more divergent as to the other way around.

 

  • KSS: Widely viewed to be a positive print, margins headed back to zero-barrier (even with last year) but inventories slid the most out of the group -- so mush that we had to readjust the vertical axis on the chart.

 

  • JWN: Conversely, viewed as the biggest disappointment of the group. Yes, margins eroded sequentially, but JWN also showed proportionally the best improvement in inventories out of the group. In another two quarters, compares get much easier for JWN, and it's on a trend of improving inventories.

 

  • M: The steady performer in the group, but proportionally showed the worst inventory move aside from KSS. This is more of a concern for M given that it has been in the upper right hand quadrant for five-quarters and margins remain positive. In other words, it has more to lose.

 

  • JCP: Lastly, JCP is in its own little cycle. EPS was a disaster this quarter, and both inventory and margins are triangulating with sales in the dangerous lower left quadrant of this analysis (inventories up, margins down). But it is the only company that sequentially posted a moved headed up and to the right. When evaluating stock price movements, it does not matter as much which quadrant a company is in, but rather which one it is pointed toward.  Ironically enough, out of all four, JCP comes out ahead in the 'incremental rate of change' contest.

 

JCP/KSS/M/JWN: JCP Winning? - department store sigma


HOUSING: DATA SOFTENS, BUT NOT REALLY

Takeaway: Housing starts appear to have weakened sharply, but here's our take on what the data is really telling us.

This note was originally published May 16, 2013 at 14:57 in Financials

Do Starts Matter More than Permits?

Yesterday (Wednesday), after the close, we published a note on why we think it's increasingly likely that housing starts will work their way back to a 2.0 million run rate in the coming years. The timing of that note could have been better, in light of this morning's (Wednesday morning's) 16.5% month-over-month decline in April housing starts. Our view on getting to 2 million, however, is unchanged, and we'd encourage you to take a look at our note when you have a chance. Here's our take on today's data.

 

The first point is that the weakness in the starts data this morning was on the multi-family side, where starts dropped 155k MoM. Single family starts fell by 13k to 623k. The second point is that while starts were weak, permits were strong. The second chart shows permits. Single family permits rose 18k MoM while multi-family permits rose 109k. The strength in permits largely offsets the weakness in starts, and the single-family starts/permits dynamic is much less of an "event" than the multi-family data. In looking at the trend lines in the permits chart, we see little cause for concern.

 

For those curious which is the better indicator, starts or permits, we've looked into this question in the past. It turns out the answer is neither. Our analysis found no discernible lead/lag relationship between starts and permits. We realize it's intuitive that permits lead starts, but in practice they don't. We've run correlations between the series at varying lead/lag intervals and found that the strongest relationship occurs on a no-lag basis. 

 

One interesting consideration, however, is that the Census dept points out that you need only 2 months of permits data to draw conclusions, whereas 4 months of starts data is needed. On that basis, we'd be slightly more inclined to believe the permits numbers.

 

Here's the full disclosure they provide: In interpreting changes in the statistics in this release, note that month-to-month changes in seasonally adjusted statistics often show movements which may be irregular.
It may take 2 months to establish an underlying trend for building permit authorizations, 4 months for total starts, and 6 months for total completions.

 

HOUSING: DATA SOFTENS, BUT NOT REALLY - 1

 

HOUSING: DATA SOFTENS, BUT NOT REALLY - 2

 

HOUSING: DATA SOFTENS, BUT NOT REALLY - 3

 

HOUSING: DATA SOFTENS, BUT NOT REALLY - 4

 

HOUSING: DATA SOFTENS, BUT NOT REALLY - 5

 


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