U.S. Markets open in 8 hrs 38 mins

China’s soft landing: Is the Chinese economy on firm ground again?

Marc Wiersum, MBA

How wage inflation in China supports Baidu over Google and Yandex (Part 9 of 11)

(Continued from Part 8)

Is this the floor for China’s growth?

The below graph reflects a slowdown in China’s gross domestic product (GDP) growth rate. The Chinese economy has grown dramatically from a low base level over the past 30 years,and is now the second largest economy in the world at $8.2 trillion versus $15.6 trillion in the U.S. As noted earlier, the International Monetary Fund, or IMF, estimates China’s growth rate to stay right around these levels for 2014 and 2015. Apparently, China’s soft landing is in the works, with post-2008 inflation resting nicely at 2.0%.

In contrast, the Eurozone, lacking China’s centrally planned economy, has had challenges, raising inflation over 1.0%. Should the IMF be correct in its estimates, and China GDP growth rates stay at current levels, while inflation stays on target, it might seem that Chinese equities can see an upgrade in value as the year progresses. Bank risk remains the focal point in the soft landing scenario. However, as the global economy returns to growth, it could be that the worst is over for China’s banks. Should the Producer Price Index start to head north of 50 later in the year and capacity utilization head back toward 80% as 2014 progresses, this year could be the beginning of the end of China’s post-2008 soft landing. (But don’t take off your seat belt until capacity utilization and PPI have come to a more normal level.)

For a detailed comparative analysis on Google (GOOG) versus Yandex (YNDX) and Baidu (BIDU), read Market Realist’s Evaluating Yandex versus other key search engines.

The yuan can weaken for a change

While the yuan has continued to appreciate over many years, it has also depreciated against the dollar by around 3% since the beginning of the year. The extent to which the Chinese yuan is overvalued is becoming less clear. As noted above, real short-term interest rates in the U.S. are still in the negative 2.0% area. The graph in the prior article shows the 7-day inter-bank rate at around a positive 2.0% real rate. So, the difference in real interest rates in the U.S. versus China is around 4.0%.

This fact would suggest that the Chinese yuan would likely appreciate 4% over the course of 2014. However, the slowing economic data and PPI have led to some downward pressure on the Chinese yuan, which has actually depreciated 3% this year. Looking forward, it is possible to believe that the Chinese yuan appreciation is not a sure thing. Modest weakening in the yuan could help to firm up Chinese exports and reduce the excess production capacity that is beginning to emerge. This would be some relief for Chinese exporters. However, a weak yuan could lower the value of Baidu’s earnings.

Asia’s equity outlook

The weakening yen and a relatively flat wage growth in Japan has supported Japanese markets, as reflected in Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETF’s. An aggressive monetary policy in the U.S. 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 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, banking flagship Bank of China, trading at 0.84 price to book and a 4.95 price to earnings ratio, one has to wonder how much lower Chinese banks and financials can go.

For an overview of the U.S. macroeconomic recovery, which can support China’s export economy, read 2014 US macro outlook: The crack in the debt ceiling.

The next part discusses how the U.S. equity market has been performing relative to the Asian equity markets, including China.

Continue to Part 10

Browse this series on Market Realist: