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China's continuing bear market: What's driving it and when will we see a bottom?
01/03/2012 8:30 am EST
But at 2199 on December 30 the Shanghai Composite Index hasn’t been this low since March 2009.
Forget about the October 20, 2011 low at 2331—that’s 6% above the current market. And the November 3, 2010 high at 3161? Well, the Shanghai market is down 30% since then.
Next stop of significance would be the November 2008 low at 1720. That’s another 479 points below where we are today—or a 22% drop from today’s index level. A move back to 1720 would mark a huge 46% plunge from the November 2010 high.
Why is the Shanghai market still falling—even though it looks like the People’s Bank of China is starting to loosen its monetary policy? Why am I even contemplating a 45.6% super-bear for Chinese stocks?
Because at the recently concluded annual Central Economic Work Conference China’s political leaders and its top economic officials decided that the government would continue to squeeze the housing sector until prices returned to “reasonable levels.”
What’s reasonable? Well, the work conference didn’t define the term but a recent report from the Agricultural Bank of China, one of China’s four big state-controlled banks, has fleshed out what “reasonable” might mean for housing prices in China’s cities. The numbers sure aren’t pretty: Housing prices in China’s most developed, first-tier cities (Shanghai and Beijing, for example) would need to drop another 10% to 25%. Prices in second-tier cities would need to drop another 5% to 15%.
The bank got to these numbers by looking at a 1998 survey by the United Nationals of housing affordability in 96 countries. To be “reasonable” the bank concluded prices should be 6 to 8 times the average level of household income in China. (The bank, to its credit, assumed that China’s average household income is 1.5 times the official figure from the National Bureau of Statistics.)
You can certainly pick holes in the Agricultural Bank of China’s methods and the exact extent of the decline to “reasonable” is only a rough estimate. But the important thing from the work conference and the bank’s report is the conclusion that the government is serious about continuing the current pressure on housing prices. The work conference’s concluding statement said the government would “unswervingly adhere to real estate control policies.”
You can understand why this has kept the pressure on the stocks of property developers such as Poly Real Estate and China Vanke. Total housing starts could fall by 15% in 2012, according to UBS.
The fear, for China’s stock market as a whole, is that a slowdown in the real estate sector will ripple out through the rest of the economy creating a slowdown that the government can’t counter before the country comes in for the dreaded hard landing. The residential real estate sector itself accounts for 6.1% of China’s GDP, but investment in the sector drives demand for everything from cement to copper to construction equipment to home furnishings. Rising prices for residential real estate help drive up land prices—and since land sales are a critical source of revenue for local governments rising land prices are a source of money for local infrastructure development, funding for local education and health care, and local business investment. This connection between local revenue and real estate prices is especially important because China’s official stimulus policies often rely upon local governments to provide the cash to fulfill directives issued in Beijing.
Any attempt to put an exact figure on the extent of real estate’s actual share of China’s GDP is just an estimate—15%? 20%?—but you can see why investors and economists might be worried about the impact of a continued policy of reducing real estate prices and about the ability of the central government to make up for the short fall.
The worry among investors isn’t that the government in Beijing isn’t unaware of the danger, but that it won’t be able to do enough to avert it. . So, for example, there’s been talk of a tax cut to stimulate consumer demand. Still a tax cut wouldn’t have the power in China that a tax cut would have in the United States. It’s one thing to say “The government will stimulate consumer spending with tax cuts that put more money in the hands of consumers” in the United States where consumer spending makes up 70% of GDP and it’s quite another thing entirely to say that in China where consumer spending makes up just 35% of GDP.
The People’s Daily has reported that the country will spend 200 billion yuan ($32 billion) on constructing rural roads in the years that end in 2015. That would be more than the total for the previous five years, it’s true, but it’s less than the country spent on its big infrastructure splurge after the Lehman bankruptcy and I wonder if strapped local governments will be able to kick in their usual big share of spending mandated by Beijing.
There’s also widespread conviction that the People’s Bank will cut reserve ratio requirements again—by another 0.5 percentage points—after New Year. (A reserve ratio cut was the subject of a front-page editorial in the government-controlled China Securities Journal on December 29.) That projected cut would follow quickly on the heels of the last cut that took effect on December 5. Each half-percentage point cut frees up about $50 billion in money that banks can now lend rather than keeping as reserves. But China’s money supply expanded by just a 12.7% annual rate in November, the slowest rate of increase in a decade, so any monetary stimulus from reserve ratio cuts has a lot of ground to make up.
The government has also approved a new quota for Qualified Foreign Institutional Investors, the first since May, that will bring new money to China’s financial markets. Still, a skeptic might note, that the additional quota of $950 million still leaves the total amount of foreign money that can be invested in China’s financial markets just under $22 billion.
For all these reasons, as attractive as prices of China’s stocks are right now—a 31% drop from the November 2010 high is a significant drop—I’d wait before making a big move into Chinese equities. I’d certainly wait until after the Lunar New Year/Spring Festival, when liquidity improves. That holiday comes early this year in late January. Waiting even longer is probably a good idea. Let the fear of a hard landing as a result of falling real estate prices play out for a quarter of longer. Let GDP growth slow some more. Let the People’s Bank loosen monetary policy some more. Let investors start to think that an actual interest rate cut is likely for June or July.
I still like Chinese stocks—it’s just that I still like them for the middle of 2012.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did not own shares of any stock mentioned in this post as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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