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The Chinese stock market has had a volatile year, initially rallying before slumping as concerns about a hard landing culminated in speculation on the end of the Chinese economic growth model. If history shows us anything it's that people will always overreact; on the down side and the upside. But is it an overreaction to still be bearish on China?

In order to answer this question, we need to review a number of key economic and market themes. The bottom line is that there is a compelling outlook, but it's not as simple as it may seem.

The case for Chinese equities, the macro view:

  1. The Chinese economy has slowed its rate of growth recently, but the drivers of this slowdown are known and relatively benign. Monetary policy tightening in 2010-11, along with regulatory measures to curb property speculation and inflation resulted in a slowing of activity growth (this is what you would expect when monetary policy tightens). The European sovereign debt crisis and subsequent austerity induced recession also put a dampener on external demand for exports.
  2. In the backdrop of this engineered and externally driven slowdown, there have been some efforts towards rebalancing the economy away from investment and exports and towards domestic consumption. This is a good idea for China, and will ultimately result in lower but more sustainable growth. But this has not been a key driver of the recent slowdown, and will take decades to come to full fruition.
  3. Thus we can note that the slowdown has been largely engineered by policy moves and compounded by challenging external conditions (Europe). It is by no means the harbinger of a broken economic model or a hard landing. In fact, recent data including PMI, earnings, various survey, and official statistics show signs of an upward turn in growth (remember we're talking about slowing of growth rates - not negative growth rates).
  4. The base case for 2013 is a reacceleration of activity growth, but it is unlikely that GDP growth will return to double digits. The key drivers will be a cyclical rebound in domestic activity, a less acute drag from Europe, a new leadership that will be keen to get some early wins, and relatively looser policy settings.

The case for Chinese equities, the market factors:

  1. Chinese stock market valuations are near or at historical lows (whether on a PE, price to book, or dividend yield basis). In the long run, market valuations at the time of purchase will have a significant bearing on your returns; the lower the starting valuation, the better the return - holding all else equal.
  2. The main reason for lower valuations has been the slowdown in activity growth, speculation of an impending hard landing, and generalized risk aversion, including strategic asset allocation moves away from equities into bonds following the financial crisis.
  3. Meanwhile company earnings and sales have slowed along with the economy, but have already shown signs of turning up again.
  4. Given that the Chinese economic model is not broken, this could be a rare opportunity to pick up some cheap stocks. The catalyst for an upswing will ultimately be stronger earnings growth (which should come with the economic reacceleration), but there is also upside risk from monetary policy, upside global growth surprise, and improving risk appetite. Downside risks are largely external, but it would be prudent to keep an eye on domestic inflation also.

Strategy

In the short term (6-12 months), the trade to make is simply getting beta exposure through a broad market ETF like FXI or MCHI. For those with high conviction and the risk appetite, adding delta through the longer term near the money call options on FXI might be worth looking at.

In the longer term, the trade to make is to get smarter beta that capitalizes on key macro trends such as a stronger, more confident, and wealthier middle class that will lead strong growth in an already vibrant consumer sector. A key example is Global X China Consumer ETF (CHIQ).

Source: Bear No More - It's Time To Get Beta In China