In the last decade, Chinese reforms stalled and the stock market lagged the world. However, China's macro history implies market reforms are irreversible and to accelerate after the 3rd Session of 18th National People's Congress this November. This is comparable to the 1980s Reaganomics and will usher in a golden era for Chinese stocks. CSI300 Index has bottomed with a 60% upside for the next 12 months (Chart 7). In the de-quantitative-easing world ahead, China is becoming all the more interesting.
The Chinese dichotomy is the most puzzling: world-beating economy vs. world-beaten stock market. Shanghai has suffered consistent de-rating (Chart 1 and 2). Despite a decent long-term earning curve, Chinese P/E is at historical low, more pessimistic than the US multiple during the subprime trough. Of course, the U.S. has gone through an actual banking crisis; China is priced to have one worse coming. Is this a contrarian buy or value trap?
The market worries are interconnected (Chart 3). The banking health concern sits at the center and depresses stock valuation.
Since China's entry into WTO, the growth model is powered by the duo engines: world factory and urbanization. And the former has lost fuels after the subprime and European debt crises. Thus urbanization is left as the only functional engine. Policymakers designed a virtuous cycle and it worked well until being abused. See Chart 4.
Starting from Farm Land A near a city, local government buys it dirt-cheap from farmers, and put it in a local government financing vehicle (LGFV) as collateral to get bank loans. Valuing the potential and state-backing, the banks lend generously. LGFV proceeds to build infrastructure: road, subway, airport, etc. Land upgraded, developers bid hard with bankers' help. Then houses build and all the associated industries benefit. In turn, house appreciates with land, luring speculators and homebuyers. Land sales and housing related taxes get government ready for Farm Land B.
This is self-reinforcing initially but self-limiting eventually. The bears have analyzed the resulting bubbles in depth and are waiting for a collapse. Clearly the government is the main driver above: central government asks local governments for both growth and social betterment; via land local governments overinvest for short-term GDP and personal promotion, but are not liable for the long-term consequences; with state backing, banks and State-Owned-Enterprises (SOEs) corner the housing market, starving the private sector.
Thus the solution must start from the government. Last year Xi-Li stepped into office with a new growth model, but the market is still skeptical.
Overall reforms since 1978 have pushed for a market-driven economy; SOEs were restructured and the private sector was encouraged to lead the economy. However, things stopped when Hu-Wen took office a decade ago and a reversal followed.
Their "harmonious society" came as a compromise at the top. The 1990s privatization set off by Jiang-Zhu met intensified criticism of giving away state assets and hit a wall in the 2004 Tieben event. Since then SOEs have re-marginalized the private sector esp. after the subprime crisis. As the macro-control tool, SOEs divided the 4-trillion stimulus. State muscles advanced SOEs, not better management.
The 2013H1 earnings show the consequence best: a few state monopolies (banks, oils, telecoms) grabbed the majority of profits. The largest losses went to the non-monopoly SOEs despite generous subsidies. Most private companies struggled.
However, history suggests market reforms are reasserting themselves. As historian Ray Huang argues in his book, China: A Macro History, in the long transition from a system of agriculture to one of commerce, China has already made a breakthrough and the process is irreversible. See Chart 5.
Thus the reform stagnation in the last decade was a tactical regroup rather than strategic reversal. The political debate at the top echelon has come to a conclusion with the current trial of Xilai Bo. A new consensus has formed around Xi-Li, and another wave of reforms are expected at the 3rd Plenary Session in this coming November.
The Reagan parallel
In my respects, China today shares many similarities with the U.S. in early 1980s, when Reaganomics successfully transformed and revitalized the U.S. economy. First of all, the stocks were equally depressed with single-digit P/Es. See Chart 6.
The "stagflation" challenge is similar. Only for China, the growth downshifts from 8% to 7%, and inflation is reflected more in housing prices. As a result, the policy responses both aim at the supply side of the economy:
- A smaller government: break state monopolies and open up competition; cut taxes and spending; reduce regulations and strengthen supervision;
- Keep credit growth under control.
Reaganomics ended the "stagflation" and opened a golden era for U.S. in the next 20 years. This, plus China's reform record since 1978, bodes well for the Chinese.
The Chinese stocks
The Reagan parallel has implications for Chinese stocks today: market confidence is bound to recover from panic levels. The equity risk premium (ERP) drop will be swift, which implies significant upside for Chinese stocks in the next 12 months (Chart 7).
Rate drivers point to stable treasury yields in China. Growth will slow from 8% to 7%; the Reagan experience foresees a strong Yuan and controlled inflation ahead; China sovereign risk is contained given the relatively strong balance sheet.
ERP dropped 6% after Reagan's takeover. Despite a higher starting point, assume the same 6% drop in China for the next 12 months, in which treasury yield adds 2% while earning yield down 4%. Thus P/E will go from 10ish to 16ish, a 60% upside.
This is a conservative estimate. First, it assumes zero earning growth-just valuation normalization gains. Secondly, assuming 2% Treasury yield pickup already prices in substantial country risk (Chart 8).
As shown in Chart 4, urbanization is much financed by shadow banking. Many short-term products offer 9-11% returns and are perceived as riskless due to implicit state backing behind LGFVs and banks. This largely explains why stocks P/E is subdued at below 10.
But the seemingly riskless 10% returns from shadow banking are disappearing. Either the 10% has to drop to match the long-term stable but low returns from government projects. Or the "riskless" will be re-labeled "risky" as Beijing removes the implicit backing.
Shadow investors have to reallocate capital. The risk-averse will seek safety from treasuries, capping yields. The risk-seeking may return to stocks to chase higher returns, pitting the re-discovered credit risk against equity risk. 10 times P/E is too low to last.
With rock-bottom equity valuation, the impending 3rd Plenary Session in November will probably kick off a bull run comparable to Reagan's. To capture this opportunity: go long CSI300 index ETF. Liquid proxies overseas: FXI and HSI.
In fact, long-term strategic investors have acted. However most participants are sensitive to short-term volatilities, as we have observed aplenty at the beginning of the Reagan cycle. Therefore, we add prudent risk controls: stop loss @ 2200 for CSI300 index.
Since the 4-trillion-stimulus lifted the market to a peak in 2009, CSI300 drifted to a bottom at 2109 last November. Then Xi-Li's takeover induced a strong rebound, followed by corrections. Weak Q1 data and the June liquidity squeeze broke 2109, which was regained after People's Bank of China injected liquidity and Q2 data improved. We see policy and technical support around 2200.
- Housing bubble burst, LGFV blowup and banking crisis
This is a reversal of Chart 4, but unlikely to be an utter disaster. Given low leverage, a house price collapse won't dent the household sector much. Local governments are more vulnerable than the developers, but less mentioned are their substantial financial assets, esp. the local SOEs listed on stock exchanges.
When pushed, Beijing can and will clean up. A much tougher bailout worked out in 1997-98. After all, Beijing rallied up local governments and banks with 4 trillions; Beijing encouraged local GDP contests; Beijing assigned local governments more spending than revenues. Of course, bailout will come at a cost: we earlier already price in a 2% treasury yield pickup to estimate market upside.
- Reform-induced volatilities
Reform by definition realigns economic interests, and usually challenges the vested interests. The establishments control vast resources and markets cough when they sneeze. We already see aplenty: the anti-graft push by Xi-Li hit consumption hard in Q1; People's Bank of China refused to inject liquidity in June, forcing banks to fix their shadow books. Both caused panic selling, and we can expect more to come.
- IPO resumption
IPOs are still suspended, pending on the final draft of IPO reform. Market fears new supply, but historically IPO resumption had no consistent impacts on markets. It is a non-issue if reforms can revive market confidence. In fact, a vibrant IPO market can de-leverage the economy, which is bullish in the long run.
- Session fail to deliver reforms and/or reforms fail to work
All evidences are pointing to further reforms, but nobody can be sure they will work. However, the Reagan experience shows that the swift valuation normalization happened despite the widespread skepticism towards Reaganomics at the beginning. For our trading horizon, all needed are deep undervaluation and a confidence boost.
- Fed QE tapering
Fed tapering will have limited impacts on China. For the real economy, the 'world factory" engine has already broke. For the financial economy, the Chinese market has de-synchronized with global counterparts as evidenced by the recent EM selloff.
All and all, the stop-loss seems enough to deal with the above risks and guard against other unforeseen risks.
The concluding remarks
Global markets are entering a new territory. The Fed is wrapping up QE and the only question is how fast. Abenomics is missing the third arrow and Europe seeks salvation from European Central Bank rather than structural reforms. Emerging markets and commodities are to swim in a receding tide of liquidity.
From the perspective of both alpha and beta, the emerging opportunities in China are becoming all the more appealing.