World Out of Balance

Responding to the recent somewhat encouraging official economic data, the Hang Seng Index (HSI) jumped 12.6% in the past 30 days and 28.6% YTD, and the details show widespread improvement. The PMI in May fell to 53.1, a small drop compared with April data but still above 50, and surprisingly the positive contribution came from the exports. Construction activities continued to rebound in April and property transaction volumes up, the growth in urban fixed asset investment accelerated to 34% yoy in April from 30% yoy in March. Interestingly, China’s industrial output grew by 7-8% yoy, its electricity consumption dropped by 4% yoy in March-April.

The question now: Do these data signal that the Chinese economy has reached a turning point or is recovery still off in the distance? In my view, the economy still faces strong headwind but we probably have seen a bottoming process in 4Q08. Correspondingly, incoming data likely will be less bad but still mixed, volatile and thus harder to interpret. The HSI and associated components over the past few months are perfect examples of such reports, and I would caution investors to reconsider their risk appetite in the short-term.

The recent economic data surely spurs interpretation and debate. On the one hand, China’s surging credit supply continued to expand with the quantitative easing policy. For instance, growth in overall bank lending remained high at 30% yoy, while M2 growth increased slightly, to 26% yoy in April - indicating that, at the very least, there will be sufficient liquidity to support an economic growth. Moreover, in a favorable development for the near-term outlook for the overall Chinese economy, both the property transactions and vehicles sales increased significantly in the past 2 months. In fact, the April passenger vehicles sales up 30.7% yoy on low inventory levels and policy stimulus – making passenger vehicle sales booked a new historical monthly high in April.

Nevertheless, some critical economic indicators failed to comfort investors. Most notably, industrial earnings fell 37% yoy in the first two months of 2009, led by profits declining in the mining and metals sectors. The growth in retail sales fell in April, while real sales growth stayed flat due to falling prices, showing domestic private consumption remains weak. Likewise, China’s exports continued its sequential decline, exports in April dropped by 22.6% yoy from 17% yoy in March. Indeed, while I still expect economic growth in 2009 can register 8%, I remain cautious with the sustainability of this recovery, if there’s no additional economic stimulus plan announced.

Furthermore, China’s economy shows some signals of recovery, companies’ earnings and margins were not improving. On the bright side, China’s RMB4 trillion economic stimulus plans has started to show some effects in the real economy, and some sectors – mainly construction materials, machinery and non-ferrous metals do benefit from the huge infrastructure construction. However, we see more feasible revenue growth in these sectors, but not necessarily their earnings and margin, implying that they competed extensively to obtain orders from government-led infrastructure projects. Moreover, other sectors which represent a larger percentage in the economy, sees that the quality of their firms’ earnings had worsened over the past year due to the worsened external demand and low utilization of manufacturing equipments.

Broadly speaking, these findings generally affirmed my bearish perspective on corporate earnings throughout the rest of this year. I noted that the property, manufacturing, and technology sectors were particularly vulnerable to further earnings disappointment and lower guidance. Reinforcing this conclusion, I expect companies’ margins would either shrink or stay the same in 2009, and HSI index is unlikely to enter a structural bullish circle.

I believe that a sharp, V-shaped recovery from this severe economic downturn is unlikely. Moreover, despite being a reasonably effective economic barometer over the past six years, the HSI has traditionally been highly volatile on a monthly basis throughout its history. Thus, I expect the index will continues to be volatile as the overall economic indicators will remain mixed. So what economic data do we have to pay particular attention to? The answer is investors have to focus on those data which determines the sustainable recover of real economy, including: 1) fixed assets investment growth in private sector. Although we have seen positive effects from China’s economic stimulus plan, China has already spent approximately one third of the RMb4 trillion in infrastructure projects, without mentioning infrastructure investment is hardly to compensate weakened exports. So the question is, if companies still don’t intend to invest on capex given the sluggish consumption growth and weakened external demand, at end of the day when China spend out the RMB4 trillion package, the government may need to announce additional plans to aid economy; 2) exports data and recovery of the G2. While China is still heavily rely on external demand, and most of China’s export companies found it difficult to fully switch to domestic market, an stabilization of G3 economy and recovery of export orders will be key; 3) property market recovery. Yes we have seen transaction volumes up in some coastal cities and some developers have started to bid for new land acquisition, but investors have to bear in mind that affordability is unlike to improve substantially in a short-term. Indeed, a more sustainable recovery in the property sector, which has been approved repeatedly, is that the transaction volume rebound with price correction, and property developers start to accelerate the construction process in order to maintain a healthy inventory level, but so far this has not been the case.

There are some good news to China’s A-share investors: The new local-currency lending leapt 900 billion yuan in the first 20 days of January, building on a jump of 772 billion yuan in December. January PMI rebounded to 45.3 from 41.2 in December. While the stock reacted reasonably well this week, I see nothing that makes me believe China has been on the road to recovery soon. In my view, there are only two things we need to know about China going forward. First, economic growth momentum is not likely to sustain. And second, the worst is yet to come.

Why would I say that the economic growth will not continue its momentum? Looking at some of the details of these published data, January output index recovered 45.5 from 39.4 in December, and new order recorded 45 against December’s 37.3. This looks as if the economy is starting to recover and companies are rebuilding their confidence in the next few quarters. But then look at the following data: the export order was only 33.7 which is rather depressed; the employment balance dropped to 43.0 from 43.3 in December and reached a record low since the index was launched. Where did these confusing messages coming from? The answer is re-stocking. The destocking process in China was probably ended in early December last year, prices of some raw materials were increased and companies resumed production after inventory was reduced. This reflects of the fact that export continues worsening and unemployment is climbing. In this situation, it should come as no surprise that Chinese government is preparing to launch further economic stimulus plans in addition to the RMB4 trillion package. In other words, the authorities still believe the overall economy “still needs monitoring” - and that’s just what we have to do in the next few months.

Now let’s look at the bank lending data. It’s true that excluding RMB400 billion of discount notes, bank loans can still reach above RMB900 billion in January, up 13% yoy. But by analyzing the flows of these loans, we can see the largest portion of the loans went to working capital lending and government’s infrastructure investment. Private sectors are still suffering from the tough market environment and lack of motivation to spend on capex, that said, corporate activities remain weak and banks are still not keen to lend to corporate with cash constraints, therefore I believe the bank loan growth may continue in the first half but will not sustain. The rapid growth of bank loans in 1H09 may contain potential risks of NPL rising, this has been true during the Southeast Asia crisis, however we need to wait for 2-3 years to see it’s impact on banks’ balance sheets.

But why the worst is yet to come? There are three reasons I believe the economy has not bottomed yet. 1) G3 economies continued worsening and China’s export will suffer more difficulties in 2009; 2) China’s domestic consumption growth may have been slowed down; and 3) China’s property market remains sluggish.

Firstly, U.S. real GDP fell 3.8% in the fourth quarter of 2008, which is the largest quarterly decline since the first quarter of 1982. Although some economists believe the real GDP is expected to fall further in 1H09 then start a recovery in the second half, the financial impacts have become unusually severe and so far we have not seen any indicators showing the U.S. economy will start recovery in 2009 – the market remains highly volatile, credit market is still freezing despite a series of federal rate cuts, real estate market has yet to bottom, consumer spending growth remains negative. As the recession spreads to Europe and Japan, China’s external demand will suffer further worsening in 2009, and the contribution of net export to GDP growth may further decrease.

Secondly, the Chinese New Year holiday sales still looks good, but consumer confidence is softening. Consumers tend to spend less when they consider the slowdown of economy and feel lack of job security, Chinese consumers are not exceptions. It’s true I have been optimistic on China’s consumption in the long-term, but we have seen weakened retail sales in sectors such as auto, airlines, home appliance…etc. As I have discussed previously, without a real economy recover and establishment of social welfare system, the government’s efforts to stimulate private consumption will be proved to be rather difficult.

Finally, although property investment only accounts for 22% of China’s fixed assets investment, a recovery of property market will be the key to economic growth, given the property sector’s contribution to GDP has been falling, and government’s infrastructure investment can only partially offset the decrease of real estate investment. The latest data shows property sales remain weak in January, transactions volume is still low, and absolute inventory stays at very high level. The bottom will be seen when property prices continue to drop while transaction volumes up, but so far it has not been the case yet.

So where do we end up this year? There’s no question that we should end up with an overall slowdown in real GDP growth: I still look for 9.0% pace to subside to around 8% this year, considering the government will announce further economic stimulus plans this year, but this simply does not mean China has been already on the road to recovery.

China’s National Bureau of Statistics recently announced that it revised up 2007 real GDP by 3.1% to RMB25,731 billion from the previous RMB24,953 billion. Based on this figure, China has already outpaced Germany as the world’s third largest economy in 2007. The correction is mainly from underreported activities occurring in small and medium enterprises in the service industry.

Tertiary industry accounts for the bulk of the upward revisions: Tertiary industry value-added in 2007 (Rmb10.4 trillion) was adjusted up by 7.8%, and makes up 40.4% of GDP. Smaller revisions were also made to secondary industries (+2.8%), but the weight of secondary industry was down to 48.5% from 49.2%. The primary industry now only accounts for 11.1% of GDP.  

Source: National Bureau of Statistics

I don’t think the data adjustments change the structural problems that China is facing – overinvestment, too much dependence on external demand, low efficiency of resource use and income inequality. For instance, the revised share of investment in GDP might fall to around 53.3% in 2007, compared with 55.0% in the original data. But 55.3% would still be at the high end of the historical range for the rapidly growing East Asian economies. Similarly, the dependence on trade in 2007, though revised downward, is still as high as it was last year without revision. 

In my view, the important implications of the data adjustments are: (1) the private sector accounts for a much bigger proportion of the economy, which implies better sustainability of economic growth going forward; and (2) the actual inflation rate is higher than official data suggest as the high-inflation service activities account for a bigger share of the consumer basket. I maintain my view that Chinese growth is likely to moderate in 2009 due to: (1) narrowing profit margins; (2) deteriorating G3 economic outlook and China’s export; (3) likely moderation of consumption growth; and (4) weakening forward-looking indicators such as PMI. But I think the possibility of China’s 2009 GDP slow to 7% is minimal.

I believe 4Q08 will grow between 7.0-7.5%, given NDRC has approved some large infrastructure projects, and local governments have started initiating aggressive plans to boost economy since November.

CPI inflation decelerated to a 22-month low of 2.4% yoy in November, this compared to 4.0% in October. The November CPI is in the lower end of my forecast but higher than the market consensus. The drop of CPI was largely triggered by lower food prices, as nonfood inflation was merely 0.6% yoy. Pork prices declined by 9.3% in November, as sufficient supplies have triggered wholesalers to lower the price. 

In the details, food price inflation moved lower to 5.9% yoy in November, compared to October’s 8.5% rise, reflecting both better supply situations and a favourable base effect. In particular, meat price inflation fell by 2.0% yoy in November. Meanwhile, grain (up 6.9% in October) and edible oil (up 10.9% in October) price inflation both decelerated steadily to 5.8% and -0.1% respectively in November.

Excluding food items, non-food inflation moderated to 0.6% in November, the lowest reading in the past three years. Fuel cost remained elevated at 14.3% last month, reflecting the lagged effect of the energy price hike in June. Meanwhile, many manufacturing goods, including clothing (down by -1.4%), telecom products (down 19.0%) and auto (down 1.3%), continued to stay in deflation territory. Price inflation of consumer durable goods stayed largely steady at 1.2% in November.

The decelerating CPI is mainly due to falling commodity prices and slowing down of Chinese economy. Employers’ rising bargaining power in wages seems to be another source of inflation deceleration, owing to the oversupply of skilled migrant workers due to the large number of company bankruptcies in the export processing and construction sectors in China’s coastal areas. Pricing power in the manufacturing sector seems to remain low, due to climbing overcapacity. Overcapacity and relatively benign consumption (through Chinese government indicated it would like to turn its economic growth model from investment and export to consumption) limits the pass-through power to the consumer. I believe that competitive price cuts with razor-thin margins will not finish but continue, as utilization of China’s many sectors remain low. PPI data for November released yesterday suggested a drop in consumer goods pricing (2.9% in November vs. 3.6% in October) together with the easing in raw material inflation (+4.7% in November vs. 11.0% in October). Looking ahead, I see further downward pressure in consumer inflation. 

China's producer price inflation (PPI) came in below market expectations, at 2.0% yoy in November, drop from 6.6% in October. The median estimate surveyed by Bloomberg is 4.5%. The sharper-than-expected drop of PPI reflects that Chinese economy is deteriorating rapidly.

The drop of PPI inflation was largely driven by falling energy prices. Along with the global commodity price correction, crude oil and non-ferrous metal prices in China dropped 14.7% and 19.4% yoy respectively in November. Currently China’s refined oil and power tariffs are priced at the peal level in July this year, the refined oil price reform and falling commodity price are likely to push China’s PPI into negative in 1H09, thus turning the economy to deflation in 2009.

Ex-factory food prices up 3.3% yoy in November, down from 5.4% in October. CPI inflation, which until now has mainly been driven by food inflation, is due tomorrow. I expect a downside risk to the November CPI inflation number and forecast November CPI will fall to 2.3-2.7 in November (market consensus is 3.2%).

On 26 November 2008, the People’s Bank of China announced an aggressive and surprising rate cut. This is the fourth easing measure in the past two months and this brings the one-year benchmark lending and deposit rates down by 108 bps - the biggest single rate cut in the past decade. In addition, the reserve requirement ratio (RRR) was lowered by 100 bps for large banks and by 200 bps for small-middle sized financial institutions.

PBoC stated that the move was in line with the “appropriately easy” monetary policy to support stable economic growth. Although investors have expected rate cuts before the end of this year, the aggresiveness of yesterday’s announcement was still a surprise to the capital market. I believe the government’s action is front-loaded due to their concerns over rapid economic slowdown in 2009 and possible deflation in 2010.

This move may reflect that November economic data such as industrial production and retail sales would likely be worse than expected. The sharp slowing in October activities showed further deterioration, meanwhile with export orders and the PMI index disappointing, electricity output and retail sales rapidly decelerating, the economy is likely to maintain the weak momentum in the next several months. Now I expect 4Q08 GDP to grow below 7.5% over year ago.

The rate cut will add around RMB600 billion to the financial market, and it will lower the borrowing costs of corporate sector and encourage consumers to spend. In addition, I see this is a signal that the government will soon issue fiscal bonds to partly fund the RMB4 trillion stimulus plan, and I expect the budget deficit/GDP ratio to reach 2.3% in 2009.

Looking ahead, as China’s external environment continues to turn more unfavorable, resilience in retail sales and fixed investment will be the key to support China’s economic growth. In order to execute the economic stimulus plan and encourage private consumption, I expect the PBoC to continue rate cuts by 135 bps and lower the RRR to 9.5% in 2009.

In the past several months, we have seen credit crunch shaking Wall Street – Bear Sterns acquired by JP Morgan, Fannie and Freddie bailed out by the government, Lehman Brothers went bankrupt, Merrill Lynch acquired by Bank of America, AIG bailed out by the U.S. government, Goldman Sachs and Morgan Stanley turned to commercial banks, Washington Mutual sold to JP Morgan…etc. While this is not the end of the list, whether Wachovia will become the next victim and acquired by another large commercial bank is not that important. In order to save investors’ confidence and inject liquidity to the market, the secretary of the U.S. Treasury Henry Paulson tries to launch a US$700 billion rescue plan to buy “troubled” assets from financial institutions via a so called “Troubled Asset Relief Program” (TARP).

While I believe if the plan was approved by the congress, it will be a turning point in rebuilding investors’ confidence in the US economy and financial sector in the short-term, it’s more like feeding the market with stimulant drugs, the property and derivatives bubble will turn more resilient in the near-term but will become increasingly harmful to the U.S. economy. By saying that, it’s critical to have a rough understanding of the U.S. loans and securitized assets, below is a summary of estimates:

Source: IMF – Global Financial Stability Report, 8 April 2008

Given the total size of he US subprime loans is about US$300 billion, by adding US$600 billion of Alt-A and US$3,800 billion of prime mortgages, the U.S, residential mortgages alone account for US$4.7 trillion, of course not all of these loans are considered as “troubled”, why the default rate of Alt-A and prime mortgages won’t climb up if credit crunch and property prices drop continues in 2009? There is about US$700-800bn of subprime ABS trading at 20-45% of book value, and about US$900-1,000bn of Alt-A trading at 50-70% of book value, Henry Paulson’s US$700 billion plan appears enough to buy these assets (excluding those of Fannie and Freddie), as default rate is increasing in more areas such as commercial mortgages, credit cards, consumer loans, if Mr. Paulson would like to save the whole credit market, the government may need additional US$400 billion, adding the total rescue plan over US$1.1 trillion.

The objective of TARP, as explained by Fed chairman Ben Bernanke, is to rescue American financial institutions and to help not to sell securitized loans with a significant discount, thus save the U.S. economy, the question remains why the loss of these financial institution shareholders need to be paid by taxpayers? If the Fed decides not to use the treasury but adding M2 supply, then the depreciation of US$ will accelerate and inflation will raise up, to become another challenge to the country.

Interestingly, U.S. has been criticizing other economies about their government interfering in private-sector problems and has tight control over the financial system; America is doing the exactly same thing to itself with more and more government involvement in business and finance. While I still believe Mr. Paulson’s rescue plan will be approved by the congress (otherwise Warren Buffet may suffer a huge loss from its recent equity investment in Goldman Sachs) despite arguments from republicans, I am still bearish on US economy (not necessarily the U.S. capital market) and believe the country need 3-5 years to fully recovered.