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Takeaway: Chinese equities might appear “cheap”, but cheap is likely to get sustainably cheaper in the absence of a positive catalysts.

SUMMARY BULLETS:

  • Recent statements out of Chinese policymakers lead us to reasonably conclude that Chinese officials are less concerned about the outlook for future [unabated] property price appreciation than they had been in recent months. While we continue to think Chinese monetary policy will remain relatively tight with respect to the intermediate-term, we must acknowledge the emergence of a more unfettered path towards PBoC easing – which, generally speaking, is being appropriately reflected in Chinese money markets.
  • Even if Chinese officials suddenly decided to implement another big stimulus package for reasons we can’t fathom (Xi and Li will be in office for 10 years; 2H13 growth pales in comparison to the task of maintaining economic stability over the long term), it remains to be seen how much incremental debt the system can take on over a relatively short period of time.
  • Where Chinese growth trends from here is anyone’s best guess; the most probable answer is “sideways” given the uniform guidance out of the Chinese policymaking spectrum of late.
  • Our GIP algorithm suggests a slight uptick in 3Q followed by a deceleration in 4Q; leading indicators for Chinese growth are starting to rhyme with this quantitative outlook. Interestingly, Chinese GDP seasonality trends concurs with the aforementioned “sideways” view. Lastly, the case for continued slowing is supported by diminished cross-border liquidity, at the margins, and a probable uptick in NPLs in the form of debt rollovers across the Chinese banking system.
  • In the absence of meaningful deposit growth, debt rollovers slow broader economic growth by diverting incremental credit away from productive enterprises, at the margins, to unproductive enterprises that are merely trying to stay afloat. This phenomenon remains a core tenet of our structurally negative outlook for Chinese economic growth. Contrary to the 2008-09 period, it’s almost impossible for us to model in another dramatic [positive] inflection in Chinese growth/growth expectations that is worthy of investors getting excited about on the long side of Chinese equities.
  • Economic gravity in China is – at best – trending sideways though 2H13. Moreover, structural growth headwinds for 2014 and beyond remain a clear and present danger for what we’d argue are increasingly consensus “value buyers” of Chinese equities. Chinese equities might appear “cheap” (a view that we wholeheartedly disagree with), but cheap is likely to get sustainably cheaper in this case in the absence of a positive catalyst or series of positive catalysts.

POLICY GAME-CHANGER?: SHORTING CHINA JUST GOT A LOT MORE DICEY

From our 6/26 Early Look titled, “Uncertain China”: “We’ve become a broken record on this, but it’s critical to remember that China’s present day economic woes are actually a function of very deliberate macroprudential policies. While highly unlikely, at any given time, Chinese officials can reverse course and keep the credit bubble inflating longer than any of us short-sellers can remain solvent.”

Today, Chinese officials finally signaled that they are perhaps more willing to keep the game going for longer than us short-sellers of the heavily indebted Chinese financial system and associated fixed asset bubble might prefer. Today President Xi Jinping said the leadership will guarantee that the +7.5% growth target for this year will be met, despite a notably absent inflection in economic momentum. In addition to Xi’s statement, the official Xinhua News Agency also chimed in with an update from Beijing:

  1. “Authorities will maintain steady second-half expansion amid extremely complicated domestic and international conditions.”
  2. “China will keep a prudent monetary policy and a proactive fiscal stance.”
  3. “China will ensure major tasks in full-year economic and social development are completed.”
  4. “Authorities will coordinate the multiple tasks of stabilizing growth, restructuring the economy and promoting reforms.”
  5.  “China will promote reform of the fiscal, tax and financial systems and seek stable and healthy development in the property industry.”

Statements #1-4 do not reflect a meaningful shift in China’s fiscal and monetary policy guidance. Conversely, statement #5 does signal a slight change relative to previously implemented property curbs and an overt focus on combating speculation across China’s bubbly property markets.

IS CHINA A “VALUE BUY” OR A “VALUE TRAP”? - China Real Estate Climate Index

Taken in conjunction with a less-than-subtle statement today put forth by Sheng Songcheng, head of statistics with the PBoC, we can reasonably conclude that Chinese officials are less concerned about the outlook for future [unabated] property price appreciation than they had been in recent months:

“Unbalanced supply and demand caused rising home prices, not the country's ample money supply… One of the main targets of monetary policy is to maintain the stability of overall consumer prices and not to target prices of specific goods.” (emphasis our own)

The key takeaway from this statement is that the PBoC’s preexisting reservations about meaningfully easing monetary policy in the face of a buoyant property market are now likely mitigated, on the margin. In kind, the property sector outperformed the broader Shanghai Composite Index by +195bps on the day.

All told, while we continue to think Chinese monetary policy will remain relatively tight with respect to the intermediate-term (first chart), we must acknowledge the emergence of a more unfettered path towards PBoC easing – which, generally speaking, is being appropriately reflected in Chinese money markets (second chart).

IS CHINA A “VALUE BUY” OR A “VALUE TRAP”? - China Interest Rate Markets

 

IS CHINA A “VALUE BUY” OR A “VALUE TRAP”? - China Money Markets Monitor

WHERE TO FROM HERE?: CHINA’S 2H13 GROWTH OUTLOOK REMAINS SOFT

Where Chinese growth trends from here is anyone’s best guess; the most probable answer is “sideways” given the uniform guidance out of the Chinese policymaking spectrum of late. Our GIP algorithm suggests a slight uptick in 3Q followed by a deceleration in 4Q; leading indicators for Chinese growth are starting to rhyme with this quantitative outlook:

IS CHINA A “VALUE BUY” OR A “VALUE TRAP”? - CHINA

 

IS CHINA A “VALUE BUY” OR A “VALUE TRAP”? - Rebar YoY

 

Interestingly, Chinese GDP seasonality trends concurs with the aforementioned “sideways” view:

IS CHINA A “VALUE BUY” OR A “VALUE TRAP”? - China GDP Seasonality

Lastly, the case for continued slowing is supported by diminished cross-border liquidity, at the margins, and a probable uptick in NPLs in the form of debt rollovers across the Chinese banking system.

IS CHINA A “VALUE BUY” OR A “VALUE TRAP”? - China Cross Border Liqudity Flows

In the absence of meaningful deposit growth, debt rollovers slow broader economic growth by diverting incremental credit away from productive enterprises, at the margins, to unproductive enterprises that are merely trying to stay afloat. This phenomenon remains a core tenet of our structurally negative outlook for Chinese economic growth. Contrary to the 2008-09 period, it’s almost impossible for us to model in another dramatic [positive] inflection in Chinese growth/growth expectations that is worthy of investors getting excited about on the long side of Chinese equities.

IS CHINA A “VALUE BUY” OR A “VALUE TRAP”? - China GDP Expectations

Even if Chinese officials suddenly decided to implement another big stimulus package for reasons we can’t fathom (Xi and Li will be in office for 10 years; 2H13 growth pales in comparison to the task of maintaining economic stability over the long term), it remains to be seen how much incremental debt the system can take on over a relatively short period of time.

The latest statistics from ChinaScope Financial indicate that total assets and liabilities of SOEs were respectively 45T yuan and 30T yuan, respectively, in 1H13. The debt ratio of 66.7% is fast approaching the regulatory ceiling of 70%; among the 294 listed SOEs, 26.9% exceeded the limit and will eventually have to become compliant either through asset growth or deleveraging…

Jumping back to the Chinese banking system for a minute, we’ll leave you with a few data points that suggest parts of 2H13 could rhyme with what we saw in JUN from an interbank liquidity perspective:

  • The China Banking Association said in an annual report that bad loans at Chinese banks could rise by between +70B yuan and +100B yuan ($11.4-16.3 billion) in 2013 due in part to delinquency risks from industries plagued by overcapacity – which, per recent mandate, must begin to pare back operations starting in SEP. For context, aggregate NPLs across the Chinese banking system are already up +33.6B yuan in the YTD (through 1Q, when liquidity was extremely plentiful). An upside surprise through the top end of the guidance range is more than likely.
  • Some 127B yuan ($20.7 billion) of LGFV notes expire in 2H13 according to Everbright Securities Co., the most in its data going back to 2000 and more than double the 62.7B yuan that matured in 1H13. As it stands currently, the 2014 LGFV debt maturity total of 208.8B yuan ($34.1 billion) is roughly +10% higher YoY. Note that PBoC Governor Zhou estimated in MAR that roughly 20% of local government debt was “risky”. All in, LGFVs may owe more than 20T yuan according to an APR statement from former Finance Minister Xiang Huaicheng, but we’ll soon learn the full extent of local gov’t indebtedness upon the results of the recently announced nationwide LGFV debt audit.
  • Aggregate industrial profit growth slowed in JUN to +6.3% YoY from +15.5% YoY in MAY. A recent report from the China Iron and Steel Association said the group's 86 members made a combined loss of 669M yuan ($109.2 million) in JUN, marking the first aggregate loss this year. The report said that there was unlikely to be any recovery in demand in 2H13 as China's economy slows.

CONCLUSION: CHINA REMAINS A VALUE TRAP

We’ll conclude this note with exactly how we concluded our 7/10 note titled, “CHINA WON’T STIMULATE UNLESS GROWTH FALLS OFF A CLIFF… IS THAT WHAT CONSENSUS WANTS?”:

“In the immediate term, macro markets mean revert and we recommend having a tried and tested quantitative risk management process to properly interpret the price action. Over the intermediate-to-long term, however, macro markets tend to trend in the absence of a fundamental inflection(s) in economic gravity. With respect to Chinese stocks – specifically bank and property developer shares – we think that trend remains south [for the foreseeable future].”

Economic gravity in China is – at best – trending sideways though 2H13. Moreover, structural growth headwinds for 2014 and beyond remain a clear and present danger for what we’d argue are increasingly consensus “value buyers” of Chinese equities. Chinese equities might appear “cheap” (a view that we wholeheartedly disagree with), but cheap is likely to get sustainably cheaper in this case in the absence of a positive catalyst or series of positive catalysts.

Darius Dale

Senior Analyst