Is the dragon turning?

As I write, the MSCI China Index is up over 15%¹ since the Chinese Central Bank announced its latest stimulus/reform package on September 24. Unlike some previous piece-meal efforts, the package featured a co-ordinated series of monetary, fiscal and reform measures including:

• cuts to key institutional lending rates

• more measures designed to boost housing, including cuts to mortgage rates and reductions in down-payment ratios on second homes

• boosting liquidity by lowering banks’ reserve requirements

• State Council directives aimed at speeding up infrastructure spending and cutting unemployment.

There were also very large fiscal measures including a transfer of one trillion Chinese Yen (CNY) from the Central Government to local governments to help them reduce debt and another one trillion CNY to fund equipment trade-ins and thus boost demand in the real economy. These moves represent around 1-2% of GDP with potential for more. That’s significant when you consider that China’s GDP growth target is 5%.

One reason the market response to this package was so strong is that the quantitative easing element - subsidising companies to buy back shares and encouraging financial services firms to borrow to invest in stocks – both directly boost sharemarkets.

My reading is that this is a much more committed and cohesive response to China’s challenges than previous packages. The People’s Bank of China’s Governor Pan said the RMB800 billion in total support for markets could be doubled or tripled if needed. That’s a big signal to investors.

A bigger bounce?

When I look at what the authorities have done and how the markets reacted, a few things stand out.

• The size of the bounce reflects just how badly beaten up the Chinese market was and how cheap it had become. Even after this big, rapid bounce many Chinese stocks still look undervalued and that calculation is based on current weak economic conditions. If you redo your valuations on the assumption there will be an economic recovery, stocks look even cheaper.

• Banks and other financial institutions will be delighted to accept the government’s invitation to invest in equities. They can borrow at around 2% and buy companies yielding 5%, 6% and 7%.

• Foreign investors have been shunning China and many hedge funds were shorting it. That flow of money is likely to reverse, adding another layer of demand.

 
Though less widely discussed than the monetary and fiscal measures, the authorities also announced regulatory changes that should strengthen corporate governance and enhance shareholder returns. We’ve seen these policies have a big effect in Japan (and increasingly in Korea) so they are a medium-term positive.

Is a recovery guaranteed?

We won’t know – until we know – whether these latest stimulus measures will be enough to underpin a full economic recovery in China. Each subsequent policy announcement will now be carefully assessed to see whether it adds to or detracts from the momentum of China's recovery. Markets will no doubt respond to those announcements, sometimes with a bounce, sometimes with a slide. What matters is the longer-term economic impact.

A stabilisation in the property market still looks to be key to completely rebuilding consumer and business confidence. The government has put in place many of the policies needed to drive that property recovery but lack of action at the local level is holding it back.

That said, there is evidence the inventory of unsold and uncompleted properties is now falling. If the property market is clearing that will be a huge step towards a full economic recovery. The Politburo’s recent announcement explicitly stated: “Stop the decline in the housing”. That’s much more direct language than they’ve used in the past.

Chinese stocks in Platinum’s portfolios

Despite the negatives around China we’ve held sizeable positions in high quality stocks like ZTO (China’s FedEx), tech/internet giant Tencent and China Merchants Bank for some time. These companies have all been performing well and growing earnings. An economic recovery will make them even more attractive.

Paradoxically, more speculative names may outperform these quality holdings in the very short-term as the market resets its view of China. Even so, ZTO and Tencent are up over 15% over the past month and China Merchants is up over 35%. While welcome, we didn’t invest in these stocks in search of a spike like that. These are the types of businesses we want to own over the longer term.

1: Stock and Index performance sources for this article: Factset, all local currency as at 11 October