Must-know: Chinese equities and consumer spending

Market Realist

Apple’s earnings: Why the biggest risk to investors is now China (Part 9 of 10)

(Continued from Part 8)

China’s large cap rally: Flat since 2010

The following graph reflects the long-term out-performance of Chinese and Korean equities over the U.S. equity markets, while Japan, the red line, has made a strong comeback post-2012. As global economies engineered monetary and fiscal stimulus to reduce the impact of the 2008 financial crisis, equity markets recovered well. Chinese and Korean markets returned to high levels, although they have flatlined since 2010. The U.S. equity market has continued to increase, while Japan has experienced periods of growth on monetary policy activism. This article evaluates China’s prospects to see its equity market rally once again after a few years of soft landing–induced tightening.

It might appear that China has avoided the hard landing so far and that the caution fixed into Chinese equity valuations could subside as 2014 progresses. The outlook for Chinese equities based on low valuations is looking more positive, although China’s capacity utilization and producer price levels need to see some improvement before the bull market returns in Chinese equities in general. While ongoing wage growth has supported Apple’s sales in China, and rising real estate prices in urban centers have supported the urban consumption of smartphones, a long-awaited increase in Chinese equities would help support greater consumption of Apple’s products in China.

For an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Equity outlook: The U.S. dominates while international markets slow near-term

Asian markets have remained flat since 2013, and China is no exception. Recently, tensions in Ukraine led to a nearly 20% drop in the Russian stock market, although the market has recovered half of its losses since then. China’s Shanghai composite index is also down 15% from its 12-month peak. The VIX volatility index in the U.S. increased to 17% during the height of Ukraine’s tension, although it has returned to a very low 13% as of May 1. There’s still a fairly low level of volatility in the U.S. markets, as VIX volatility is usually within the 12%–20% annual volatility range. However, the volatility in global markets is being driven, to some degree, by the tensions in Ukraine and evidence of oversupply in China. Given this unclear international outlook, it might appear that investors are finding comfort in the U.S. dollar and U.S. equities, while international markets, such as Japan, China, and Korea, are receiving less attention. With the U.S. at record highs, an interest rate spike and equity market drop would refocus attention on China’s lower price-to-book equities.

China’s credit issues—just a few bumps or getting worse?

In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is experiencing increased pressure. With China’s ICBC bank letting trust product investors take the losses on this $500 million coal company loan, it might appear that the speculative Chinese investor on the mainland is getting a lesson in credit risk—just like Chinese investors in Hong Kong did in 2008, when they invested in Lehman Brothers’ structured investment products. This should keep the speculative investment climate a bit cooler in China. Asian markets in general will likely not see significant real money asset shares increase any time soon. The engineering of a potential slowdown in China has investors uneasy, although as the situation resolves itself, China’s relatively low equity valuations should become attractive as the year progresses.

China’s central bank cools speculation with rate spikes

While the allowed defaults in China should lessen speculative investing, the China Central Bank has also been careful with interest rates in order to control speculative lending. During the summer last year, the seven-day benchmark lending rate spiked over 10% and increased to near 9% at the end of 2013. China’s short-term benchmark seven-day repo rate hit 2.5% on March 12. With the appearance of a shadow banking default looming in China, the Central Bank, since the beginning of 2014, has ensured, at times, extremely low interest rates. Cautious investors could see this as an extreme level of credit market facilitation on behalf of the China Central Bank, suggesting that the Central Bank may be nervous about potential credit market contamination. However, a month later, the rate is back to 4%. The credit crisis was averted, but could there be more in store? With inflation at 2% and the interbank rate at 4% for now, it appears that the Central Bank of China has rates and speculation in check, though it needs to see growth return with a little more vigor.

China’s need for stablization

As China’s lessening growth slows interest in Asian equities in general while the U.S. market is on a bull run, readers should remember that Japan is in a very different situation than China and Korea. The effects of Japan’s massive monetary and fiscal stimulus that was applied over the course of 2013—and that’s still reinforced with equal vigor in 2014—has probably not been felt completely in the broad economy in Japan, and Japan’s trade deficit with China could shrink. While China has various growth-related issues to reduce throughout the year, at least China has managed a soft landing so far. If the U.S. and the European Union (or EU) can get back to the trend growth of 2.5% or so in the next year or two, that should be enough to support China’s excess capacity and producer price weakness near-term. This scenario would support Chinese equity valuations and Apple’s exceptional growth rates in China.

Asian equity outlook

The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), State Street Global Advisors Dow Jones SPDR (DIA), and Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year.

However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should eventually become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.

Continue to Part 10

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