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China; A Pivotal Moment?


Earlier this year China entered the zodiac year of the Dragon. It has been an auspicious year so far for equities with MSCI China up 28.4% since the January 22nd low and CSI300 up 12.3% over the same period in US dollars. The rally follows a three-year bear market that brought equity valuations, sentiment and positioning down to episodic (revulsion) levels. There was also a phase of emotional or waterfall price action to the downside that was a signal of capitulation by many investors.


From a macro perspective there has been a series of policy measures introduced by authorities to support growth. Last week policy makers announced additional measures to assist property stabilisation (crucial for consumer and investor confidence) as well as measures for “structural” growth at the Third Plenum scheduled for July. The property stabilisation measures announced last week probably fall short of a “whatever-it-takes” moment. According to JP Morgan, total housing inventory is ~CNY 15 trillion while total unsold completed units is ~CNY 4 trillion. The support measures represent around 8-9% of volume, assuming a 20% discount on the existing stock. More importantly, investment demand depends more on price expectations than on liquidity provisioning.


Stated differently, the authorities are still attempting to address an insufficient demand problem with more supply side type measures. As we noted earlier this year when we added to our China equity exposure, the fundamental bear case was widely appreciated and reflected in valuations. The Shanghai Composite was trading at 4.7 times two year forward earnings in late January. They key element we had been waiting for was capitulation, forced selling from levered investors and redemption flows. Our sense was that climaxed in late January and early February. The major push back on the bull case was the absence of more forceful (“whatever-it-takes”) policy action.


We have been sympathetic to the argument that the currency and aggregate debt have been a genuine constraint on more aggressive policy. If China implemented US style bond purchases (QE) or more aggressive rate cuts that would risk putting further downward pressure on the currency and outbound capital flows. China has also been constrained by “higher-for-longer” US rates and related dollar strength. Our sense is that “fair value” for the USDCNY is quite a bit higher or above 8.1 (chart 1).


Chart 1


From our perch, the key macro news flow in China also reflects the cyclical weakness in this cycle. The credit impulse (the rate of change in credit growth) has been very weak in the current mini cycle. Credit is inflationary when taken on and deflationary when paid back. The relationship to activity growth in China is also due to the importance of investment, infrastructure, and real estate (25% of GDP) as a contribution to growth. The weakness of the credit impulse in the current cycle is also consistent with the Li Keqiang index (credit, cargo freight and electricity consumption) which is a more reliable indicator of activity than official GDP data (chart 2).


As we noted earlier this year when we added to our China equity exposure, the fundamental bear case was widely appreciated and reflected in valuations. The Shanghai Composite was trading at 4.7 times two year forward earnings in late January. They key element we had been waiting for was capitulation, forced selling from levered investors and redemption flows. Our sense was that climaxed in late January and early February. The major push back on the bull case was the absence of more forceful (“whatever-it-takes”) policy action.


Chart 2


While more debt could be taken on to the central government balance sheet, total debt is already around 300% of GDP. A more aggressive (“whatever-it-takes”) policy response would likely amplify structural imbalances and risk material weakness in the currency. The good news is that the cyclical and structural bear case is widely appreciated and priced in valuations. The bad news is that it is a genuine problem. Therefore, the rally in China is probably a tactical opportunity rather than a potential multi-year bull market from depressed levels. Although it is interesting how China reopening stocks and iron ore are behaving (chart 3). We would also note that our preferred exposure (large platform or service sector stocks such as Alibaba and Tencent) have much stronger cash flow, balance sheet fundamentals and valuation upside.


Chart 3


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20240521_China_A Pivotal Moment
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