It looks like the slowing growth in China has been priced into stocks, providing the first buying opportunity in many months.
By Darius Dale, Hedgeye
Shanghai Stock Exchange
Late last week, we opened a position in Chinese equities within the Hedgeye Virtual Portfolio for the first time since closing a long position in late September of last year. The recent weakness in the wake of Japan's crisis provided a buying opportunity we couldn't resist.
"Why buy China?" one might ask, given that our outlook for the Chinese economy calls for slowing growth and accelerating inflation. Simply, put, the answer to that question is a question in and of itself: "What price does one pay for slowing growth?"
While some investors are following the Chinese government in revising down their growth assumptions for China in the first half of 2011, we are inclined to believe the bear case on China is getting increasingly priced in. In fact, we were among the few to be appropriately bearish on Chinese equities in early 2010 -- since then, China's Shanghai Composite Index is down nearly 10%, including a peak-to-trough decline of 26.7% recorded on July 5th.
We get the bear case on China, so naturally, our next risk management tasks are to figure out whether that's fully priced in and if the market is leading us to a re-acceleration in Chinese growth. Addressing the latter point specifically, there are signs that China is indeed entering a bottoming process, from a growth perspective.
Year-over-year growth in Chinese exports, retail sales, and money supply all slowed to multi-year lows in February (in part due to the timing of the Lunar New Year). While there may be further downside in the coming months, the risk-reward setup is skewed to the upside for the first time in several quarters.
From a financial market perspective, we see that China's 12-month interest rate swap contract (which exchanges fixed payments for the seven-day repurchase rate) backed off its high of 4.04% on Feb. 21 to 3.4% earlier this week. The key takeaway here is that the Chinese bond market's expectations for additional tightening have receded. While still elevated relative to the 1.99% we saw last August, the slope of this trend remains positive for Chinese growth expectations on the margin. For now, the trend is moving in the right direction.
We'd be remiss to not mention the impact of inflation on Chinese equities. Prior to the current rally, which began on Jan. 25, Chinese equities had sold off due to fears that accelerating inflation would lead to aggressive tightening of monetary policy. With three interest rate hikes and six announced reserve requirement hikes since late October, a great deal of tightening may indeed be in the rear view. This opens the door for Chinese stocks that benefit from higher levels of inflation to outperform.
An analysis of industry contributions to the Shanghai Composite's current rally confirms this:
Buying China here is certainly not without risk, however. Given that the current rally is highly levered to accelerating inflation, any disinflation in real-time commodity prices (via strength in the U.S. Dollar) may prove detrimental.
What could also happen in a disinflationary scenario, however, is that the outperformance shifts from inflation-positive names to consumer and industrial stocks, keeping a bid under the market at large -- particularly because many investors have likely chosen to remain on the sidelines due to the current round of tightening. At any rate, given that it's increasingly likely that slowing growth and additional tightening may be priced in, Chinese equities look poised to benefit in an inflationary or disinflationary environment.
Also on Fortune.com:
Screen name (Select one with 3-12 characters; Numbers and letters only)
Enter your e-mail address below and we will send you an e-mail with a link and code to reset your password.
Already have the reset code?
Reset code
New password
Password
Forgot password?
Not a member yet?
Screen name
Password
Type what you see in the grey box
CNNMoney will use the information you submit in a manner consistent with our Privacy Policy. By clicking on "sign up" you agree with CNNMoney's Terms of Service and Privacy Policy and consent to the collection, storage and use of this information in the U.S. subject to U.S. laws and regulations. (learn more)
This service is temporarily unavailable. Please try again soon.
Thanks!
Please check your e-mail and click the link to confirm your membership. Then, you'll be ready to participate in all activities and conversations on our site.
Go to your Profile page
Be the first to know when there is breaking financial news with timely alerts delivered straight to your inbox.
Fortune's Philip Elmer-DeWitt brings you Mac news from outside the reality distortion field.
Fortune columnist Anne Fisher answers your career-related questions.
Money Magazine's Walter Updegrave answers readers' toughest financial questions.
Fortune managing editor Andy Serwer keeps tabs on Wall Street
CNN's Gerri Willis gives tips and tools for saving more and spending wisely.
A complete roundup of each day's trading activity.
Fortune editor at large Pattie Sellers shares fascinating, fun and valuable insights into people who sit at the pinnacle of power.
The companies, deals, and trends in tech that are moving market and making headlines.
Read Full Article »