The bullish case for Chinese shares

Rice and pork are such a high component of the Chinese CPI that the government hoards grain reserves to keep food prices stable and the mandate of heaven clearly is in the close grip of the Communist Party

There was once a time when the world financial markets caught pneumonia whenever Wall Street sneezed. No more. Shanghai has now arguably replaced downtown Manhattan as the epicentre of global equities angst. The People’s Bank of China (PBOC)’s move to tighten yuan money market rates and a 50 basis point rise in the bank reserve ratio (RRR) led to falls in Asian equity indices, commodity currencies like the Brazilian real and Australian dollar, the price of copper and crude, Latin American and GCC sovereign debts. Nothing dramatic but the message from the markets is all too ominous. The global bull market is hostage to policy shifts decreed by the mandarins of Middle Kingdom’s central bank.

EXTREMIST LENDING
The Chinese flooded their financial markets with 9trn yuan in modern history’s most extreme example of state directed bank lending to combat the post-Lehman risk of deflation. Even as Chinese exports collapsed and 40 million workers lost their jobs in the coastal provinces, the Shanghai A share index and property prices surged on an epic scale.

Even Premier Wen Jiabao complained that the Chinese economy was overheated and raised property taxes, stamp duty and mortgage rates to restrict speculative lending. Yet the PBOC cannot risk a significant monetary tightening as long as their export growth is anemic and inflation does not accelerate. Chinese bank loan growth will moderate and the PBOC will raise the cash reserve ratio again but successive rate hikes will not derail the 9-10 per cent GDP growth momentum. In China, only a monetary sledgehammer (high real interest rates, loan quotas, credit rationing) kills bull runs in the Shanghai and Shenzhen stock exchanges.

GALLOPING ECONOMY
Chinese is the world’s fastest growing major economy. Earnings growth will surge in Chinese consumer banks, insurance, media and telecom shares, thanks to a nine per cent GDP growth, the government stimulus and the emergence of a new middle class. Retail sales and car sales in China have surged. It is entirely rational to expect a 25-30 per cent EPS growth for Chinese companies in the MSCI China index yet MSCI China trades at a modest valuation of 15 times earnings. These are hardly bubble metrics.

Aggressive central bank tightening is as low risk a probability in China as a double dip recession unless inflation goes ballistic. Yet rice and pork are such a high component of the Chinese CPI that the government hoards grain reserves to keep food prices stable and the mandate of heaven clearly is in the close grip of the Communist Party.

SAFE BETS
My favourite Chinese blue chip bets for 2010? CNOOC, the Chinese oil major whose takeover bid for Unocal provoked Congressional outrage and a Washington engineered white knight deal with Chevron. CNOOC profits will surge due to aggressive upstream deals in West Africa and Kazakhstan, rising output and new projects. China Life, China Telecom, ICBC, Focus Media and the Bank of China are pure proxies for the growth of the Chinese economy and consumer. Retail investor in the Gulf could well buy the Footsie Xinhua index, which trades as a listed country index fund in New York under the symbol FXI. The PBOC move could trigger a 10 per cent correction in Chinese equities as major bank shares in the index fall. I believe a 30 per cent rise in the dollar Chinese index fund FXI is entirely rational as emerging markets money managers are now underweighting China.

ROAR OF DRAGON
What could derail the bull momentum in Chinese equities? A policy mistake by the Federal Reserve could trigger a global risk aversion scenario and hit emerging markets shares with a vengeance. The IMF estimates bank write offs will exceed $3-4bn. Ethnic secessionism in Tibet and Sinkiang could provoke political risks. Sovereign debt risk could escalate with a new Iceland/ Dubai/ Latvia style debt shock. While the Chinese dragon is set to roar in the Year of the Tiger, the world’s pneumonia could well make Shanghai sneeze on occasions.

SENSEX CORRECTION
I believe Dalal Street’s bull run since March 2009 is now living on borrowed time. I believe Indian money market rates will rise by 300 basis points in the next six months. Of course, it is entirely possible that Sensex companies will deliver 15-18 per cent earnings growth. So I believe a bear market is not on the horizon. Yet a 2000- 3000 point correction on Indian shares is entirely possible. This was the lesson of October 2005, when the RBI last began a tightening cycle.

CHEAP EQUITIES
It is significant that GCC/ Arab shares have underperformed on the broader emerging markets indices due to the Dubai World debt shocks, higher borrowing risk premium in the capital markets and credit rating downgrades across the region. Yet Arab equities are now cheap, at a 10 per cent discount to the Morgan Stanley emerging market index. I would buy Saudi, Qatari and Omani shares but avoid UAE and Kuwait, where banking and property shares will post major losses in 2010.

IT IS SIGNIFICANT THAT ARAB SHARES HAVE UNDERPERFORMED DUE TO THE DUBAI WORLD DEBT SHOCKS AND CREDIT RATING DOWNGRADES

MOST ATTRACTIVE SHARES
CHINESE FLAVOUR
 - CNOOC – oil major
 - China Life
 - China Telecom
 - ICBC
 - Focus Media
 - Bank of China
OTHER MARKETS
 - Sensex
 - GCC/ Arab
 

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