China Watch Update

Thursday, June 30, 2011

Over a year has passed since we posted a blog “International Stock Markets: Searching for Goldilocks” (5/12/2010) in which we commented on the rising inflation problem in China and the damage it was inflicting on the Chinese stock market. More recently, on March 22, we issued a blog “China Watch: Is Goldilocks Waking Up” in which we pointed out that continuing stock market underperformance was a consequence of increasing concern among investors that the government would go too far and inadvertently cripple economic growth. We drew 3 conclusions:
  • Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.
  • Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.
  • The “soft landing”would spark a strong stock market rally.
Fear of inflation and possible asset bubbles continues to be the central focus of investors and the Chinese government. Since the start of 2010 the People’s Bank of China (PBOC) has hiked bank reserve requirements 12 times, and on 4 occasions it raised the base interest rate. Nevertheless, inflation has risen steadily and is now, at 5.5%, above the government’s 4% target.
The latest important development was an article “How China plans to Reinforce the Global Recovery” in The Financial Times (6/23/11) authored by Chinese Premier Wen Jiabao. After touting the considerable strengths of the Chinese economy and the government’s achievements in promoting social reforms, implementing massive infrastructure programs, and sponsoring scientific and technology initiatives, he made remarkably confident statements regarding inflation:
There is concern as to whether China can rein in inflation and sustain its rapid development. My answer is an emphatic yes…China has made capping price rises the priority of macroeconomic regulation and introduced a host of targeted policies. These have worked…We are confident price rises will be firmly under control this year.
Investors in Chinese stocks interpreted the Premier’s confidence as a signal that the period of restrictive credit policies was over and China was headed for the desired “soft landing.” Since June 20, the Shanghai Stock Exchange Composite Index (CSEX) has rallied 4.1%, but is still down -10.6% since April 15 and over 50% from its peak in October of 2007. If the government can convince investors that it is correct in its claim that inflation can be kept below 5% and GDP growth over 8% for the foreseeable future, then the Shanghai market recovery has only just begun. The market’s P/E valuation, at 11.6 times estimated profits, is the lowest since the global financial crisis in November of 2008 and, according to research analyst estimates compiled by Bloomberg (6/27/2011), Shanghai index profits are expected to soar 32% in the next 12 months.