What’s the matter with China?
While U.S. stock indexes have hit all-time high after all-time high, China’s markets have been in retreat. After peaking on January 30, Hong Kong’s Hang Seng index had fallen by 5.4% as of March 15. The Shanghai Stock Exchange Composite index peaked on February 6. It was down 6.4% from that peak to the close on March 15. The Shanghai index was still up considerably—16.2%–from its December 3 low through the March close, but that was a retreat from the 24.2% gain the market had recorded from the December 3 low through the February 6 high.
To understand the drop in Chinese stocks even as U.S. stocks soar, it’s important to understand the two groups of investors and traders that—in the short to medium term–drive the prices of Chinese stocks. The two groups don’t have a lot in common nor do they look for the same things from China’s economy and stock markets. But both have been disappointed that trends they thought they saw in place in December and January are either in jeopardy or else were never actually there to begin with. And that has left China’s stock markets without the support of the two groups that usually lead China’s stock prices higher.
Where China’s stock markets go from here—in the short-term—rests on whether the disappointment of these groups increases or reverses. Certainly with turmoil in the EuroZone pushing global markets toward risk off positions, it’s hard to see Chinese stocks getting a boost from macro trends outside of China.
First, China’s domestic investors and traders. This is the key group for determining prices in Shanghai in the short-term, and it has been disappointed by recent government economic and monetary politics. These investors were looking for quick action by the government to stimulate economic growth and to prop up asset prices. This group thought it saw those policies about to drop into place in December—and so these investors bought Chinese stocks, especially those such as real estate developers and securities companies most likely to benefit from this change in government policy.
Second, overseas and institutional investors. This is the key group in determining prices in Hong Kong and Shanghai in the medium term, and it has been disappointed by government economic policy. These investors had counted on measures to increase economic growth but, just as importantly, they had been looking for signs of new economic policies that had the potential to break China out of a traditional reliance on export-driven growth that looked increasingly exhausted. Recently, though, they’ve seen signs that China isn’t willing to explore changes to its economic model or, and this might be even worse, that China’s leaders don’t know how to put together a new growth model.
Let me take what these two groups thought they saw in December and the grounds for their recent disappointments.
In the late fall and early winter of 2012 China’s domestic investors thought they saw exactly the kind of policy changes they were looking for. For example, China moved to expand the number of overseas institutional investors approved to invest in China’s financial markets. As of November 20, 64 overseas institutions had been approved to invest up to $11.9 billion in China’s markets through the Qualified Foreign Institutional Investors program. In January the head of the China Securities Regulatory Commission said that China could increase these quotas ten–fold.
On the central bank front, China’s money supply grew by 13.8% in 2012, up from 13.6% in 2011 but with inflation under control—inflation climbed at a rate of only 2.6% in 2012, down from 5.4% in 2011 and well under the government’s 4% target for the year—government economists strongly argued that growth in the money supply wasn’t too fast and that it even had some room to speed up. Analysts in- and outside of China finished 2012 talking about further loosening by the People’s Bank of China in 2013. Maybe not a reduction in the central bank’s benchmark interest rate but certainly a cut or two or three in the ratio of reserves that banks were required to keep.
No wonder that the stocks of companies that would directly benefit from these policies soared. Shares of Citic Securities, China’s biggest securities company, climbed by 60.6% in Shanghai from November 29 through February 1, 2013. Shares of China Vanke, one of China’s biggest real estate developers, moved up 63.1% from November 12 to January 31, 2013.
But then doubts began to surface that the government’s policy would be as hell-bent on stimulus as those early signs indicated. On March 4 Beijing told cities with higher than average rates of real estate appreciation to tighten lending standards and to impose a 20% tax on profits from real estate sales. Then the January-February inflation rate came in higher than expected at 3.2%. That is close enough to the 3.5% inflation target for 2013 to raise concerns among investors that the People’s Bank would become concerned. At the least the new inflation numbers suggested that the central bank would take a wait and see attitude toward increasing the speed of growth in the money supply or in cutting either the reserve ratio requirement or the benchmark interest rate.
The hopes for looser money and more stimulus that had fueled the rally that began in December weren’t exactly dashed but they weren’t strong enough to bet on either. Domestic investors in China took profits.
At the same time overseas investors were starting to wonder if China’s new leadership was up to the task of breaking China out of its economic policy rut. The consensus among economists outside China is that the country has moved beyond its old policy of export driven growth. The fuel for that huge leap forward—a massive army of cheap migrant labor created when workers moved from rural areas to the cities—was starting to run short. Wages were rising in the traditional coastal areas where exporting companies were located. Companies cut labor costs by moving production to inland areas that had missed out on the earlier phases of the boom. But this was clearly just a stopgap measure. China needed to move up the value chain as cheaper labor in countries such as Vietnam and Bangladesh took Chinese jobs as globalization continued its advance. And China needed to rebalance its economy so that more growth came from Chinese companies producing goods and services that they sold to Chinese customers.
Initially, the trends here were encouraging to overseas investors. Indeed at the end of 2012 it looked like they might get the best of both worlds. Chinese exports growth soared to a seven-month high in December, hitting a 14.1% annual rate after growth of just 2.9% in November. And the new leaders of China looked to be building on domestically-oriented policies in the new Five Year plan that had promised double-digit annual increases in the minimum wage, increased government contributions to pension plans, and higher healthcare spending outside China’s major cities.
Shares of domestically-oriented growth stocks, which had lagged behind real estate and financial stocks, began to move up too—although more slowly in overseas-influenced Hong Kong than real estate and financial stocks were advancing in a Shanghai market dominated by Chinese traders and investors. Hengan International (1044.HK), a maker of baby diapers, advanced 21.2% from December 14 through March 8. Shares of insurance company Ping An (2318.HK in Hong Kong and PNGAY in New York) moved up 22.9% from December 4 through February 1.
But then just as in the Shanghai market, but for different reasons, optimism began to fade. The government fell back on the policies of the past that had worked so well to stimulate the economy in the aftermath of the global financial crisis. Announcement followed announcement of new (or at least it seemed to be new) spending on rail lines, airports, and subways. Infrastructure spending, it seemed, was once more the policy of the day.
But what of the new initiatives to rebalance the economy? The rhetoric was there, certainly, as, for example, when new president Xi Jinping told delegates at the closing session of the National People’s Congress on March 16, that economic benefits must be shared more equally in China. And in his closing address at the congress new premier Li Keqiang promised to crack down on corruption and clean up pollution. Li’s speech came while China was still in the midst of an effort to pull dead pigs—12,000 so far—from the waters of the Huangpu River that supplies drinking water for Shanghai.
But overseas investors and economists are increasingly wondering if China can actually implement policies that will rebalance the economy, reduce pollution, tame corruption, and remove the heavy hand of the state from crucial industries. Typical of these worries is the call from Zhang Zhiwei, the chief China economist for Japan’s Nomura Holding, for a second half slowdown in China’s economic growth. The days when China could turn in 8% or 9% growth without target-busting inflation are over, he told Bloomberg on March 13. The Chinese economy has matured, he notes, and the speed limit is now more like 7%. Anything above that—like the 7.9% rate of GDP growth recorded in the fourth quarter of 2012—will start inflation on an upward track again. Add to these doubts worries over whether the central government has the means—whatever the will—to contain official corruption or to control pollution from companies with government connections—and you’ve got doubts among overseas investors that are serious enough to put a check on the December 4 rally.
Where do we go from here?
A lot depends on whether the Cyprus bailout—and bank run—does indeed lead to a major revival of the euro debt crisis. If it does, global markets will continue the shift to risk off assets that was so evident on Monday. That will take a bite out of Chinese stocks—and those of other emerging markets. The winner will be the yen and the dollar, again, as traders and investors seek safe havens. (A stronger yen won’t be good news for Japanese stocks, I’d note.) If the China story doesn’t itself give investors a reason to buy Chinese stocks, then the risk off trade could wind up taking back even more of the gains from the December 4 rally.
From a slightly longer perspective, though, investors should realize that what they’re seeing is China’s evolution toward a more normal financial market. In this more normal market stocks won’t stage 25% rallies on rumors of changes in government policies and investors will start to discriminate between companies that can grow quite nicely, thank you, in an economy growing by 7% and those that, because of their own inefficiencies, product problems, and management deficiencies need 9% growth to paper over their problems.
From that longer run perspective, I think its worth gradually moving your China portfolio to a mix of buy-and-holdish (not buy and forget—this is still an emerging market) growth companies that are positioned and managed for the increasing importance of growth in the Chinese domestic economy. Names like Tencent Holdings (700.HK), Home Inns and Hotels Management (HMIN), Hengan International, and Ping An Insurance come to mind. I don’t think I’d add to positions now—the uncertainty is simply too high. But I’d look to buy on this dip or correction, when either the euro debt crisis hits another climax or the current pessimism on China’s economy reaches an extreme.
The rest of your China exposure should be devoted to more cyclical plays on natural resources, real estate, and financial companies. Right now the cycle seems to be running against those companies. But as the December 4 rally shows, when the cycle shifts, the returns can be explosive.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund 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, Ping An Insurance, and Tencent Holdings 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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