Buy on China skep­ti­cism

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Wide­spread skep­ti­cism about the power of mon­e­tary pol­icy at the out­set of eas­ing cy­cles can pro­vide great in­vest­ment op­por­tu­ni­ties. De­spite clear lessons about the ef­fects of cen­tral bank ac­tivism in the US in 2009, Ja­pan in 2012 and Europe in 2014, in­ter­na­tional in­vestors still doubt the qual­ity of the bull run in China’s on­shore stock mar­kets ig­nited by the Peo­ple’s Bank of China.

As a re­sult, even though the Shang­hai A-share mar­ket has climbed 66% in six months, re­peat­edly set­ting new sev­enyear highs on el­e­vated turnover, the H-shares of Chi­nese com­pa­nies listed in Hong Kong have failed to keep up, ris­ing a com­par­a­tively mea­gre 29% as for­eign­ers have held back from the mar­ket.

In­ter­na­tional in­vestors do not ques­tion the po­ten­tial for a sus­tain­able rerat­ing of Chi­nese as­sets be­cause they doubt the PBOC’s com­mit­ment to re­fla­tion. It’s just that most think they can af­ford to wait. In re­cent years, the knee-jerk re­sponse to ag­gres­sive cen­tral bank eas­ing has been cur­rency de­pre­ci­a­tion, which ini­tially at least has off­set the con­tri­bu­tion of any stock mar­ket rally in in­ter­na­tional bench­marks.

Although Chi­nese A-shares are not in­cluded in bench­mark in­dexes, the same at­ti­tude has pre­vailed. So far, in­vestors have de­cided to bide their time, ex­pect­ing a ren­minbi de­pre­ci­a­tion.

How­ever, as we have ar­gued be­fore, de­val­u­a­tion is not in China’s in­ter­ests. Bei­jing needs ex­change rate sta­bil­ity both to ad­vance its in­ter­na­tional fi­nan­cial agenda and to pre­serve do­mes­tic fi­nan­cial sta­bil­ity. With China’s lead­ers press­ing for the in­clu­sion of the ren­minbi in the In­ter­na­tional Mon­e­tary Fund’s Spe­cial Drawing Rights bas­ket this Oc­to­ber, the cen­tral bank is highly un­likely to coun­te­nance any sig­nif­i­cant cur­rency de­pre­ci­a­tion against the US dollar over the com­ing months.

With a closely man­aged ex­change rate, un­like most other emerg­ing mar­kets, China has the tools to counter the po­ten­tial tight­en­ing ef­fects of any cap­i­tal out­flows by eas­ing do­mes­tic pol­icy with­out let­ting go of its cur­rency. And with both nom­i­nal and real in­ter­est rates well above zero, China has plenty of room for ef­fec­tive eas­ing un­con­strained by the zero lower bound, and with­out the threat of fall­ing into a liq­uid­ity trap.

More im­por­tantly, if they are com­bined with fur­ther struc­tural re­forms, the cen­tral bank’s eas­ing mea­sures could help to chan­nel credit flows to­wards pro­duc­tive in­vest­ments.

While the jury is still out on this, one of our pre­ferred in­di­ca­tors, which tracks the rel­a­tive per­for­mance of the listed pri­vate sec­tor ver­sus listed state sec­tor com­pa­nies, is show­ing en­cour­ag­ing signs.

Af­ter a wor­ry­ing un­der­per­for­mance in 4Q14, which could im­ply cap­i­tal fun­neled into the wrong hands, pri­vate­ly­owned en­ter­prises are at­tract­ing re­newed in­vestor in­ter­est this year af­ter de­liv­er­ing solid profit growth in 2014.

The risk for in­ter­na­tional in­vestors is that when they wake up to the re­silience of the ren­minbi and of pri­vate sec­tor earn­ings, they will find them­selves forced to pay a much higher price for Chi­nese stocks. The val­u­a­tion gap be­tween the on­shore and off­shore mar­kets is still wide, with main­land listed A-shares trad­ing at a pre­mium of al­most 30%.

But with Bei­jing al­low­ing more main­land funds to en­ter the Hong Kong mar­ket, the gap can close very quickly. In­deed, with Hong Kong’s H-share in­dex of lo­cally listed main­land com­pa­nies up an im­pres­sive 4.5% last week, wallflower in­vestors who con­tinue to hang back may soon be in dan­ger of miss­ing the party.

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