Taking a Flyer on a Higher Yuan

11/30/2010 9:57 am EST

Focus: GLOBAL

Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Heritage Corporation

China has an incentive to let its currency rise, writes Paul Goodwin of the Cabot China and Emerging Markets Report. He’s also tracking a Chinese airline stock with strong potential.

Conflict always makes for exciting news stories, and the possibility of a trade war between the US and China has yielded some great headlines in the past couple of years.  

But it’s also interesting to see that recent headlines point to a possible convergence in the interests of the US and China that could yield changes that would benefit both countries. Specifically, we’re thinking of recent stories about China’s attempts to rein in inflation.

The threat of additional interest rate increases by Chinese central banks and restrictions on housing speculation has been viewed with some alarm by stock markets around the world. That’s because, with China now almost universally acknowledged as the main engine of global growth, the prospect of China’s rulers taking their foot off the gas looks like a recipe for a global slowdown.

But there’s one option for slowing the growth of Chinese inflation that might just scratch the backs of both countries, and that’s allowing the yuan to appreciate further versus other world currencies. This option has been floated by several Chinese officials, and it would have some great benefits.

First, a partial yuan float would reduce pressure on US legislators to “do something” about the overvalued currency. Second, a stronger yuan would provide the kind of organic dampening of China’s export-led growth that would moderate factory growth using the corrective power of real market forces.  Some people see the possibility of price controls on Chinese commodities, and the government has been working to increase supplies to counter speculative pressures. But a higher yuan would push all the right buttons without the blunt instrument of price controls becoming necessary.

Let’s hope that’s what happens, and that the results follow this optimistic scenario.

A Chinese High-Flyer
My stock pick for today is China Southern Airlines (NYSE: ZNH), which is the dominant passenger, cargo and mail carrier for the southern provinces of China. Airlines are traditionally tough ways to make a profit, but the Chinese government’s control of rate structures, routes and operating rules takes a little of the uncertainty out of the equation for China Southern.

The company’s major appeal is its last three quarters of steady revenue growth (31% in Q1, 52% in Q2, and 48% in Q3) and the huge earnings growth that can come seemingly out of nowhere, such as the 816% jump in third-quarter earnings.

This isn’t a stock for the faint of heart, or for those who like to invest and forget about it for months at a time. ZNH has a beta of 1.46, and the chart shows some big volatility. But the chart also shows a stock that put in a nice base from April through the end of August, then broke out above 26 on good volume in September. The stock soared to 39 in late October before the correction set in. [Shares closed at $34.74 Friday—Editor.] Note that volume is minuscule, which guarantees high volatility.

But with a price/earnings ratio of just seven, annual sales or more than twice its market cap, and a generous float of 66 million shares, ZNH can provide a good opportunity for a trader with the patience to sharp-shoot it near the 50-day moving average.

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