To outperform the crowd, you must dare to be different. Put another way, the best investments are typically made from a position of deep discomfort. Earlier this year, following a 3-year bear market and waterfall price action, equity valuation, positioning and sentiment had reached episodic or revulsion levels in China. While the pessimism was warranted by fundamentals (structural and cyclical), there was evidence of capitulation by domestic and global investors.
However, as we noted at the time (see Enter the Dragon) the series of policy measures introduced by the authorities and recently in the July Plenum to support growth probably fell short of a “whatever-it-takes moment.” For example, the property stabilisation measures announced earlier this year represented only around 8-9% of total housing stock. However, the valuation of the domestic stock market at 4.7 times two-year forward earnings in January was so extreme that the probability of a tactical recovery was high. MSCI China did rally almost 32% from the January trough to the May 2024 high. Note that we have scaled back exposure into the rally.
Our key fear for a durable rally was the great constraint on policy. As we noted at the time, if China implemented US style bond purchases (QE) or more aggressive rate cuts that would risk putting further downward pressure on the currency and outbound capital flows. China has also been constrained by “higher-for-longer” US rates and related dollar strength. Our sense is that “fair value” for the USDCNY is quite a bit higher or above 8.1 (chart 1).
Chart 1
From our perch, the key macro news flow in China also reflects the cyclical weakness in this cycle. The credit impulse (the rate of change in credit growth) has been very weak in the current mini cycle. Credit is inflationary when taken on and deflationary when paid back. The relationship to activity growth in China is also due to the importance of investment, infrastructure, and real estate (25% of GDP) as a contribution to growth.
The weakness of the credit impulse in the current cycle is also consistent with the Li Keqiang index (credit, cargo freight and electricity consumption) which is a more reliable indicator of activity than official GDP data. Related to this point is also the high level of total debt (300% of GDP) which is a constraint on the capacity to expand credit.
As dedicated equity investors know, China has been an excellent example of the divergence between nominal GDP and earnings per share. The divergence likely reflects, dilution, poor productivity, excess capacity, and infrastructure investment that has not improved returns to shareholders. Looking forward, China might also face additional resistance to expanding global export market share. Especially if the next US Administration materially increases tariffs. China’s authorities are still attempting to address an insufficient demand problem with more supply side type measures.
Chart 2
The way price is responding is thoroughly unconvincing - what is your quarrel with price? Not only are the broader China indices failing to signal confidence, but Bloomberg’s China re-opening index (a proxy on cyclical recovery) has also made a new low. We doubt that China’s policy makers desire currency devaluation, especially if it was amplified by confidence and self-reinforcing capital flow. However, “fair value” for the CNY is probably much lower (higher USDCNY) and might be the consequence of a more aggressive US policy following November. We would also note that the recent weakness in iron ore and commodities more broadly is likely consistent with the cyclical and structural growth weakness in China. In addition to the narrow equity premium on US equities (the global risk proxy) the lack of cyclical momentum is a challenge for EM and China, more broadly.
Chart 3
Comments