World Out of Balance

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.

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)

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.

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%.

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.

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.