The big challenge this year as opposed to other years is how much will opposing forces interfere wit...
The next macro event that will drive global stocks? My bet is on announcements of new stimulus from China
10/02/2012 8:30 am EST
The Communist Party finally announced a date—November 8—for the 18th party congress that will formally transfer power to Xi Jinping and a new (or “newish” anyway) group of leaders for the next ten years. Investors have been waiting, increasingly tensely, for the party meeting date. Each day that passed without an announcement raised fears a little higher that the transition would turn out to be tumultuous. So there was a small but still audible sign of relief on September 28 when the schedule was finally set.
The odds are good that investors will drive the prices of Chinese stocks higher as soon as the National Day Golden Week holiday that began on October 1—with a estimated 85 million Chinese hitting the road—ends and markets open. Last week stocks in Shanghai started to rally on speculation that the government would use the holiday period when the stock market is closed to announce new rules to encourage stock buying and new stimulus measures.
Let’s handicap the odds that Chinese markets will see that rally continue after this week’s holiday.
First, valuations are extremely low on the Shanghai market. The Shanghai Composite Index is valued at 10.3 times estimates earnings. That compares to the U.S. Standard & Poor’s 500 Index, which trades at 14.19 times projected earnings, 12.6 times projected earnings for the London FTSE 100 Index, and 35.68 times projected earnings for Tokyo’s Nikkei 225 Index.
Now there’s absolutely no reason that a cheap market can’t get cheaper, but the Chinese media have been full of statements like this lately: “History shows that a low market valuation tends to be followed by a considerable rebound,” Liu Ti, director of the Financial Innovation Laboratory at the Shanghai Stock Exchange, said last week. The laboratory also reported that blue chips in Shanghai (however defined) are now trading at the lowest level in history.
Second, continued bad economic news has heightened speculation that the government and the People’s Bank will move more forcefully and sooner rather than later so that the new leadership team will take over an economy showing accelerating growth.
From this perspective, the September 30 report that the manufacturing sector had contracted in September for a second month for the first time since 2009 is actually good news since such bad news increases pressure on the government to step up stimulus. The Purchasing Managers’ Index fell below 50, indicating a contraction, in September for a second month in a row for the first time since 2009, a survey for the National Bureau of Statistics and the China Federal of Logistics and Purchasing indicated, increasing pressure for government measures to reverse a stubborn economic slowdown. The index came in at 49.8 in September. That was better than the 49.2 reading in August but still indicated the economy was contracting. (Anything below 50 indicates contraction.) And it was below the 50.1 median forecast from economists surveyed by Bloomberg.
From this point of view even bad economic and financial news from Europe (unless it turns deeply scary) can be seen as a plus since slower growth in China’s biggest export market will goad Chinese officials and regulators into earlier action.
On this kind of thinking Shanghai stocks rose 1.45% on Friday and gained 2.96% for the week. That gave the index a 1.91% gain for the month to snap a streak of four straight losing months.
Traders and speculators were encouraged last week when Shanghai stocks rebounded strongly after dipping briefing through the 2,000 level.
You’ll notice that all this is about sentiment and attempts to read the tealeaves to predict what twists and turns that sentiment is apt to take. Certainly investors can’t yet see any fundamental improvement in the Chinese economy that would lead to higher earnings in order to support Shanghai stocks at higher prices. In fact what we can tell of the upcoming third-quarter earnings report argues that large swathes of the Chinese economy will report falling profits if not outright losses. Already leading Chinese companies such as Baidu (BIDU) and critical Chinese sectors such as the steel industry have guided stock analysts to expect hard times.
But stock markets in all countries look ahead so it wouldn’t be unusual if the Shanghai market was looking past a rocky third quarter for earnings and anticipating a better fourth quarter. In addition, the Shanghai market also normally moves in attempts to predict changes in government policy. Traders in that market frequently buy and sell in an effort to profit from shifts in government policy and the timing of those shifts. In that context a rally here wouldn’t be unusual.
Do you want to put some money into a potential rally built on speculation about sentiment built on the crowd’s anticipation of a change in government policy?
If I put it that way, your answer is almost certainly No.
But how about if I argue this: The Shanghai Composite Index is down 70% from its all time high of October 2007 and down more than 40% from its post-financial crisis high in August 2009. The index is trading at the same level as in mid-2001. The stock market of one of the world’s fastest growing economies has gone nowhere in a decade. Isn’t it ready for a period of outperformance?
Especially if China (and other emerging stock markets) re-establish the kind of anti-correlation to developed markets that they’ve show for a good part of recent history—until the euro debt crisis in fact. From a long-term point of view the recent period where Chinese stocks tanked when European stocks stumbled has been the exception and not the rule. If China can re-accelerate its rate of economic growth, aren’t investors looking at a return to a period of anti-correlation with developed stock markets and a period of outperformance for Chinese stocks?
You might recognize this as just another version of the Shanghai market has to go up because it’s so cheap story above with a different—more global--set of statistics.
Like the more purely Chinese version of the story, it is based on a belief that an acceleration in growth—while not visible now—is just around the corner. We can’t yet see signs that current stimulus has had any effect on growth, but we’re convinced, this view goes, that the government is about to increase the speed and volume of its stimulus measures and that those new measures will work where the old ones haven’t.
Frankly, I think I’d put more faith in the theory that Chinese stocks will rally on speculation that the government will move than I would in the theory that new stimulus will actually work this time. I’m just about positive that the government will announce new stimulus measures in the weeks leading up to the party congress and then pile on even more after the congress in order to show the vigor and control of the new leadership after what many Chinese analysts are now calling a period of drift.
Those announcements themselves will likely be enough to fuel a rally.
I’m much less positive that those stimulus measures will actually work to accelerate growth. In the last couple of months I’ve given you a laundry list of drags on the Chinese economy that have rendered invest-heavy stimulus measures much less effective now than in 2008 and 2009. For example, local governments have announced huge programs of new investment of the sort that jump-started the economy after the Lehman bankruptcy, but this time local governments are so cash strapped with actual spending may fall even further below announced totals than usual. Banks are sitting on huge portfolios of—unreported—bad loans that inhibit their willingness to lend, especially since so many of the state-owned companies in China’s export sector are showing falling sales and profits—or would be in the government at all levels wasn’t propping up sales. (For example, local governments have been subsidizing local steel companies, keeping blast furnaces blasting and workers working but building up large inventories of unsold steel.) The slowdown in Europe, China’s biggest trading partner, shows no sign of reversing before late 2013 at the earliest, which makes it tough if not impossible for China’s exporters to export their way to growth.
Which leaves investors with some odd choices.
You can, of course, sit out any possibility of a speculative rally. Such a rally would be quite explosive if it did occur but that doesn’t mean you have to chase it. The downside risk probably isn’t huge with the Shanghai Composite near 2000 but that doesn’t mean the risk is non-existent.
You can decide to go with the odds in favor of a relatively short-term speculative rally. The upside in the short-term of the next two to three months is attractive—10% to 15% conservatively, I’d estimate. But fully participating in this kind of a short-term move requires that you buy shares of exporters and industrial companies that are most likely to rally hardest but that stand to fall hardest if the rally doesn’t materialize at all. And that will certainly fall hardest if a speculative rally doesn’t turn into a rally based on signs of accelerating growth. Some stocks that fit this profile include China Coal Energy, Hong Kong Exchanges and Clearing, Jiangxi Copper, Sany Heavy Industry, and China Railway Group. You can buy shares of most of these companies on the Hong Kong market but few have enough volume in New York to make it easy to get out if something goes wrong.
Or you can eschew the biggest gains in any short-term rally and go for the long-term recovery in China’s growth that is likely to be led by domestically oriented companies rather than exporters. I continue to believe that the most effective stimulus measure that the government has passed recently is the promise of a 13% annual increase in the minimum wage embedded in the five-year economic plan promulgated in February 2012. That will mean rising incomes that will be spent on instant noodles and bottled drinks (Tingyi Holding (322.HK) and Want Want Holdings (WWNTY in New York or 151.HK in Hong Kong)), on travel (Home Inns and Hotels Management (HMIN) and Chinese Eastern Airlines (CEA)), Internet services and shopping (Tencent Holding (TCEHY in New York or 700.HK in Hong Kong)), and financial services such as insurance (Ping An Insurance Group (PNGAY in New York or 2318.HK in Hong Kong)) and China Life (LFC).) These stocks won’t fall quite as hard as their export-dependent counterparts if China’s growth rate disappoints, but they will decline. (Check out the chart for Home Inns and Hotels to see a typical pattern.) I’d recommend buying them with a strategy in place for an exit if the economic fundamentals don’t live up to speculative anticipation.
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, Hong Kong Exchanges & Clearing, Jiangxi Copper, Ping An Insurance Group, Tencent Holdings, and Tingyi Holding as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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