World Out of Balance

Capitalism with American characteristics?

Sat, 27 Sep 2008 09:29:05 GMT

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:

Subprime                                   300 bn
Alt-A                                          600 bn
Prime                                      3,800 bn
Commercial Real Estate            2,400 bn
Consumer Loans                      1,400 bn
Corporate Loans                       3,700 bn
Leveraged Loans                         170 bn

Total Loans 12,370 bn

ABS                                         1,100 bn
ABS CDOs                                   400 bn
Prime MBS                                3,800 bn
CMBS                                          940 bn
Consumer ABS                             650 bn
High-Grade Corporate Debt        3,000 bn
High-Yield Corporate Debt             600 bn
CLOs                                           350 bn

Total Securities 10,840 bn

Total Loans & Securities 23,210 bn

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.

Ten questions on China's A share market

Wed, 10 Sep 2008 11:18:01 GMT

China has been a very disappointing market over the past 12 months. This year to date, Shanghai A share index and Shenzhen A share index – down 59.3% and 59.9% respectively – are the worst performers globally. Based on my observation, individual investors now have little interest in China equities, and are cashing out from the stock market.

There have been numerous arguments that the stock market would probably perform poorly in the second half and 2009 because: (1) companies’ earnings are decreasing (this has proved to be the case – total earnings of A share companies grew 15.6% in 1H08, significantly lower than 49.5% in 2007); (2) The Chinese economy is slowing down and may enter stagflation in 2009; and (3) a large number of restricted shares will become tradable in 2008, theoretically the number of tradable shares will increase by 230% by 2011.

So the crunch time is approaching for judging whether the Chinese market will rebound in 2009? In this article, I pose what I see as the 10 key questions, and try to come up with tentative answers.

The 10 questions:

1) Is Chinese economy slowing down?

Yes, and the economy is likely to face greater downturn pressure in 2009. According to the economic figures announced by National Bureau of Statistics today, China’s fixed asset investment grew 28.1% yoy in August, down from 29.3% yoy in July. Exports grew 21.1% in August to $134.9bn, off nearly $2bn from July. The consumer confidence index was 94.5 in July, down from 96.7 yoy. In addition to these figures, passenger vehicles and home appliance sales are decreasing; the number of property transactions is declining significantly in all of first-tier cities and most of second-tier cities. China’s economic slowdown is mainly driven by: 1) worsened global economic outlook; 2) tightened credit policy; and 3) high inflation and RMB appreciation. Although commodities price is likely to drop in 2009, and the government may have a economic stimulation package to maintain the GDP growth above 9%, considering the US and Japanese economy may enter recession in 2009, and Chinese government is not like to ease tightening measures too much in order to avoid overheating risks, the economy is very likely to enter further slowdown in 2009.

2) Is China’s share reform the main reason of A share market collapse?

No. While this has been a concern to most of investors, I believe demanding valuation, other the share reform itself, is the reason of the bubble collapse. Although nearly RMB20 trillion restricted shares will become tradable by 2011, only about 40% of the current free float and less than 20% of the total unlocked, may actually get sold when their lockup expires. In addition, a significant portion of the sales proceeds, particularly for those owned by mutual funds, may get recycled into the stock market anyway. The share reform started in 2005 not 2008, if the share reform was the main reason lead to the bubble bust, when why investors were still making the bubble even bigger in 2007? And since the market is hitting historically low, why the shareholders should sell the stakes now, other than hold them until the market rebound? Actually In the past few months we can see only some shareholders with less than 5% of stakes sold their shares to cash out from the market, and larger shareholders are still holding the stakes for strategic reasons.

3) Is the A share market bottoming?

Not yet, but value is emerging in some sectors and stocks. China’s A share index dropped nearly 60% year to date, and has been the worse performing stock market globally, but the market may still need to time to have a meaningful rebound due to the risk of worse than expected economic fundamentals and uncertainties of corporate earnings growth. However value has been emerging in some sectors and companies, because some stocks such as Baosteel (600019.CH), Yutong Bus (600066.CH), Conch Cement (600585.CH)…etc. have been over sold in the market correction thus provide opportunities to long-term value investors.

4) Does China still face inflation pressure?

Yes. Although CPI is decreasing steadily in recent months, the headline CPI remains very high compared with that in previous years. PPI remains high at double digit, and this may transfer to greater inflation pressure in the coming months. In addition, the non-food CPI is still increasing steadily. If the government eases domestic energy and utilities prices control further, then the country will immediately face inflation pressure again.

5) Will the government announce economic stimulates plan?

Very likely. JP Morgan said the government is considering an economic stimulus package of “at least RMB 200-400bn” in a report issued last month, I think the government will use neither foreign reserves nor its sovereign wealth fund China Investment Corporation to invest in A shares market. But I do believe the government is very likely to consider fiscal measures in order to maintain economic growth, these measures including: increasing bank loan quota, higher VAT rebates to exporters, raising exemption thresholds for personal income tax, removing administrative tariff and taxes receivable from small to medium sized enterprises.

6) Is banking the last safe-heaven to stay?

No. Banking has been one of the most resilient sectors in the market, many investors favour banks for their robust earnings growth in the first half, and bet the economy will continue rapid growth in the second half and 2009. While the fundamentals of Chinese banks remain strong, and they typically don’t have a large subprime exposure, their earnings are expected to grow at a slower pace, not profit losing. However the banking sector is also suffering various risks under the theme of economic slowdown, including: 1) earnings from interests is declining due to inflow of savings from stock and property market, which has been the main earnings driver to Chinese banks; 2) burst of property bubble in some areas is very likely to increase NPL of banks; and 3) historical statistics show NPL increases during economic slow down due to worsened exports and domestic market. Therefore I believe banks may still have room to drop further recently and may reach bottom in 3Q/4Q 09.

7) Are consumer stocks over valued?

I do think so. When investors rush to consumer stocks in a bear market, most of consumer stocks have become too expensive, despite some consumer stocks do offer long-term growth story. In my view, consumer stocks have various risks that do not support demanding valuation: 1) raw material costs increase; 2) intensified competition; and 3) less consumer spending on some consumer staples. Given retails are traded at an average of 17x PE and food and beverages are traded at an average of 28x PE, investors may wait until the share prices fall to a more reasonable level.

8) Can consumption drive China’s growth?

Currently consumption only accounts for roughly one third of China’s GDP growth, although we have seen the consumption showed robust growth in the past, I still don’t believe consumption alone will be able to drive China’s economic growth, instead China may still rely on increased capex on fixed assets investment and adjustment of its exports portfolio and destinations. Chinese economy is still not a consumption-driven economy like US, the saving rate is still high and most of Chinese people lack of a credit consumption culture. In addition, China still lacks of a well-established social welfare system to protect basic living standards, and the sluggish property market development recently offer more downside pressure to China’s domestic consumption.

9) Will earnings beat market consensus?

Well it depends. The total 1H08 earnings of A share companies reached RMB549.7 billion, grew 15.6% yoy, the growth is mainly driven by financial institutions (49%) and service sector (47%), energy, IPPs, and chemicals showed 35%, 91% and 76% of earnings deduction in 1H08. I expect the earnings growth of financial institutions will drop to 10-15% in 2H08, earnings growth of energy, IPPs and chemicals are likely to improve in the same period, the current stock prices have been pretty much factored in earnings decrease in the future, their earnings remain uncertain and heavily rely on government’s policy of easing credit control and remove of utilities price hike.

10) Will China’s property bubble repeat the story of US property crash?

No. There are two reasons that China’s property developers will enter a tougher market environment in 2H08 and 2009, but the market will not repeat the US property crash story. First, unlike in the US, China does not have a well developed securitization market, and Chinese investors are more conservative when making the decision to buy properties, which means the default rate won’t be as high as in the US; second, I don’t see a huge property bubble nationwide, instead I believe the bubble mainly exist in China’s mega cities and some second-tier cities, by saying this we can see that in some interior cities such as Chongqing, Changsha, Zhengzhou and Shijiazhuang, the property price is still at affordable level (the unit price per sqm equals to roughly 4-8 weeks of average wage); and third, property loans only account for 18% of total loans, compared with 53% of total loans in the US. I expect property prices to drop 10-20% in some overheating second cities such as Hangzhou and Qingdao, and 20-50% in Beijing, Shanghai and Guangdong province.

China's A share market - short-term pain, long-term gain

Thu, 14 Aug 2008 10:42:47 GMT

The Shanghai and Shenzhen A share index have dropped 54% and 52% YTD respectively. Despite all the uncertain indicators under the theme of China’s economic slowdown and global recession, the decreasing of earnings among listed companies has proven to be reasons – other than results of the market correction. In the brief period of the past 10 trading days, the loss generated from China’s equities since January 2008 have all been significant. Greed has finally been overtaken by fear.

My reassessment of the risk/reward tradeoff still suggests a further 10% to 20% downside in the market, but value is emerging as trading range nears to bottoms. I still reiterate my cautious market view – but I believe that the market is closer to valuation support levels and value investors can start accumulating positions if market weakness extends.

Near-term macro headwinds do not favor market momentum. Although I do not see any significant negative macro catalysts that could cause the market to collapse, ongoing measures by PBoC to tighten the economy could introduce more uncertainty into the market. In addition, the recent commodities prices and PPI may lead to another round of high inflation given the pace of RMB appreciation is likely to slow in 2H08. If the China economy reports weak numbers in the coming quarters and the inflation remains high, these indicators could backfire in sentiment towards the equities market.

It is early, but not too early to re-enter the market as I expect further meaningful downside is unlikely to happen in the market. I advise investors to focus more on stocks’ valuation and growth visibility to remain defensive. I recommend that they offload cyclical sectors, especially those stocks that have shown strong performance in the year to date such as shipping, airlines, commodities and capital goods, which are vulnerable to the global liquidity rollover, in particular in emerging markets.

CSI300 index trade at 20.8 times trailing P/E and 16.40 times 08 P/E, while it still represents premiums of to the US and Hong Kong markets, current valuations back to attractive in some sectors given the long-term growth prospects, particularly the forward P/E of 16.40 is below than the historical average of 20.

China’s inflation may have peaked in February 2008, and I expect inflation is likely to keep at 6.0% or below in 2H08, given the decrease of commodities price and normalized vegetables and meat supply. Although fuel prices hike is still likely to happen in 2H08, but considering food and related accounts for 33.2% of weight in China’s CPI basket, the fuel price hike can be offset by softened food price in the second half.

While the market consensus suggests a 21.6% of EPS growth in 2008, down from 31% in the beginning from this year, if we use 15% of EPS growth for 2008 and 9.5% of cost of equity, we still can get a fair value of CSI300 at 2850 which equals to a 15.3% upside potential.

My investment strategy recommendation is to:

1) avoid exposure to cyclical sectors such as shipping, airlines, commodities, capital goods
2) buy stocks with attractive valuations and that have been weak market performers so far this year, such as insurers, banks, properties and auto makers; and
3) place capital in correction leaders with attractive valuations and visible growth.

I am making a list of pure long stocks for value investors based on the above recommendations. I am underweight in coal, commodities, media and technology, utilities as well as capital goods; overweight in banks, insurance, properties, consumer products, and retail.

List of stock recommendations:

- ICBC (1398.HK; 601398.CH)
- Bank of Communications (3328.HK; 601328.CH)
- Ping An Insurance (2318.HK; 601318.CH)
- China Life Insurance (2628.HK; 601628.CH)
- Gemdale Corporation (600383.CH)
- China Vanke (000002.CH)
- Mengniu Dairy (2319.HK)
- China Yurun Food (1068.HK)
- Parkson (3368.HK)
- Lianhua (980.HK)

Chinese economy enters a slowdown but not a recession

Wed, 06 Aug 2008 13:16:19 GMT

China’s GDP grew by 10.1% yoy in 2Q08, this is significantly lower than the GDP growth of 12.6% in 2Q07. While China’s double-digit growth still appears respectable despite the global economic slowdown and domestic credit controls, I believe Chinese economy is facing further slowdown pressure in 2H08 and 2009.

China industrial production slowed to 16.3% yoy in 1H08, lower than the growth of 18.5% growth in 1H07 and 17.4% in December 2007. Industrial production accounts for approximately half of China's GDP by output; slower growth indicates that China’s GDP growth will slow in 2H08.

The growth of China’s export reached 21.9% in 1H08, dropped sharply from 27.6% in 1H07, mainly due to worsened economic outlook in the US and Europe, where rising inflation and slowing economy is expected to decrease household consumption.

China’s July PMI headline dipped to 48.4, the first time shown below 50.0 since the data became available in 2005. This is supported by anecdotal weakness in power consumption, airport traffic, passenger vehicles sales, property transaction and energy imports.

In my view, China’s central bank now is more concerning about economic slowdown other than inflation, as China’s inflation may have peaked and the upside risk is low. Different from matured economies such as the US and Europe, a sub-10% GDP growth is a clear signal to show economic slowdown in China, and a sub-8% growth means “recession” to Chinese officials, because low GDP growth will not be able to create sufficient job opportunities and support strong fixed assets investment and consumption.

The inflation risks may have peaked, because: first, the effects of natural disaster happened in January and the earthquake in May have been normalized; second, China’s inflation has been driven by food and energy prices hike, we have seen oil price has dropped significantly on international market from its peak and may continue due to less speculation on the market; third, the summer harvest is expected to record a marginal increase in grain production, and meat supply is expected to improve over 3Q.

To balance the upward inflation risks and economic growth, I think PBoC is unlikely to hike interest rates but may still hike RRR once or twice in 2H08, with selective credit easing measures such as loan quotas increase and further. RMB appreciation is likely to continue but the pace will be slow in 2H08.

PBoC raised RRR by 100bps to control inflation and hot money

Wed, 11 Jun 2008 10:20:15 GMT

On June 7, 2008, PBoC announced that the reserve requirement ratio (RRR) will be raised by 100 bps to 17.5%. The 100 bps RRR hike will be implemented in two stages. The first 50 bps hike will be effective on June 15 to 17%, and the second 50 bps rate hike will be effective on June 25 to 17.5%.

In my view, this shows PBoC is concerning the excessive liquidity in China, and still relies on RRR hike as the primary tool to control liquidity and money supply. Considering the timing of the RRR hike this time, I believe the May CPI, which is due tomorrow, is higher than market consensus and will be higher than 8.0%. In addition, M2 growth and forex reserve accumulation growth may have been accelerated in May, resulting authorities applying the tightening measure more frequently to control inflation and hot money inflow at acceptable level.

While I still believe RRR hike in an ineffective policy tool to control inflation and hot money, because 100 RRR hike will only lock up RMB420 billion liquidity, indeed the authorities don’t have much other measures to choose. As international investors still expect RMB appreciation will accelerate in 2H08, hot money is continuously flowing into China. A higher interest rate would likely attract more hot money into the country.

I see this RRR hike a strong signal that PBoC remains highly sensitive and committed to control inflation and hot money, but PBoC is unlikely to increase interest rate in the short-term. Going forward, I believe inflation pressure will sustain in 2008 and I expect PBoC will have at least two additional RRR hikes in 2H08 which will drive the RRR to 18.5%.

Rebound but not recovery

Tue, 06 May 2008 09:45:01 GMT

After a very strong rebound of Hong Kong market recently, I believe the market needs to take a break, especially as the FED is not likely to continue US rate cut and inflation pressure remains. We have recently already seen some rotational buying into blue chip names. However, given this round of China buying is more driven by global funds, I believe large market cap names will continue to dominate and outperform.

Several negative signals remain intact for China shares, in my view:

1) Earnings are not likely to maintain high growth
2) US economy is not likely to get rid of slowdown until 3Q09
3) RMB revaluation is likely to decelerate
4) Commodity prices are likely to remain high
5) Inflation pressure will persist in the long-term

The investment strategy is based on financials remaining the key holding structure for China investments in 2008, and thus I continue to overweight banking and insurance. I prefer telecoms, conglomerates and utilities as they are more defensive in a downturn market. I underweight industrials, chemicals, energy and properties. I still like the consumer story and agricultural products in China, and favor various names such as Mengniu Dairy and Yurun Food.

Is China's A share market bottoming?

Fri, 11 Apr 2008 10:29:14 GMT

The recent rebound of China’s A share market, is mainly driven by a rebound in US equity market, and a perceived relaxation in macroeconomic tightening. In my view, the peak has been reached and excesses are being unwound. I remain cautious on the A-shares market and believe any rebounds will be the opportunities to sell.

The fact that earnings downgrades have not yet happened does not mean that they will not happen. Pre-tax profits of industrial enterprises grew 16.5% yoy in January and February 2008, substantially decreasing from 31% and 37% in 2006 and 2007 respectively, and this is expected to challenge the sustainability of the high industrial profits growth, without RMB appreciation and commodities price hike problems in China. A decline in upstream product prices is likely to trigger a major earnings downgrade of China stocks. In my view, this will be the key determining factor in the market’s performance, as the overall China market has been over valued, the slowdown of earnings growth is an alarming sign showing repricing of A-shares is necessary and unavoidable.

Interestingly, the government allowed appreciation of RMB to 6.9923 versus USD yesterday, but is keeping the interest rates unchanged in 1Q, despite the high inflation pressure. While I still believe the government’s top priority is to reduce inflation pressure and avoid economic slow down, I expect RMB exchange rate will continue raising, and the central bank will raise interest rates by 27 bps in 2Q, given March CPI is likely to remain above 8%. Raising interest rates and appreciating the RMB exchange rate have the effect of raising the cost of capital, which in turn will drag down long-term economic growth, as well as reduce the importance of investment as a growth driver.

I maintain a defensive and consumption-oriented bias in China’s A shares market, particularly when some energy stocks’ valuations are very stretched now. Indeed, an appreciating RMB would hurt energy, as their RMB-denominated price would decline if the US-dollar denominated price remains high. In contrast, an appreciating RMB would benefit those companies with large domestic sales (with prices not internationalized) but with a high forex-denominated cost structure. I overweight banking, industrials, consumer staples, and underweight energy, auto, materials and utilities.

China's January CPI inflation continues the upside trend

Thu, 21 Feb 2008 02:01:03 GMT

As expected, consumer price index rose 7.1% y-o-y in January, up from December’s 6.5% and the previous 10-year record of 6.9% in November 2007. The pickup in food inflation (18.2% YoY in January 2008 vs. 16.7% in December 2007) was the key driver behind the rebound in overall CPI in January. Grain prices rose 5.7% YoY in January versus 5.5% in December. Meat price further acclerated to 41.2% in January versus 38.8% in December, price of aquatic products rebounded to 8.7% from 6.1% and vegetables price increased to 13.7% from 9.5%.

Non-food inflation remains stable at 1.2%. Residence inflation edged up to 6.1% YoY in January from 5.9% in December, led by housing rent (4.7% vs. 4.4%), utility costs (5.5% vs. 5.2%), and building materials (5.7% vs. 5.5%). However, inflation from other categories has been moderately keeping at similar level, and inflation from communications, healthcare, garment, and education have been offsetting the inflation from other non-food categories. In fact, non-food inflation has been heading up steadily in recent months, consistent with my expectations.

Overcapacity and deceleration of exports has limited the pass-through of higher raw material, energy, and labor costs to the consumer over the past years. However, I believe that competitive price cuts are reaching their limits amid razor-thin margins, and manufacturers are now starting to raise product prices. PPI (ex-factory price) data for January released earlier this week suggested a pickup in consumer goods pricing (4.6% vs. 3.7% in December) is in line with raw material inflation (8.5% vs. 7.7% in December).

Looking ahead, I see further upward pressure in consumer inflation, and I believe the February and March CPI is very likely to accelerate because:

1) The winter storm started in mid-January has caused disruption of airports, railways, and highways, many cities are experiencing vegetables and meat shortages

2) Shortage of electricity and raw materials may bring negative influence over industrial production, these factors have not been fully reflected in the January CPI

3) Accelerating M2 supply (18.9% in January) brings more pressure to inflation in the next couple of months

4) China’s PPI was up 6.1% y-y in January, with domestic oil prices still below market and temporary price freezing of key industrial products to rise in 2008, non-food inflation pressures remain high

To China’s policy makers, inflation control remains the top priority and tightening credit controls should not be eased. Although the negative real interest rate and sufficient liquidity still offers policy makers the room to further raises the interest rate, export and industrial production may suffer from interest rate hike, therefore the more appropriate way is increasing RRR other than interest rate in the short-term. In my view, Chinese government should continue the tightened credit policy by further increasing the RRR by 50 bps and control M2 supply, and allow faster CNY appreciation against USD.

The dilemma faced by Chinese policy makers

Tue, 08 Jan 2008 04:53:14 GMT

For the first time Chinese policy makers face dilemmas when using interest rates to control inflation in the past five years. Chinese policy makers either continue the interest rate hike to reduce inflation pressure but attract more speculative hot money flow in; or stop raising interest rate and face greater inflation pressures.

China’s surging CPI seems to be serving as immediate catalysts to further raise interest rate, in order to maintain the real effective one-year deposit rate positive. Although we haven't seen the meat price inflation spreading into other sectors yet, I believe this will happen in the coming years and China's inflation pressure will persist. The inflation is driven by:

1) Food price inflation will continue. In my view, the food price inflation cannot be simply explained as pork price hike due to the blue-ear disease. Other food prices are rising too, including edible oils, dairy food, vegetables, and grain. The hidden reasons are farmers didn't intend to maintain and invest in agricultural plantation due to the rising pesticide, fertilizers, and animal feeds prices, as well as sluggish bulk agricultural products prices in previous years. Lack of investment in such sectors results food price hikes due to supply shortage.

2) Oil price and commodity shocks. The oil supply shortage is likely to maintain in 1H08 as OPEC doesn't plan to increase production quotas. China and India remain hungry for commodities in the next decade given their huge investment on infrastructure and industrials capacity expansion.

3) China's wage increase and particularly rural migrates wages increase. For decades we have seen China's total wage increase slow behind GDP growth. This is primarily because China's huge labors pool in rural areas and tough competition among Chinese companies to win export orders. However, urban incomes have been growing at a steady pace and rural migrant wages accelerate growing across the country. The dilemma that Chinese manufactures face is they either close their plants and quit the game, or increase wages to retain production workers but gaining more bargaining power from their overseas clients by increasing efficiency or switch to more value-added products production.

Currently China's real effective one-year deposit rate remains negative, which in turn result capital flood to speculative investments in property and equity markets. The low interest rate also stimulates local government and companies to expand China's already high fixed assets investment.

The question is: does China need to frequently raise interest rate in 2008 to calm down the CPI pressure and overheating? The answer is no.

In order to answer this question we need to look at the US-China interest rate gap. While FED has cut the benchmark federal funds rate to 4.25%, and the market still expects FED to further cut the rate in order to overcome the fears of credit tightening and US economy recession. If China and FED continuously raise and cut the interest rates respectively, there will be a big gap between USD and RMB interest rate, speculative capital flow to China will be significantly increased due to following reasons:

1) The arbitrage opportunities between RMB lending rate and USD deposit rate

2) Expectation of overseas investors that RMB will accelerate appreciation against USD

3) Foreign investors will seek to buy China's assets due to the bearish outlook of US economy

Historically the RRR hike was approved a blunt and ineffective tool for conducting monetary policy, given PBoC faces difficulties to conduct effective monetary policy with undervalued RMB. As a result, China needs to accelerate RMB appreciation against USD to rebalance its economy. China’s currency fundamentals remain compelling, including:

1) China enjoys record-high trade surpluses and complaints from its trading partners

2) The rapid export growth of Chinese manufacturers

3) The rapid accumulation of foreign exchange reserves and USD in particular

4) The real exchange rate depreciation

Going forward, as Chinese policy makers try to tighten monetary policy, I believe that quantity-based measures such as RRR hikes and administrative controls over bank lending will feature more prominently than price-based measures, such as interest rate hikes in the authorities’ monetary policy management in 2008. I expect PBoC to continue interest rate hike only 1 or 2 times in 2008 but a 12% increase of RMB exchange rate against USD.

RRR hike - beginning of a new round of tightening

Mon, 10 Dec 2007 05:41:03 GMT

On November 8, 2007, PBoC increased the reserve requirement ratio (RRR) increased by 100 bps to 14.5% from 13.5%, effective from December 25, 2007. Although this is the tenth RRR rise in 2007, this is the first time that the PBoC has raised by 100 bps. Even more worrying, PBoC said the government would have more tightening measures on the annual economic conference in Beijing last week.

The RRR hike – although clearly seen as a part of the tightening measures, which started in July 2006 – is hardly likely to be effective to control China's liquidity boom and asset price bubble. I see it only as an indication of China's concern about overheating. Indeed, the past RRR hike has approved its market impact was limited.

Going forward, I expect PBoC to maintain the tightening stance, and reiterate my view that an interest rate hike would be a more effective tightening measure given the pressure from asset price bubble and inflation appear more challenging to China's central bank compared with over lending and fixed assets investment acceleration.

Brace for further tightening

Thu, 06 Dec 2007 03:32:21 GMT

On an annual economic conference in Beijing this week, China’s policymakers has shifted the monetary policy stance from “prudent” to “tightening”, in addition, the governors also shown concerns over inflation and fixed assets investment.

I believe this is the beginning of a series of significant tightening moves on the interest rate front. The decision of the policy move also means that a series of hiking interest rate and reserve requirement ratio in 2008 would likely to happen, but the GDP growth will remain at over 10% next year. The central bank may want to watch if fixed assets investment continue to rise at a fast pace in 1Q08, and whether CPI will decrease to acceptable level, before deciding on whether and when to raise the interest rate and reserve requirement ratio.

In my view, while negative interest rates have clearly contributed to the overall loose monetary environment, hiking interest rates without simultaneously allowing more RMB appreciation would encourage more capital inflows into RMB assets, accelerating forex reserve accumulation and thus making domestic money supply expansion harder to curb. It also would contradict the goal of encouraging more consumption and discouraging saving. Fundamentally, China needs to address the root problem of excess liquidity by allowing the RMB to appreciate faster, and continuously hike the interest rate. Therefore, for the HK market and China listed shares in HK, the negative influence from this policy move is limited.

I believe China should stick to the course it started in July, 2005 to appreciate the RMB at a faster pace, as well as to try to channel the excess liquidity out of the domestic market through further liberalization of the capital account, given that the root cause of the fast pace of expansion in money supply, bank loans and fixed investment is the elevated external trade and overall balance of payments surpluses, and hence the rapid accumulation of forex reserves. Meanwhile, in addition to the stricter enforcement of the central bank's full-year loan growth target for individual commercial banks, there could be more targeted, area and sector specific administrative measures to address the overheating risks in the near term.

Hong Kong equity market - uncertainty continues

Fri, 30 Nov 2007 08:47:35 GMT

Despite the recent weakness in global equity markets, the Hong Kong equity market has shown high volatility these days. While warrant accounted for over 30% of the total trading volume last week, I believe this signals investors remain cautious on HK market due to the uncertainty surrounding expected US slowdown and its impact on Hong Kong and mainland China.

Market participants face four sources of uncertainty in the HK market.

1) The concerns over US subprime woes still continue and a recession of US economy becomes highly possible to happen in 2008;

2) High oil price is expected to maintain until 1Q08 and this will result earnings downward revisions;

3) Rapidly slowing growth of credit and consumers spending in US shows US economy is likely to have a soft landing next year;

4) Investors are concerning the market could divert its near to mid-term attention to potential further monetary tightening as China still faces inflation and liquidity pressure.

The inflation and liquidity pressure is now clouded with more uncertainty than before and may thus pose a risk. Longer-term inflation expectations are drifting higher again, and I continue to think that commodities price pressures will rise to complete the circle of inflation. The flood of liquidity into HK market from mainland China is a result of the simulative policy allowing China's domestic financial institutions investing in overseas market and HK in particular. H-shares are still trading at a significant discount of A shares, and Chinese fund managers still think they can arbitrage from buying low of red-chip and blue-chips.

Given higher uncertainties from the market, I suggest investors to focus on value plays to achieve the best risk and reward tradeoff in a potentially high volatility trading market. I recommended investors retain a market-neutral strategy with a near-term focus on the sectors with strong domestic consumption.

Turning cash into value

Wed, 28 Nov 2007 11:35:31 GMT

As investors re-assess risk tolerance to the crunching beat of the credit markets, credit constriction ups borrowing costs globally; therefore investors now turn to a more defensive strategy and prefer companies with strong cash positions.

While this rule does apply on the global basis, the impact on Hong Kong companies is far less pronounced than in US and Europe, because HK companies have cash-rich domestic balance sheets, strong EPS growth, as well as a combination of USD weakness, rising local inflation, and potential US interest rates cuts spells Hong Kong asset inflation.

To HK and China listed companies, cash is welcomed in some industries and companies only, but this does not apply to all. As Chinese companies usually don't spend cash for share buybacks, and only some companies pay dividends to shareholders, most of companies would still like to spend cash on capital expenditures for future growth, or cash M&A.

As a result, investors still favour companies with rich cash in property and banking sectors, but such companies in sectors like machinery, automotive, and building materials appear not attractive.

Hong Kong market perspectives

Wed, 28 Nov 2007 10:45:59 GMT

I think if US enters recession, capital inflow to HK market is likely to increase.

I think investors will still prefer resource-oriented markets such as South Africa, Canada, Russia, Indonesia and Australia, as well as several emerging markets (such as Hong Kong, Korea, Singapore, Malaysia, and Brazil).

My thoughts are:

- Investors still prefer compelling stories that currently exist in some of the emerging markets (China and India in particular)

- Comparing with Eastern Europe, Latam, and SE Asia, HK market is more open and efficient to overseas investors

- Although HKD's link with USD has negative influence over the HK market in the middle-long term, but investors are still able to share the high quality EPS growth of H share companies

In conclusion, I expect volatility to continue to increase during 2008 because of increasing uncertainty about global monetary policies and credit conditions, but I am still bullish on emerging markets and commodities.

Remain bullish on Korean equities

Wed, 14 Nov 2007 10:45:26 GMT

I remain bullish on Korean equities. Statistical data shows steadily growth in exports and domestic demand. Industrial production remains strong with the high-tech recovery. Domestic consumption is recovering and I am confident that the income and consumption will continuously grow next year. I expect GDP growth to remain at 5% and inflation at 3%. Tech exports and investment would be hindered by higher interest rates and appreciation of KRW. I expect double digit EPS growth for 2008.

Valuation remains attractive. The median PE of KOSPI is around 15, which is low comparing with most of industrial economies in Asia such as Japan and Singapore. Attractive headline valuation metrics reflect investors still has concerns over the sluggish corporate capex and domestic consumption, in my view. I estimate the market will trade on a normalized PE of 19 by end of 2008.

Big-caps are last pocket of value. In my opinion, big-cap companies will have more opportunities as cyclical industries are recovering from strong demand and export market, these stocks so far still look cheap. Market consolidation in various sectors such as consumer products is continuing. I expect more capex and M&A continue to increase in the next year.

My themes for 2007: 1) Raise weightings in big-cap stocks. 2) Buy consumer products and industrials – growth of these sectors are accelerating as both domestic consumption and exports are recovering. 3) Buy healthcare – I think the sector is still cheap, offers re-leveraging opportunity and has potential for positive earnings surprise.

Hidden risks behind China's earnings momentum

Sat, 10 Nov 2007 10:52:56 GMT

I have the following thoughts on the recent market corrections:

1. The robust growth of corporate earnings is not based on fundamentals but the market itself. Watching from a distance, my thoughts on the corporate earning growth are: (i) why China's A share companies have outperformed H share companies in EPS growth; and (ii) what is the average percentage of corporate earnings come from investment activities other than operations. China's dual-listing companies, especially financial institutions and energy companies, have more non-operation earnings than in Hong Kong. In a market with upward curve these companies can enjoy a higher earnings growth, thus in turn further support the market go upward with a better earnings expectation. However, when the market exuberance ends, decreased corporate valuation with result significant negative influence over their invested companies and corporate earnings.

While some analysts pointed out the average percentage of earnings from investment only accounted for 25% of total earnings in the market, I believe taking a micro perspective to analyze these earnings is necessary. In certain sectors such as insurance, brokerage services, banks, energy, and conglomerates sectors companies have significant investment in China's equity market, facts are these sectors showed relatively higher volatility, I estimate over 30-40% of earnings are from investment activities in such sectors; this brings high risk in a market with downside market performance expectation and worries.

2. The rapid growth of corporate earnings is not sustainable. I don’t believe corporate earnings could growth at six times of GDP growth rate in the long-term, though A share and H share markets were expected to reach 46% and 19% of earnings growth respectively in 2007. Interestingly, many private sectors are suffering from higher inflation risks, commodities price hike, and intensified competition. The positive factors that influence the earnings are one off items, these factors will no longer exist after 1H08.

3. Valuation of key sectors will become higher in a market with down turn risks. As the market enters the downside curve, decreased share price will have negative influence over the earnings to investing companies, thus making the valuation of investing companies even higher.

4. Recommend investors to adjust the portfolio more defensive and reduce the weight of financials. Ultimately, the real Chinese economic fundamentals will drive financial prices and risk-taking, in my view. A market correction is necessary and healthy. I maintain a structurally negative outlook on the A share market, based on the opinion that most of stocks have been overvalued and the foundation of earnings improvement is doubtful. I suggest investor to keep a distance with China's financial sectors and become more defensive by increase the weight of consumer goods, IPP and infrastructure.

PetroChina - Trillion dollar baby

Tue, 06 Nov 2007 05:12:52 GMT

PetroChina closed at RMB 43.96 yesterday, following a dramatic stock market debut in Shanghai that saw its shares surge by 163%. Based on its closing price, PetroChina now is the first company in the world to be valued at US$ 1.00748 trillion, equivalent to the combined market value of ExxonMobil and Royal Dutch Shell. The interesting facts are, however, PetroChina’s A and H shares are currently trade at PE of 50 and 20 respectively, while ExxonMobil is traded at a PE of 10; PetroChina’s 2006 turnover and net profits are US$ 91.9 billion and 19 billion respectively, while ExxonMobil’s 2006 turnover and net profits are US$ 365.5 billion and US$ 39.5 billion respectively; PetroChina’s crude oil output was 1.06 billion barrels in 2006, while ExxonMobil’s oil output was 1.56 billion barrels in the same period. In conclusion, I still believe PetroChina offers long-term investment opportunities given the company’s strong cash flow, large oil reserve, optimistic oil price forecast, and China’s robust demand for oil and chemicals, however at its current share price, I think that PetroChina’s A share price is overvalued considering a significant share price premium over its global peers.

I remain cautious on PetroChina and rate PetroChina Sell/High Risk, as I see PetroChina's valuations as high compared to other large global oil companies. PetroChina’s future margins are at risk – with current oil dominant production likely to make way for lower margin gas. Under current capex spending rates, Gas IRRs are suspect and need gas prices to rise significantly to make healthier margins. In addition, PetroChina’s actual development costs are 40-80% higher than street expectations and traditionally calculated metrics. This will continue to be the source of surprise in the next 12- 18 months. Rising Cost and Capex leave room for negative earnings and cash flow surprises. Also the company's refining division, which is currently loss making, should see a recovery over the next two years as we expect the government to improve domestic refining margins.

Rising oil prices to create investment opportunities in the upstream sector

Tue, 09 Oct 2007 12:07:22 GMT

The oil inventory level is decreasing worldwide, as an increasing number of investors are rushing into the commodities market for oil price speculation opportunities. Today WTI crude future hits US$78.67/bbl, a 31.92% price hike compared with early this year.

I recommend investors switch from downstream to upstream counters, as I believe the potential benefits of long-awaited refined product pricing reform are already in the price. Despite the recent new highs in underlying commodities and shares prices, I remain positive on industry fundamentals and believe that the Chinese oil and gas sector provides an attractive risk/reward profile in the next 12 months. My top picks are CNOOC and PetroChina, because I believe upstream counters should be able to provide better leverage on such positive momentum than their downstream counterpart Sinopec.

I raise long-term oil price forecast to US$95/bbl: OPEC's announcement of increasing production by half million b/d is behind of demand growth and the increase is still limited; I expect inventories to decline continuously this winter, which will likely cause prices to spike higher as inventories are drawn down near critical levels, while growth of the demand is moderate I believe the drop of inventory is mainly driven by supply shortage.

China‘s interest rate hiked again, as expected

Fri, 14 Sep 2007 11:05:33 GMT

A couple of minutes ago, the People’s Bank of China (PBoC) raised both base lending rates and base deposit rates by 27 bps to be effective on September 15, 2007, not a surprise to the market.

Interest rate hikes do not seem to have meaningful impact on equity market, nor do they have on real economy. The market has shown robust growth yesterday despite the high CPI figure announced this Tuesday, and the real interest rate remains negative giving the high inflation rate, therefore the "hot money" inflow will not stop.

Today’s rate hike is positive in two ways. First, it is encouraging that the PBC continues to respond to the excessive liquidity in the economy, which has been causing asset price bubbles, notably in the equity market. Second, the PBoC is frequently using a more effective market-based instrument. In my view, with China’s economy becoming increasingly open and market based, administrative measures have been losing their effectiveness in managing the economy.

The 27bps rate hike is unlikely to have a major impact on China’s economy, and at this stage I have no intention to change my 2007 CPI forecast of 4.1%. It should lead to a moderate slowdown in loan growth, but on the other hand it could encourage stronger “hot money” inflows. This could put more pressure on the RMB to appreciate, and it will be important for the authorities to let the CNY/USD to appreciate at a faster pace to avoid a further liquidity build up. It is possible that today’s rate hike will be followed up by more tightening measures. However, in my view, the aim of China’s policy makers is not to slow the economy sharply; rather it is to improve the quality of growth, rebalancing it away from wasteful investment, and toward consumption.

China--Higher inflation, more decisive monetary tightening expected

Fri, 14 Sep 2007 03:11:35 GMT

On 11 September, the National Statistics Bureau (NSB) announced that CPI had edged up to 6.5% in August from 5.6% in July, in line with market expectations that CPI is trending up, but still higher than expected. The rapid rise in food, in particular pork and vegetable prices, were the main driver of the rise.

Going forward, inflationary pressures are likely to persist in until 1Q 2008, even if activity and credit growth continue to moderate, because inflation tends to reflect changes in aggregate demand and money supply with a significant lag in time. I expect yoy CPI inflation to trend above 4.1% in 2007, and tighter monetary policy in the coming months given heightened inflation risks and negative real interest rates.

Although the central bank might choose to hike the reserve requirement ratio (RRR) first since the last rate hike was only one week ago, I continue to believe that they will hike both the lending and deposit rates twice in the rest of the year by 27 basis points each time.

Photo Album: Hong Kong

Sat, 17 Nov 2007 07:15:38 GMT

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Photo Album: Oxford

Sat, 17 Nov 2007 06:17:17 GMT

Oxford

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Photo Album: Cambridge

Sat, 17 Nov 2007 06:13:26 GMT

Cambridge

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Photo Album: British Museum

Sat, 17 Nov 2007 06:08:06 GMT

British Museum

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Photo Album: Windsor

Fri, 16 Nov 2007 07:35:51 GMT

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Photo Album: London

Fri, 16 Nov 2007 07:13:33 GMT

London

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Photo Album: Volendam

Thu, 22 Sep 2005 12:29:44 GMT

Volendam

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Photo Album: Leiden

Thu, 22 Sep 2005 12:25:46 GMT

Leiden

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Photo Album: Leeuwarden

Thu, 22 Sep 2005 12:19:51 GMT

Leeuwarden

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