Analysis: Why China is better than you think

The China of today is for stock pickers. The soft landing guys are still right.

The China of today is for stock pickers. The soft landing guys are still right.

The “imminent” demise of China will have to be postponed…again. The risk to third quarter growth forecasts in the market are now to the upside.

On  Thursday, HSBC’s China Flash PMI data showed a sharp rebound to 50.1 in August from 47.7 in July. Consensus estimates had it rising slightly to 48.2. Today’s manufacturing data is consistent with headline activity indicators such as industrial production, which also recovered in July. It confirms that the economy has stabilized in the short term at least and downside risks seen in the second half of the year have subsided.

Perhaps the best piece of news out of the PMI numbers is that it was driven by domestic demand. New export orders dropped to 46.5 from 47.7 in July, while total new orders rose sharply to 50.5 from 46.6.

Based on this flash PMI, we now see upside risks to our third quarter GDP forecast,” said Nomura Securities senior economist Zhiwei Zhang in Hong Kong. His forecast is for 7.4% growth, declining from the first (7.7%) and second quarters (7.5%).

For the last three years, the Chinese government has been trumpeting its stated goal to move away from its old export-driven export model. China is turning inward. That will come with growing pains as it transitions from a low-cost producer to one that produces value-added, even high end goods made by workers earning middle class incomes who then buy new apartments, cars, refrigerators, and — of course — take trips to south China for Disney and Macao casinos.

“I am very pleased by the way China is handling this transition,” said Michael Reynal, a fund manager at the $492 million RS Emerging Markets Fund (GBEMX). “The China commodity boom story is over, but there are a lot of companies that will benefit in this transition,” Reynal said.

His fund has been buying China Construction Bank (HKG: 0939), one of the big five government owned lenders. China Construction has been hard hit because of government policies designed to curb the real estate market.  But in the last month, China Construction Bank has outperformed the Hang Seng by around 500 basis points, up 7.16%. It’s an underperformer on the year and is down over 6%.

Real estate and banking have been the two China sectors investors fear most. That concern has driven a lot of the negative sentiment over the past year.

On Tuesday, Zhang Xin, the well-known CEO of China developer SOHO China Ltd (HKG: 0410), said her company was also transitioning. SOHO is moving away from flipping properties to becoming happy landlords.  In its core market, Beijing and Shanghai, occupancy rates are high. Net profits are up over 200%. For a real estates giant, it’s beating the Hang Seng and MSCI China, up 5.8% year-to-date and 21.5% over the last 12 months, smack dab in the middle of a Chinese housing bubble.

“I think the argument of not investing in China because of the housing bubble is misplaced,” said Joel Wells, a fund manager at Alpine. “There are a lot of things that can go wrong in China and I’d put a bubble low on that list.”

The favorite thing to worry about?  China’s municipal lenders.  The Central Bank issued a warning to over extended muni funders in June. They said they would not save those banks from defaults. The market panicked in what The Economist called “The Shibor Shock“, named after the Shanghai Interbank Offered Rate. Money market rates soared frightfully high for China, over 10%.

China is not a free market. When the market panicked that smaller banks in municipalities would face a funding crisis, the Central Bank authorities did a 180 degree turn and basically changed their minds. They would help them with liquidity if needed.

Regardless, muni-banking and the trillion dollar “shadow banking system” is seen as a house of cards in China. It could hurt some companies.  As a result, investors have to be more bottoms up in their approach to China.

That is especially true for real estate. “You have to find the big companies that will grow through acquiring the smaller developers,” said Wells.

Real estate, like banking, is part of China’s domestic consumer story. There are many ways to play it. Some take a sector leadership approach, investing in big electric power companies or firms that dominate market share. Others like consumer discretionary and staples. Mirae Asset’s China Sector Leader (MALCX) fund is up 5.23% year-to-date, for instance.

The China of today is for stock pickers. With the economy avoiding the hard landing that some have predicted, many stock pickers focused on domestic names are beating the market.  Melco Crown Entertainment owners of the City of Dreams casino in Macau, is up 61.05% year to date, beating every major index on the planet. Another casino, Galaxy Entertainment (HKG: 0027) is up over 43%.

Those two stocks may very well be over cooked. But with new investments connecting the gambling island getaway to the mainland via high speed rail, more middle class Chinese will head south to roll the dice, said Jason Ader, a board member at the Las Vegas Sands.

Policies designed to stabilize China growth, notably the planned acceleration of railway investment, may have played a role in Thursday’s PMI figures, said Jian Chang, an analyst at Barclays in Hong Kong.

Imports of raw materials such as iron ore and crude oil rose, while output of steel and cement rose at the fastest pace year to date. Fixed asset investment growth, led by infrastructure and commercial real estate, also stemmed six months of deceleration in July. Finally, the modest and gradual recovery in the advanced economies is further helping manufacturing activity to stabilize in China.

The official National Bureau of Statistics manufacturing PMI — due out on Sept. 1 — will likely rise in August as well from 50.3 in July.

Trade and activity data are also seen improving on a yearly growth basis.

Nonetheless, Barclays’  base case scenario on China remains cautious. They’re not expecting any sustained acceleration in domestic demand.

Nomura, like others, still see China’s economy struggling to stay at 7% growth yearly. That’s no hard landing. The soft landing guys are still right.

Source: Forbes “Why China is better than you think” by Kenneth Rapoza

Categories: Finance & Economy

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