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In retrospect, 2006 was an incredible year of extreme volatility in the global stock markets. Once again, the biggest winners were the emerging giants of Brazil, China, India, and Russia, the so-called BRIC countries. Together, the BRIC account for 50% of the world's population, yet their rapidly growing economies account for only 13% of global economic output. Looking forward, the four emerging giants are a major force to be reckoned with, while Japan and the US lose their leads.

The global economy produced around $36.7 trillion in goods and services in 2006, with emerging economies expanding an average 7% this year, largely as a result of high commodity prices, and booming demand in China and India, the World Bank said. The pace of expansion in emerging markets will remain above 6% in 2007, more than double the 2.6% rate of high-income countries in Europe, Japan, and the US, according to the World Bank said.

China’s H-share index of mainland companies listed in Hong Kong, that foreign investors can trade, is taking the top prize for appreciation in 2006, posting a 77% gain so far this year. The H-share index is fueled by a 29% annualized increase in industrial profits, and a 17% increase in the Chinese M2 money supply. China’s economy is expanding at a 10.4% rate this year, the fourth straight double-digit annual gain. Chinese traders are discounting several more years of double-digit gains for the local economy, with the H-share index approaching the 9500-level.

chinese blue chips chart 1

China’s exports grew 32.8% from a year earlier in November to a record $96 billion, while annual import growth stood at 18.3 percent. China is set to run up a $229 billion trade surplus with the US this year, more than 13% greater than the record 2005 surplus. China passed Mexico as the second- largest US trading partner in the first 10 months of this year, only behind Canadian-US trade.

China is the emerging economic super-power of the 21st century, and has moved into fourth place, ahead of the UK economy, quickly catching up to #3 Germany, but far behind Japan and the US. Beijing’s foreign currency reserves have soared to one trillion dollars, and are on course to reach $1.5 trillion by 2010, with cash inflows expected from foreign trade, foreign direct investment, and interest earned on US and foreign debt. Where will Beijing direct its future FX reserves?

On Dec 19th, the US Treasury Department refused to label China as a currency manipulator, and instead agreed to steps by Beijing to let its yuan currency rise in value against the US$ at a snail’s pace. Also, the US Commerce Department rejected a petition, asking it to label China’s currency policy a subsidy that could have led to the imposition of tarriffs on Chinese-made imports.

Chinese I-share index fxi

News that the US Treasury would not label China as a currency manipulator sent the Chinese H-share Index in Hong Kong rocketing 3.2% higher to a record 9430 on Dec 20th, up 77% from a year ago. Likewise, the MSCI index for the top-25 Chinese stocks, symbol FXI, has gained 73% during the same time period. Chinese stock traders are betting on double-digit economic growth for the next several years, booming exports from a cheap yuan, and surging earnings-per-share growth.

FXI contains the top-25 Chinese blue chips including, PetroChina (NYSE:PTR) 9.5%, China Mobile (NYSE:CHU) 8.4%, ICBC Bank [1398.HK] 8.3%, China Life (NYSE:LFC) 7%, Bank of China [3988.HK] 6%, China Telecom (NYSE:CHA) 4.5%, China Construction Bank [0939.HK] 4.2%, and China Petroleum (NYSE:CEO), 4.1%. It’s not wise to try to pick a top in a frenzied Asian stampede, but traders should carefully elevate their protective sell-stops along the way, while FXI goes parabolic into the stratosphere.

Petrochina

Speculative fever in Hong Kong has propelled PetroChina (PTR) past Royal Dutch Shell (NYSE:RDS.A) and British Petroleum (NYSE:BP) to become the world’s second-largest oil company by market value, with a record $237.2 billion. PetroChina’s first-half profit rose 29% to a record $10.3 billion as sales surged 25%. Shares of Sinopec (NYSE:SHI), or China Petroleum, have gained 68% so far this year, with most of the rise following recent moves by OPEC to stabilize oil prices above $60 per barrel.

OPEC has agreed to lower its oil output by 1.7 million barrels per day next year, when global oil demand is projected to increase by 1.2 mil bpd. China and the US are expected to account for 75% of the increase in global oil demand next year. China relies on imports for 40% of its oil needs, and that could double to 77% by the year 2030, according to the Int’l Energy Agency. China’s oil consumption will rise 6.2% next year to 7.01 million barrels a day, which should underpin PTR and SHI.

China Life

China Life 2628.HK, LFC.N, China’s biggest life insurer, rose to a new high of $119.16 /share on Dec 15th after it won regulatory approval to list in Shanghai with an initial public offering that could raise over 32 billion yuan (US$4 billion), making it the second biggest domestic IPO this year. China Life is the world’s third-largest insurer by market value, and earned 5.45 billion yuan (US$695 million) in net profit last year, up from 2.91 billion yuan (US$371 million) in 2004. China Life chalked up 5.81 billion yuan (US$741 million) in net profit in the first half of 2006, a whopping year-on-year increase of 61.7%, the company said.

click to enlarge
China Blue Chips chart 2

The only significant pullback in the Chinese H-share index and FXI since early October occurred on November 27-30th, after Chinese central banker Wu Xialong warned that excessive availability of funds in the money markets may lead to asset price bubbles. “The basic situation now is that liquidity is excessive, this is very dangerous. The central bank’s growth targets for the M2 money supply and bank lending have not been strictly met,” Wu was quoted as saying.

China’s 7-day repo rate briefly erupted to as high as 3.9% amid fears that the Chinese central bank was ready to take strong action to drain liquidity from the local money markets. On Oct 27th, the PBoC had lifted bank reserve requirements by half-point to 9.00%, with no material impact on the Chinese money supply. The yield on the 7-day repo has since plunged by 2% to 1.92%, once traders understood that the PBoC was bluffing, and wasn’t prepared to tighten liquidity to bust the stock bubble.

Downside Risk from Sino-US Trade Imbalance

But there is a downside risk from the massive Sino-US trade imbalance. If Beijing wants free and un-fettered access to US consumer markets for its exports, it must continue to buy US debt at historically low interest rates. Still, Democrats who will control both houses of the US Congress in 2007 are expected to enact protectionist legislation against Chinese-made imports next year.

On Dec 7th, the People’s Bank of China issued a warning to Democrats, who are angry about the loss of 3.1 million US manufacturing jobs to China over the past four years. ”If the US current account deficit continues to grow faster than GDP, then the investment value of US assets may be subjected to doubts and the willingness of investors to continue holding and buying US bonds may weaken,” the PBoC said.

That followed a warning by Chinese central banker Xialong on Nov 24th, “Firstly, long-term interest rates are falling, reducing returns on bond investments. Secondly, the exchange rate of the US dollar, which is the major reserve currency, is going lower, increasing the depreciation risk for east Asian reserve assets,” she said.

China Suffers Big Losses on US Bonds

According to currency traders in Hong Kong, Beijing is expected to allow the dollar to depreciate 5% to 7.44 yuan within the next 12-months from 7.815 yuan today. That would translate into more losses for the Chinese central bank on its US dollar bond portfolio. In terms of yuan, Beijing has already lost 10% on its depreciating US 10-year Notes since the second quarter of 2005.

The big question is: are there enough nervous Republicans worried about electoral defeat in 2008, who are ready to cross the isle and vote for tariffs on Chinese imports, to override a Bush presidential veto? If yes, the Chinese stock bubble would be in danger of a hard landing. “Greater flexibility for China’s currency is overdue. Postponing further reform not only endangers our bilateral economic relationship, but also puts China’s prosperity at risk,” warned incoming Senate Finance Committee Chairman Max Baucus, a Montana Democrat, on Dec 15th.

Source: Chinese Blue Chips Soar to the Stratosphere