Last central bank standing: Using the People's Bank to guide your investing strategy for China
09/11/2012 8:30 am EST
“One of these central banks is not like the others,
One of these central banks just doesn't belong,
Can you tell which central bank is not like the others
By the time I finish my song?”
It’s the People’s Bank of China—as Big Bird would have told you if you’d just asked nicely—that stands out among the three big central banks that currently have the power to move the global economy.
Not because the People’s Bank faces a significantly smaller challenge than that confronting the Federal Reserve or the European Central Bank. Reviving the growth rate of China’s economy while rebalancing the country’s economy without letting inflation loose is a bigger problem that the Fed faces and not all the much simpler than figuring out how to fix the euro.
And not because the People’s Bank is structurally superior to the Fed and the ECB—I think it lies somewhere in a continuum of power in its home economy between the Federal Reserve and the European Central Bank.
No, the big difference is that alone among the big three central banks, the People’s Bank can count on fiscal policy from the government to do part of the heavy economic lifting. While the Fed looks at a hamstrung national government that will be lucky to avoid sending the U.S. economy over a fiscal cliff come 2013, and while the European Central Bank can’t count on anything stronger than words about the need for economic growth from national governments, the People’s Bank has the luxury of holding its fire while national and local governments put billions to work to increase growth.
I’m not saying that those government actions in China aren’t without their long-term dangers. But I am saying that the Chinese economy isn’t dependent on its central bank in the same way that the U.S. economy and the EuroZone economy are currently dependent on their central banks.
And investors should include the way that the People’s Bank is not like the others into their decisions on when to put money into the currently very depressed Chinese stock market.
Right now slowing growth in the Chinese economy is enough to send shock waves through the Hong Kong and Shanghai markets, through the stock markets of emerging economies dependent on selling commodities to China, and through the global economy whenever it manages to stop worrying about the Greek/Spanish/Italian debt crises.
How slow? Chinese GDP grew at an annual rate of 7.6% in the second quarter. That was the slowest pace in three years. In recent days economists have cut their forecasts for third quarter and full-year growth. ING, for example, projects that growth will fall to a 7.1% annual rate in the third quarter; Bank of America is looking for 7.4% growth in that quarter. That would bring full year growth to just 7.5%, according to ING and UBS. That would be the lowest growth rate in 22 years.
That slowdown in growth and those projections for a further slowdown sure haven’t been good for Chinese stocks. For the last year (through September 7) the Shanghai Composite Index is down 14.81% and for 2012 to date the index has dropped 3.26%. That's even worse than it seems since in that period a U.S. index such as the Standard & Poor’s 500 is up 24.58% for one year and 14.34% for 2012 to date. And in the longer term you have to go back to March 2009 to match the September 7, 2012 close of 2128 on the index. (And that September 7 close is an improvement from the August low of 2038.) The Shanghai Composite Index traded recently at a trailing 12-month price to earnings ratio of just 11.47. (In comparison the trailing 12-month PE ratio on the S&P 500 was 16.66 on September 7. That’s up from 14.34 a year ago. The consensus analyst forecast puts the forward PE at 13.36 times projected earnings.)
Even at a PE ratio of 11.47, however, Shanghai stocks are only cheap if earnings over the next 12 months are going to be higher than they were over the last 12 months. And that’s where doubts come roaring in. Recent data suggests that China hasn’t finished slowing. According to data from the National Bureau of Statistics released on September 8, production in August grew at an annual rate of just 8.9%, the slowest growth since May 2009. Investment in fixed-assets, a key driver of China’s economy, grew by just 20.2% in the first eight months of 2012. That was below the 20.4% growth projected by economists In August, China’s customs service announced on September 10, imports slid by 2.6% from August 2011. Exports climbed by 2.7%. That was below economists’ projections.
If the United States or the EuroZone had just released data like that, all eyes would be on the Federal Reserve and the European Central Bank because, when it comes to growth in those economies, those two central banks are the only game in town.
And certainly this latest batch of bad economic news has raised expectations among investors that the People’s Bank will act—and soon. One of the reasons for the continued struggle of Chinese stocks has been, in fact, puzzlement over the slow response from the central bank. If growth is continuing to slow, why hasn’t the bank moved more vigorously to cut bank reserve ratios again—which would increase the money banks can lend—and why hasn’t the bank delivered the cut to the benchmark lending rate that everyone has been looking for? I’d argue that investors and traders are looking for that signal from the People’s Bank before putting money into China’s markets. They want a guarantee that the government isn’t going to let growth fall much further.
There are no guarantees, of course. Even a move by the People’s Bank wouldn’t guarantee that growth is going to pick up in China.
But investors waiting for a move by the People’s Bank are overlooking recent signs of a very big response to slowing growth from sources other than the central bank. The government hasn’t unleashed anything like the high profile $586 billion stimulus package that China unleashed in 2008 to combat the global financial crisis, but as one program after another rolls out of Beijing the numbers are starting to add up.
For example, the Railway Ministry, one of the agencies that led the 2008-2010 infrastructure spending boom, announced plans to increase spending—again—on the country’s rail system. Spending will run at a rate of 67 billion yuan a month through the end of the year—bringing the total to 496 billion yuan ($78 billion) for 2012. The new plan is an increase, the third increase since July, from the old 470 billion yuan budget, and a 7.6% increase from railroad spending in 2011.
Then on September 5 the National Development & Reform Commission, China’s top economic planning agency, approved the construction of 2,018 kilometers (1,254 miles) of roads and subway projects in 18 cities. The price tag for those projects is 1 trillion yuan ($158 billion), according to Nomura Holdings.
Let’s see $78 billion for railways plus $158 billion for roads and subways puts the total at $236 billion. That’s still short of $586 billion, true, but then China isn’t done either.
For example, although it’s difficult to put a yuan figure on it because it’s hard to separate new money from already budgeted spending, the National Development and Reform Commission has said it will accelerate approvals of the construction of new airports this year. The commission has already approved 10 to 20 new airports in 2012, the commission recently told the press. And on the same day that the commission announced those spending plans for roads and subways, it approved nine new sewage-treatment plants, five port and warehouse projects, and two waterway upgrades. The commission didn’t announce the amount of that investment.
Total infrastructure spending by the central government could increase to an annual 20% growth rate in the next twelve months from the current 15% rate, HSBC estimates.
And then, of course, there’s the always tough to estimate contribution from infrastructure investments announced by local governments. In the last two months, local governments have announced $1.02 trillion in new infrastructure spending on projects ranging from new subways to new steel mills. How much of this spending will actually materialize is anybody’s guess since local government officials always over-promise in an effort to win promotions. This year the delivered to promised ratio is likely to be even lower than usual since many of China’s local governments are broke. (More on that later in this post.)
So how do you figure all of this into your investing strategy? Let’s look at the short-, medium-, and long-term, okay?
Short-term, while the bulk of traders may be waiting for the big dog, the People’s Bank, to bark, others are already pushing up the price of stocks with the most exposure to the announced wave of infrastructure spending. So, for example, Anhui Conch Cement (914.HK), China’s biggest cement-maker by market capitalization, has climbed 12.5% since the September 5 announcement by the National Reform Commission. Other stocks that are getting a big push from the infrastructure announcements include Sany Heavy Industry (631.HK), China’s biggest maker of construction equipment. Producers of commodities have also been moving up on the infrastructure announcements. Aluminum Corp. of China (ACH) is up 7.7% since the September 5 announcement. Jiangxi Copper (358.HK), China’s largest copper producer, is up 9.3%.
I’d call most of these relatively short-term trades. The stocks should see their biggest pop in the early stages of belief in an infrastructure-led growth rebound (or growth bottom) in the third or fourth quarter of 2012.
But I wouldn’t stick around in these stocks for too long. Many of these sectors have long-term supply/demand problems that will resurface in traders’ minds after the initial initial gains. For example, Aluminum Corp. of China is looking at a big addition to China’s aluminum supply this year as new capacity in Northeastern China comes on line.
In the medium-term, say after China’s leadership transition in October, I’d be looking to the stocks of companies that would benefit from an actual interest rate cut from the People’s Bank and the subsequent expansion of any uptick in the economy to consumer sectors. Among these stocks I’d look at Sands China (1928.HK) or parent Las Vegas Sands (LVS), noodle-giant Tingyi Holding (322.HK), real estate developer China Overseas Land and Investment (688.HK), Internet leader Tencent Holding (700.HK or TCEHY in New York), and women’s shoe retailer Belle International (1880.HK or BELLY in New York.) If you’d rather not or can’t trade in Hong Kong, you can expand your potential universe of medium-term picks to include U.S.-based companies with big exposure to China’s consumer sector such as YUM! Brands (YUM) and Coach (COH.)
Long-term I worry about the fallout from an infrastructure-based stimulus effort.
Remember way back when—six months to a year ago—China’s leaders were talking about the need to rebalance China’s economy away from a reliance on exports and investments in fixed assets and toward internal consumption and consumer spending. The need for that rebalancing still exists—China’s economic growth is very lopsided and the country’s overreliance on fixed-asset investments doesn’t constitute a sustainable long-term engine of growth—but the recent stimulus announcements seem a return to the tried and true policies of infrastructure-led growth.
And the kind of stimulus we’re seeing now is really just China’s version of the kick it down the road policies pursued by the Federal Reserve and the European Central Bank. Debt levels at the local level in China climbed to 10.7 trillion yuan ($1.6 trillion) at the end of 2010 as a result of the last round of infrastructure stimulus. Estimates say that local governments are due to repay 1.8 trillion of that debt in 2012.
Which is a problem since the revenue streams that local governments depended on during the boom years—land sales and revenue from state-owned enterprises, chief among them—have shrunk.
Consider the squeeze in Changsha, the capital of Hunan Province. The city has increased its investment budget to 800 billion yuan, a 200 billion yuan increase from the 2009 stimulus budget. Revenue in the first six months of the year came to 47.2 billion yuan. City debt at the end of 2011 came to 81.2 billion.
Looking at those numbers, you do have to wonder how Changsha can afford its new investment plan. And, probably more to the point, whether the city has any real intention of paying off the money that it owes to state-owned banks.
At some point this debt does have to be repaid—or written off. Repayment looks unlikely. Writing it off would pile more bad debt on the balance sheets of state-owned banks—not that the banks would recognize most of it in their financial statements. But even unrecognized bad debt would require China’s government and the People’s Bank to come up with the cash one way or another to bolster capital at the banks. The likely method would include some replay of the bury it strategies used in the aftermath of the Asian currency crisis of 1997.
Right now, I think investors have too low an opinion of the prospects for China’s stocks. A recent Bloomberg poll showed that 25% of those surveyed expect Chinese markets to be among the worst performers in the world over the next year. That’s the worst reading that China has received since January 2010. (European markets came in even lower with 45% of those surveyed rating them most likely to underperform. U.S. markets were rated most likely to over perform with 46% rating U.S. stock markets as most likely to top the world.)
The time to worry, of course, is when China moves to the top of the most likely to over perform ratings—especially if, as I suspect, the country’s big debt problem isn’t fixed by then.
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 own shares of Home Inns and Hotels Management, Sands China, Tingyi Holdings, and YUM! Brands as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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