My Diary 635 --- A Special Note on China Market Strategy

My Diary 635 --- A Special Note on China Market Strategy

March 12, 2010

“Happy Anniversary of the rally! But now what?” --- I would twist my X-asset analytic framework for this diary as I want to focus more on the strategic view over Chinese equity markets after the down & up YTD. Since I mainly focus on Hong Kong market, the exercise focuses more on China and US, the two most important forces behind the island…Based on the MSCI China Index, Chinese equity has clawed back most of its recent losses in January and early February (-14.01% vs. +10.67% with lowest level at 57.57 on 08 February), perhaps in response to the eased tensions in EU sovereign debt markets and to the better-than-expected economic data. In particular, China 's Jan-Feb economic data have showed that the country is facing a strong economic fundamental in almost all frontlines. The concern is that v olume has not return to normal level as investors remain confused and uncommitted.

On the overseas market, such a divergence between the index performance and trading volume is also seen in S&P500, which finally closed at a 17^th-month high overnight. It seems that wall street based fund managers are paying more attention to the Tiger Woods/Jack Neo sagas than they are to markets right now. Technical analysts quickly point out that the S&P completed the 9-count of the TD sequence last night and RSIs are high. That could signal an impending reversal. In my own views, it is not a surprise to see equity markets take a break after the relentless run we have had in March (MSCI World +4%, S&P +4%, Europe +5-6%, MXEF +5%). But I think we'll see investors jump in on a pullback because they fear missing out on a Q-end rally.

Economy wise, the week’s focus was obviously on the China data dump. All numbers out of the country are clearly higher than expectations with the only exception of IP. I will discuss them in the later section. One thing caught my eyes is that loan growth still a staggering 27.7% yoy in Feb, far from the 17% target. If history is any guide, we'll get yet another RRR hike very soon. Moving on to the rest of Asia, central banks are all stay put with RBNZ, BOK, and Philippine central bank keeping rates unchanged at 2.5%, 2% and 4%, respectively. US trade deficit showed a surprising contraction to USD37.3bn (vs. cons.=USD41bn). But the details are not quite what the headline improvement suggests. The improvement came from a 1.7% drop in imports while exports fell 0.3% due to less commercial aircraft and auto shipments. Initial jobless claims improved to 462K from 468K previously month but 4WK MAVG stays at 475K level and still in an uptrend. The next macro numbers to watch are retail sales and UoM confidence.

Asset markets wise, global equities edged up 1.1% this week and +4.4% in March. MTD, equities are higher 5.3% in Japan , +4.8% in EU, +4.5% in US, and +4.4% in EM. The 2yr UST yield climbed 5bp to 0.94%, an 8WK high. The 10yr yield ticked up 5bp to 3.73%, 7bp below its 8WK high. For reference, 2yr and 10yr yields hit peaks around the turn of the year of 1.14% and 3.84%. 1MWTI oil moved up $2/bbl to an 8WK high to $82.11/bbl. The average 2010 oil price is $78.05 and the 2009-2010 high is $83.18. USD closed at EUR1.368 and JPY90.5. The Dollar has ranged from EUR1.356 to EUR1.370 in March, and JPY88.5 to JPY90.5.

Macro Economy

As for the latest economic data from China , the numbers has set the tone for the continuous rise in inflation, along with the stronger-than-expected export and consumption, while investment growth remains supported. In February, both exports (+45.7% yoy) and imports (+44.7% yoy) beat market expectations of +38.3% yoy and 38.0% yoy, respectively. Net-net, the export recovery leads to USD7.61bn trade surplus. Retail sales grew 17.9% in Jan-Feb, accelerating from 17.5% in December. FAI stood at +26.6% yoy in Jan-Feb, higher than market consensus of 25.6%. New loan growth was RMB700bn in February, largely in line with market.

The key figure is that February CPI inflation was up 2.7% yoy, distorted upward by the Chinese New Year effect, but has supported an uptrend on prices with no doubt. On a MoM basis, February CPI rose 1.2% from January, accelerated from 0.6% mom in January. Food prices rose 6.2% yoy and a staggering 3.3% mom. Non-food inflation has risen to 1% yoy from 0.5% yoy in January. Looking ahead, there are 3 potential factors driving headline inflation higher this year -- 1) domestic wage increase, led by the migrant worker market; 2) stronger rise in food prices, due to drought and shortage in hogs; and 3) a higher than expected commodity price, including crude oil (+94.2% yoy) and iron ore ( BHP and Vale are pushing 70-80% increase over benchmark contract prices) . Besides, improvement of domestic demand condition and the building up of inflation expectation are also contributing factors. I believe over next few months, the momentum on inflation can be stronger than what the market currently believes, and it could be above 5% in the middle of this year, if taking into account of seasonality factor. Given that the Chinese government has adjusted its macro policy objectives by adding “managing inflation expectations” and “adjusting economic structures” to its previous goal of targeting growth. We could see several RRR hikes over the next few months to sterilize the liquidity impact from the BoP surplus, with the next RRR hike likely to be in the very imminent future. There could have 2-3 times of interest rate hikes in 3Q10 and 4Q10, but think currency appreciation could come sooner, given the adjustment of economy structure is a top priority in 2010.

Looking across the pond, I continue to believe that renewed weakness in US consumer spending in the near term remains a risk, especially since the job creation phase of the recovery has not yet begun and consumer spending thus remains reliant on government transfer payments. The NY Fed President Dudley recently spoke cautiously about US economy, stating that the outlook was improving but that "significant downside risks" remain. In particular, he noted that small banks are still under pressure and credit conditions for households and SMEs are constrained. In addition, unemployment rate remains high at 9.7%. The recent macro data flows, including the numbers of failed banks (702, +27% in 3Q09), consumer confidence ( -10.5pts to 36), employment (Initials +469K, continuing 4.5mn ), durable goods (core -0.6% vs. cons.=1%) and housing sector (existing home sales -7.2% & new home sales -11.2%), are all sending out worrying signals and questioning what the market’s belief --- US recovery is on track?

Moreover, the correction in CRE market is not over and this poses a serious problem for smaller regional banks, of which their balance sheet have concentrated exposure to the CRE assets, a significant factor driving the pace of failures in US banking industry. The acceleration in small bank failures will make credit increasingly difficult to obtain for SMEs and could delay the recovery in US Job market since small firms create about 60% of the jobs in a typical recovery. As a result, d espite recent signs that US policymakers are preparing the way for tighter money, I do not expect a rate hike until late this year. Meanwhile, it will be a challenge for the broad equity index to make durable new highs in the coming months in the absence of blockbuster payroll reports.

Economic Policies

The focus of this year’s NPC and CPPC meeting is the economic policies of the Chinese central government, but a larger theme is emerging. Premier Wen reiterated an 8% GDP growth target for 2010. This appears to be low-hanging fruit given the economy’s strong momentum (1Q10 ~12%), but he is emphasizing “growth quality”. Compared to last year’s “growth at all costs” mentality, Premier Wen is clearly less concerned about growth. However, he continues to caution against complacency, pointing to global uncertainty as a still significant risk factor. This means the policy environment will remain accommodative, albeit much less simulative than last year.

Consistent with Premier’s broad judgment , the Chinese government is planning for a much smaller fiscal thrust for this year than 2009, but the fiscal policy remains accommodative. Fiscal budget for 2010 is much less aggressive with estimated government expenditures growing only 11%, close to the lowest level in the past two decades. Overall the fiscal deficit is likely to reach 2.8% of GDP compared to 2.3% in 2009. The budget continues to support consumer-related policies and put much effort toward beefing up the country’s social safety net. Moreover, policymakers appear to be paying much more attention to promoting income equality and raising the share of households in national income distribution. While concrete measures have yet to be unveiled, the focus of promoting equality carries the inherent risk of sacrificing economic efficiencies. This is a notable departure from China ’s reform-oriented past, where pursuing economic efficiency was always the top priority. The immediate consequence of this policy change may not be significant, but the long term impact on China ’s structural growth outlook could be substantial. This situation warrants close attention going forward.

Regarding the US , there are early signs of monetary tightening. First, the Federal Reserve raised the discount rate to 75bp (effective February 19), thus defining the corridor into which the FFTR will eventually be guided. Then it came in the Treasury announcement on February 22 that it would revive the Supplementary Financing Program (SFP), starting immediately and reaching USD200bn by April. Then, early this week, the Fed announced it would seek to expand the list of counterparties eligible to accept reverse repo transactions, one of the key vehicles the Fed intends to use to drain excess reserves. Specifically, the press release laid out the eligibility criteria for domestic money market mutual funds. These include: net assets of at least USD20bn and the ability to submit bids of at least USD1bn. Like the changing of the season, none of these events is unexpected. Chairman Bernanke has clearly telegraphed the various steps the Fed will take in order to remove monetary stimulus when the time comes. His most recent message is unchanged: rates will remain extraordinarily low for an extended period. Money markets seem to agree, having pushed the expected first rate hike of the next cycle from mid-2010 (as at the end of December) to mid-2011 according to the forward OIS curve.

Liquidity and Fundamentals

I believe the near-term liquidity environment in Hong Kong will remain loose, supported by the extended US/China’s low interest rates and the expectation of RMB appreciation. In addition the steep Asian IRS curve reflected a tightening bias for the regional market. In this regard, after a mild outflow the preceding week, regional fund flows backed to USD2.5bn last week, compared to an outflow of USD290.7mn the week before. Thus far in 2010, inflow has turned positive, totaling USD1.4bn. This is a trend that will likely persist as long as rates remain at zero in the US . This is inline with the MTD trading range of HKD, as the local currency has been traded up from 7.7767 in late January to 7.7587 as of today’s market close. This reflected a robust demand of HKD, indicating a strong money inflows from overseas, which coincidently moved with ‘HSI from its low (19595 on 08 February) to MTD high at 21228, or +8.5%.

In addition, I expect China ’s money supply growth to remain at least 18%-20% for 2010. PBOC is likely to increase sterilization and to raise RRR to mop up excess liquidity from rising FX inflows, which bet on RMB appreciation. Since early February, the 3M RMB NDF has jumped from 6.7963 to 6.7685, or equivalent to +5.3% yoy and 12M RMB NDF has jumped from 6.6814 to 6.6345, or equivalent to +7.67% yoy. This reflected the strong market expectation of RMB appreciation within the foreseeable horizon, underpinning the fund flows into Hong Kong market, which is a proxy to China .

Earning wise, the EPS growth forecasts for MSCI China have been revised up from 17.8% to 23.4% in 2010, based on I/B/E/S. Much of the growth is expected to come from the materials (30.0%), IT (82.5%), turnaround in the industrials (45.2%) from extremely loss making to positive in 2010, sustained growth in property (31.3%), and rebound in energy (16%). Valuation side, MSCI China is currently trading at 13.8XPE10, lower than its 10-year historical average of 16.5XPE (based on Bloomberg data) and in line with Asia ex. Japan market at 13.9XPE. While on the PB basis, MSCI China is already in its mid-cycle level of 2.5X vs. MSCI AxJ at 2X.

China Market Outlook

In general, the cyclical equity bull market is transitioning from a liquidity-driven phase to an earnings-driven phase, but the problem is that the sustainability of the economic recovery is still an issue. US payroll report highlighted that consumers remain reliant on government transfers to sustain income, since employment has yet to turn up. Meanwhile, t he Fed’s gesture of policy normalization will continue to test investors’ nerves as historically in the spring of 1937, Fed raised RRR twice (March and May) helping to send economy back into recession and Dow Jones to fall 49% in the 12-months following March 1937. If job growth slowly revives in 2H10, then investors will have greater confidence that the recovery will be sustained. Earnings visibility for 2011 will improve as a result. Investors will be nervous until then, especially since the Fed is preparing the groundwork for an eventual tightening in credit conditions and the fiscal sustainability issue will not disappear anytime soon. In China , economic data will likely come in stronger-than-expected in the coming months, which could lead to more tightening measures. The massive rebound in February exports confirmed that the export sector, a major drag on growth last year, will become an important growth engine this year. Recovering exports, together with a resilient consumer sector will offset slowing capital spending as government stimulus programs are being phased out. Overall, the downside risk in China ’s growth is low, and a soft-landing scenario remains my bet. In addition, the strong rebound in export supports my view that the RMB will likely resume its uptrend against USD.

That being discussed, I am strategically positive on Chinese equity. In terms of investment positioning, I am tactically positive in the near term (1-3 months), and cautious in the medium term (3-6 months). Looking at the YTD index movement, China has been treated harshly in the recent sell-off, the 2^nd worst performing market this year. I don't think China deserves this high-beta status, due to 1) growth is relatively stable; and 2) policy flexibility remains high. However, we have to acknowledge the fact that Chinese economy is in a cyclical turning point, where the economy has generated strong forward momentum while policymakers are trying to contain an accelerating trend. The latest Chinese inflation and economic activity data suggest that the People’s Bank of China may tighten further, if not sooner. This tends to generate heightened stock market volatility, particularly for the domestic A-shares. Given the potential market volatility, I think there could see a style shift into big cap index stocks, like banks. In general, SOEs and large firms will enjoy more favorable conditions than private and SMEs, when tightening starts.

Technical wise, I expect the market has higher chance to test a new low before the market can really trending up. Technically, the gaps among 600MAVG (57.9) and 120MAVG (63.6) and 250MAVG (58.2) are narrowing down. It implies that the market may have to choose a direction in next few weeks or months. But what could trigger the break down or breakup? It is hard to tell! Therefore, I would rather continue staying cautious and manage my risk exposure! Against such a backdrop, staying close to the benchmark seems the best strategy. In the event a correction materializes, I would view it as a buying opportunity. Though timing is the most difficult part of market forecast, I think investors should wait for real policy tools (RRR hike, RMB appreciation, IR hike) being implemented before positioning for a real rally. The reason is simple. China has not really kicked off any of exist strategy yet, in term of monetary policies (vs. administrative tools). Thus, investors can not assume that all the negative news have all been priced in during the Jan-Feb correction.

Short-term View vs. Mid-term View

In the near term, there seems a high probability that March CPI could show a MoM decline, relieving pressure for the government to tighten. Historically, since 1996 there is 88% chance that CPI prints lower in March. As a result, a rate hike could be delayed until mid-year. Coincidently, o vernight PBoC Governor Zhou Xiaochuan’s comment on CPI, of which he think it is in line with the central bank’s expectations, implying no interest rate hikes in short term. This should be positive for market sentiment, along with the Q-end effect. Meanwhile, MSCI China’s valuations look fair at current level, growth seems to remain strong and earnings expectations stay reasonable.

Moreover, to A-share market, domestic savings could be motivated to moved into stock markets due to negative interest rate (CPI - 1yr deposit rate = 2.7%-2.25%), given that property sector and price (+9.5% in Jan and +10.7 % in Feb) will be under very close watched by Premier Wen Jiabao, based on his promise on the NPC meeting to control the domestic property price. Since mainland based investors only have three investment choices (bank deposit, property and stock), equity markets seems the only channel to go, if we also consider the capital raising needs from Chinese banks. I could not help to think that the overall game plan is well designed by Chinese top authorizes. Interesting to note that, the pace of new brokerage account opening has been picking up in recent weeks. An up-running A-share market should give the sentiment support to overseas Chinese equities. That said, from policy cycle point of view, the only period that savings migration didn't happen when real rate was negative was during 2003-04 when the government tightened sharply. This had created enough uncertainty and high opportunity cost for cash to move around. In contrast, This round of tightening cycle so far are nowhere near as drastic as in 2003-04 and has had mild impact on market psychology based on the recent market reactions to negative policy news.

In the medium-term, I am not convinced that the market adjustment phase is over. One of the biggest concerns surrounding the equity rally over the past few months is the sustainability of the global economic recovery. Extraordinary stimulus efforts have supported the weakest economic links and put a bid under asset prices, buying time for households and the financial sector to repair balance sheets. The issue is that it is impossible to judge how much these efforts have “stolen sales from the future” or whether the pickup in final demand has been totally artificially supported. There is a legitimate concern that a growth relapse could occur once stimulus is withdrawn.

In addition, risk appetites have taken a hit on the back of global deflation strains and the gradual shift in global policy leanings. In the US , Fed continues to seek avenues to exit quantitative easing. While US interest rates will undoubtedly stay low, arguably, the extraordinary liquidity measures undertaken by the Fed have done more to stabilize the financial system than the level of interest rates, given that credit growth remains negative. Thus, the exit to quantitative easing should not be underestimated as a potential destabilizing process. In China , the central government is removing stimulus. The fear over China ’s tightening is not unrealistic, given that the February headline CPI (2.7% yoy vs. cons.=2.5% yoy) and PPI (5.4% yoy vs. cons.=5.1% yoy) have all exceeded market expectation. Obviously, domestic inflation pressure is gathering momentum as it took only 4 months for the headline consumer price index to accelerate from -0.5% in October 2009 to near the Chinese policy maker’s upside tolerance level at 3%.

Market sentiment wise, the feedbacks from broker roadshow has delivered a message that fundamental concerns over China among intentional investors do exist. For example, in the US investors were overwhelmingly convinced that there are bubbles forming in China ’s property market and were concerned about the implications for demand within the region should the bubble burst. The increase in risk aversion/awareness since the start of 2010 is also evident in Asian equity indices, which are down by between 4% and 9% in the year to February, when China ’s attempts to normalize monetary conditions by raising RRR twice. In addition, in Asian credit markets, increased risk aversion can be seen from the drop-off in primary issuance in February and lower secondary trading volumes. Putting all together, investors should stay alert to these risk factors and I generally think interest rate is more damaged to asset markets than currency appreciation.

Question to Focus On

I think currency will be the focus this year both from economic and political point of views. My general view is that in a world of strong deflationary pressures, the benefits of a weak currency are obvious. Therefore, competitive devaluation will from time to time dominate the currency market.

Globally, one complicated macro factor emerged after the recent financial/economic crisis is that most part of world, including US, EU, Japan and China , has been very dependent on exports for economic recovery and job growth. This means many economies are more sensitive to the effects of FX adjustments and the expansion of domestic manufacturing sectors. For example, manufacturing now accounts for 23% and 22% of GDP for Japan and Germany , respectively. This highlights the importance of currency movement to the major economies, which is the backbone of renewed global fights against RMB valuation to its major trading counters.

Meanwhile, the breakdown of February export data shows that China is still taking market share from other exporters. Take the US as an example: imports from Asia as a percentage of total US imports have stayed flat over the last decade, at about 30%. But China ’s share of US overall imports from Asia has risen to about 60%. Thus, China has benefited by absorbing the final step of the processing chain from other Asian locations, as well as by taking market share from other Asian exporters in areas where they compete directly. One big question which is difficult to answer is, where will China ’s trade balance go in 2010-11? The 2009 current account surplus was 5.8% of GDP, compared with 11.3% in 2007. Moreover, in Jan-Feb 2010, China ’s trade surplus was down by some 50-60% on a year-on-year basis. But in USD terms, the surplus has now stabilized and appears to have resumed a moderate upward trend. Given the mid-term election in the US coming in the 2H10, I expect the RMB will be under enormous pressure from political point of views as who else can US congressman point their fingers on? Europe ? Japan ? Or China ?

The last point is though PBoC Governor Zhou makes the first mention that CNY will be de-pegged at some stage, there appears to be divided opinions regarding the RMB policy between the Chinese central bank and some other major government departments, particularly the Ministry of Commerce. The central bank views the RMB's peg to the dollar as part of the emergency policy package and favors an “exit” from the peg as overall policies normalize. The Ministry of Commerce is understandably more concerned about vulnerability of the export sector and weak external demand, and therefore, prefers a stable exchange rate. The strong export numbers will likely give the PBoC an upper hand in the RMB debate. Overall, I continue to expect about 5-7% appreciation in the RMB/USD cross over the next 12 months. Changes in VAT rebates for exporters may be a harbinger for a potential change in the RMB policy.

Good night, my dear friends!