• It's Coming...

    MARKET EDGES

    Identify global risks and opportunities with essential macro intel using Hedgeye’s Market Edges.

Takeaway: In the note below, we debate the merits of the long-term bull case for China. We’re not impressed, but we’re not "not impressed" either.

SUMMARY BULLETS:

  1. We continue to think it’s appropriate for investors to stop shorting or selling down their exposure(s) to China.
  2. Moreover, we think China’s long-term economic outlook has indeed improved on the margin (i.e. it has gotten “less bad” recently).
  3. We’re not yet outright bullish on China, however. A trifecta of headwinds may result in negative surprises during the fourth quarter and more clarity is needed on the policy front with respect to the longer-term outlook.

[GOT] OUT OF THE WAY

My how fast things change in today’s policy-driven markets. A week ago, we were as bearish as anyone on China’s long-term economic outlook and both our top-down and bottom-up quantitative signals supported that view.

Fast forward one day from then to last Friday’s color on the Shanghai Free Trade Zone (FTZ) and the subsequent closing of the insider-dominated Shanghai Composite Index above its TREND line and, just like that, our choice to get out of the way on the short side is looking like an increasingly appropriate risk-managed decision (the index is up +5.4% WTD vs. a regional median delta of +2.6%).

Not to be all sales-y in a research note, but I personally think one of the main things that differentiates our Global Macro research product from the industry norm is the consistent demonstration of mental flexibility at potential inflection points like this (see: orchestrating a 180-degree turn to being bullish on US equities in DEC ’12 despite having US equity-bearish 4Q12 Macro Themes titled, “#EarningsSlowing and #KeynesianCliff).

Accordingly, Mr. Market doesn’t care that we’ve done months of bottom-up research on the structural headwinds facing China’s financial sector and its fixed assets investment-driven economy (most recently rehashed on slides 8, 62-72 and 77-78 in our AUG 30 EM chartbook). If it’s priced in, it’s priced in.

To that point, we turn to the latest Bloomberg Global Poll data (released today), which is based upon the responses from a random sample of 900 subscribers to the Bloomberg Professional Service (over 300k clients worldwide):

  • Q: Which of the following do you think poses the biggest risk to the world economy in 2013?: Chosen by 32% of respondents, “a slowing Chinese economy” was identified as the #1 risk… this compares to 31% in the previous survey (MAY ’13);
  • Q: What is your view of the economy in China?: 39% of respondents viewed the Chinese economy as “deteriorating” vs. 42% for “stable”, 17% for “improving” and 2% for “have no idea”… this compares to 44%, 45%, 9% and 2%, respectively, in the previous survey;
  • Q: Which market will offer investors the best opportunities over the next year?: 14% of respondents selected China… this compares to 13% in the previous survey; and
  • Q: Which market will offer investors the worst opportunities over the next year?: 23% of respondents selected China vs. 27% in the previous survey.  

On balance, it’s clear the consensus attitude towards the Chinese economy and its financial markets has improved marginally QoQ. While it’s natural to want to be contrarian and fade this delta, we’d argue that after three straight years of slowing economic growth and three straight years of rancid-to-subpar equity market performance (-14.3% in 2010, -21.7% in 2011 and +3.2% in 2012), it’s more appropriate to extrapolate these results as positive on the margin.

MAKING THE TURN?

Looking at China objectively from here, we have to lend the appropriate amount of credence to Premier Li’s most recent guidance (key highlights from his commentary at the Davos Economic Forum):

  • Li referenced the positive sequential deltas in China’s AUG growth numbers when saying, “China has entered a stage of fast expansion with its commitment to reforms growing stronger.”
  • “Beijing will be encouraging foreign companies to make investments and start businesses in China by creating a more investment-friendly environment, intensifying intellectual property rights protection and providing an environment that encourages fair play.”
  • “Now the new season of the Chinese economic miracle, one with better quality and higher efficiency, is unveiled, and I guarantee you even more exciting stories to come.”

As an aside, it’s good risk management practice to lend credence to anything that comes out of the “horse’s mouth” that is the Politburo Standing Committee (PSC); Chinese officials almost always do what they said they were going to do. From our JUN 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.”

We’re not going to make up a bunch of BS reasons why China’s economic reforms are going to specifically boost the Chinese economy; the whole, “reform ABC will contribute XYZ percentage points to GDP growth” is so sell-side/IMF. Rather, we’ll call it like we see it: no one outside of the PSC knows exactly what specific policies China will implement and at what pace.

All we really know at the current juncture is that the market clearly thinks the Shanghai FTZ and it’s “innovative tax policies” (per Premier Li… the latest rumors call for a -1,000bps corporate tax cut to 15%), interest rate and capital account liberalization and pro-foreign business reforms will be enough to help offset the structural liquidity headwinds to Chinese credit growth that are currently being predicated by deteriorating current account dynamics and a likely explosion of nonperforming assets (reported or evergreened) across the banking sector – at the margin at least!

At the end of the day, buying China here is akin to buying a tiny piece of a bombed-out stock in the thralls of its bull-bear debate. If it doesn’t work, you keep it on a tight leash and sell it; if it starts to work, you buy more and update the fundamental story as you go along.

NOT SO FAST!

All that being said, however, we are NOT telling you to run out and buy China here. Rather, we’re merely acknowledging the merits of what we view as the most credible intermediate-to-long term bull case (i.e. the rough opposite of our former bearish thesis).

Additionally, we continue to believe that SEP will mark the top in this latest cyclical uptrend in China’s monthly economic growth statistics (CLICK HERE for the analysis supporting this conclusion).

Inclusive of this short-cycle peak in Chinese economic growth, the Chinese economy as a whole looks poised to take a trip to Quad #3 on our GIP model in the fourth quarter amid a likely uptick in inflation after aggressive credit growth in the YTD (Total Social Financing is up +24.4% YoY through AUG).

DEBATING THE BULL CASE FOR CHINA - CHINA

All things being equal, that would make it difficult for Chinese stocks to perform well through the balance of the next few months – unless, of course, the insiders are looking through a sequential deterioration in corporate operating conditions in the fourth quarter to a long-term economic outlook that appears increasingly “less bad” on the margin.

Looking to the next potentially bearish catalyst, the insiders might eventually join us in looking towards NOV’s Third Plenary Session as a potential catalyst for the PSC to take down the country’s 2014 GDP growth target. As a refresher, the 2013 target is equal to +7.5% with a “floor” of +7%; will the 2014 target be revised lower to +7% with a “floor” of +6.5%?

We would not be surprised if that turned out to be the case; in fact, we expect them to keep walking Chinese growth expectations down the natural stair steps afforded by the law of large numbers – especially given their desire to rebalance the economy towards consumption in lieu of fixed assets investment and the aforementioned debt-induced headwinds to high growth rates from here.

Lastly, the Ministry of Housing and Urban-Rural Development (MOHURD) might blindside investors any month by tightening the screws on the Chinese property market(s) via additional curbs, more aggressive enforcement and/or an outright nationwide [punitive] property tax trial. Most recently, they were beginning to investigate local authorities on their potentially lax implementation of the existing nationwide curbs to housing transitions and mortgage lending.  

DEBATING THE BULL CASE FOR CHINA - China Real Estate Climate Index

One of the things we’ll monitor to determine whether or not it’s an appropriate time to buy or if more confirmation is needed is whether or not the insider-driven Shanghai Composite Index closes above its late-MAY highs; that lower-high came just before the JUN liquidity crunch and subsequent consensus debate about China’s financial sector risks (i.e. the same risks we called out in our Hedgeye Macro Emerging Market Crisis Risk Index back on APR 23).

Specifically, a close above that level would be akin to receiving a second quantitative “thumbs-up” in our playbook (the first being the recent TREND line breakout).

DEBATING THE BULL CASE FOR CHINA - China SHCOMP

Best of luck out there risk managing the world’s second-largest economy!

Darius Dale

Senior Analyst