Waiting for Something to Prick China's Bubble

Aug.17.09 | About: ProShares UltraShort (FXP)

Why do I feel like the macro data reported by China Monday night made both China-bears and bulls smack their lips?

Well, as a China-bear myself right now, I wanted to interpret the data as the first signals of a slowdown, something that could be devastating given [among other things] the leveraged asset growth that's occurred over the last few quarters. My bullish adversaries will plug the data into their analyses to reconfirm that the Chinese government is wary of burgeoning bubbles and is taking measures to not overheat their economy.

Getting technical, FXP: Slow Stochastic set new ST highs on 7/31 & 8/7, which action was confirmed by the stock's price performance= BULLISH. Couple that with a MACD cross on 8/5, where the curve is sloping up and divergence is increasing= BULLISH.

I didn't get the definitive fundamental "go" I was looking for from July's data. Rather, I translate the data from an annual perspective, interpreting it in the context of the government's FY09 targets: yes, China reported some unexpected m/m and y/y drops, but those numbers seem to have the re-aligned the economy on a track to hit its year end goals. In that context, July's data showed a gravitational pull to the mean.

Although I'm net short China right now (long FXP and short the front 13 calls) in my own portfolio, I've kept my clients on the sidelines until I get more definitive fundamental sell signals. I can day-trade technicals in my own account, but I'm cautious not to let clients' capital stagnate while shorting a consolidating Chinese market for 2 quarters.That being said, some problems still remain. While China's economic targets seem appropriate, its means to that end weren't. We're all aware of the forced lending that occurred 2q09. Credit was easy, collateral requirements were lax, and credit investment was ill-advised.

Truth be told, July's data brought some pretty volatile performance to the table, like the m/m drop in bank lending. As I said, that's fine if China's trying to cool down after an unprecedented run, but all these loans and all this investment has been channeled into assets and markets. From Ambrose Prichard:

Beijing is walking a tightrope by trying to offset the collapse in exports – almost 40pc of GDP – with an investment blitz in roads, railways, and industry through state-owned companies.

The real economy cannot absorb the money, so it is leaking into asset speculation. The central bank estimates that 20pc of fresh credit has ended up in equity markets. The Shanghai Index is up 80pc this year, though profits have fallen by almost a third. The pattern echoes the final phase of Japan's Nikkei bubble in 1989.

There's a growth requirement necessary to keep loans and investments performing, to thereby substantiate these piles of leveraged capital. While the Shanghai has rallied, credit extension swelled mostly at the end of that market run, at which time the small-money decided to jump into the swimming pool.

With China diversifying away from an Export-driven model toward a more domestic, consumer-based model, the effect of a weak USD is taking a different role. The Yuan was kept artificially low for years to lure the US to Chinese exports. Now, facing an inevitably weaker USD and a more protectionist "Buy America" M.O., China changed its strategy by divesting dollar denominated assets and stockpiling hard assets (i.e. commodities).

A 23% y/y drop in exports, a 1.8% y/y drop in CPI! It's taking some serious stimulus to displace the export evaporation with domestic consumption.

From Andy Xie:

…China’s average [property] price per square meter nationwide is quite close to the average in the US. The US’s per capita income is seven times China’s urban per capita income. The nationwide average price is about three months of salary per square meter, probably the highest in the world. As far as I can tell, a lot of properties can’t be rented out at all. Those that can bring in 3% yield, barely compensating for depreciation. The average rental yield, if one including those that can’t be rented out, is probably negligible. China’s property price doesn’t make sense from affordability or yield perspective.

So what are the definitive signals I'm looking for to prick China's asset bubble? I'm watching CPI for deflation, but more importantly, I'm watching the Dollar Index, which sits around 77 today. A secular bear market for the Dollar redirected liquidity into China, that's the executive summary of what's happened here. With the Chinese government already stimulating the economy, they could be caught with their pants down when the dollar strengthens.

Kind of a contingency of the dollar's performance, I'm also watching commodity prices. Although Chinese GDP has a heavy allocation toward net exports, commodity price performance resonates top to bottom, government to consumer, because of the leveraged buying spree we've seen. Dollar strength will support higher net exports, but the damage resulting from commodity price destruction will be a negative multiple of whatever net benefits may arise.

Disclosure: Long FXP