Late last week, we opened a position in Chinese equities within the Hedgeye Virtual Portfolio for the first time since closing a long position in late September of last year. The recent weakness in the wake of Japan's crisis provided a buying opportunity we couldn't resist.
"Why buy China?" one might ask, given that our outlook for the Chinese economy calls for slowing growth and accelerating inflation. Simply, put, the answer to that question is a question in and of itself: "What price does one pay for slowing growth?"
While some investors are following the Chinese government in revising down their growth assumptions for China in the first half of 2011, we are inclined to believe the bear case on China is getting increasingly priced in. In fact, we were among the few to be appropriately bearish on Chinese equities in early 2010 -- since then, China's Shanghai Composite Index is down nearly 10%, including a peak-to-trough decline of 26.7% recorded on July 5th.
We get the bear case on China, so naturally, our next risk management tasks are to figure out whether that's fully priced in and if the market is leading us to a re-acceleration in Chinese growth. Addressing the latter point specifically, there are signs that China is indeed entering a bottoming process, from a growth perspective.
Year-over-year growth in Chinese exports, retail sales, and money supply all slowed to multi-year lows in February (in part due to the timing of the Lunar New Year). While there may be further downside in the coming months, the risk-reward setup is skewed to the upside for the first time in several quarters.
From a financial market perspective, we see that China's 12-month interest rate swap contract (which exchanges fixed payments for the seven-day repurchase rate) backed off its high of 4.04% on Feb. 21 to 3.4% earlier this week. The key takeaway here is that the Chinese bond market's expectations for additional tightening have receded. While still elevated relative to the 1.99% we saw last August, the slope of this trend remains positive for Chinese growth expectations on the margin. For now, the trend is moving in the right direction.
We'd be remiss to not mention the impact of inflation on Chinese equities. Prior to the current rally, which began on Jan. 25, Chinese equities had sold off due to fears that accelerating inflation would lead to aggressive tightening of monetary policy. With three interest rate hikes and six announced reserve requirement hikes since late October, a great deal of tightening may indeed be in the rear view. This opens the door for Chinese stocks that benefit from higher levels of inflation to outperform.
An analysis of industry contributions to the Shanghai Composite's current rally confirms this:
1. Coal (+1.2%) – energy inflation
2. Mining (+0.9%) – precious metals reflation
3. Chemicals (+0.6%) – energy inflation pass-through
4. Banks (+0.5%) – widening yield curve
5. Oil & Gas (+0.5%) – energy inflation
Buying China here is certainly not without risk, however. Given that the current rally is highly levered to accelerating inflation, any disinflation in real-time commodity prices (via strength in the U.S. Dollar) may prove detrimental.
What could also happen in a disinflationary scenario, however, is that the outperformance shifts from inflation-positive names to consumer and industrial stocks, keeping a bid under the market at large -- particularly because many investors have likely chosen to remain on the sidelines due to the current round of tightening. At any rate, given that it's increasingly likely that slowing growth and additional tightening may be priced in, Chinese equities look poised to benefit in an inflationary or disinflationary environment.
