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Summary

  • A plethora of good data has pushed the Shanghai Composite to a six month high.
  • The Chinese government has largely resisted temptations to push through a major stimulus package.
  • Still many risks, including a potential real estate bubble, remain and investors should be cautious.

China's economy has been one of the biggest question marks within the global economy. Up until last month, factory output had been dropping while exports had stagnated and the government largely eschewed any major stimulus plans. It appears that the government's patience is paying off, however, as Chinese stock markets have surged to a six month high.

China's benchmark Shanghai Composite Index rose 2.3% to close at 2174.36 points on Monday. The composite closed slightly lower than an intraday high of 2181.50. This marks the fifth straight session that the composite closed on a high note, and marks a 2.6% gain on the year, which contrasts with a 6.8 percent decline for the whole of 2013.

Growth Fueled By A Variety of Factors

So what's behind this recent growth? First, China's manufacturing sector appears to have recovered from contractions in four of the five months to start the year. Only in February did China's HSBC flash PMI show slight growth. In June, however, China's HSBC Flash PMI recorded a reading of 50.7, representing tepid growth. For July, the Flash PMI is being projected at 52.0, which would represent an 18 month high. Given how important manufacturing is for China's economy, this news has certainly fueled optimism.

For the first half of this year, industrial profits have risen 11.4%, year-over-year. Perhaps best of all, earnings accelerated in June and appear to be building momentum. In June alone, profits were up a staggering 17.9 percent, year-over-year. What's driving this growth? In short, sales have been growing while costs have been decreasing, which is bolstering bottom lines.

Meanwhile, retail sales are growing on both a year-over-year and month-over-month basis. In June of 2014, retail sales grew 12.4% YOY, following a 12.4% gain in May. On a month-to-month basis, June retail sales grew .96% from a month earlier. Retail sales have become especially important as the Chinese government has been working to wean the domestic economy off of its dependence on exports.

Despite Optimism, It's Better For Investors To Sit This One Out

Regardless, it may be better for investors to hold back major investments in Chinese stocks. China's economy is still plagued with potential pitfalls and there are simply too many uncertainties to justify investing given the somewhat limited upside. While the global economy is growing, this growth itself has been tepid, which will restrain China's exports, weighing down on the economy as a whole. Meanwhile, labor costs and the costs of doing business have been inching upwards as China continues to develop.

At the same time, the Chinese government has been avoiding major stimulus packages, and has shown a willingness to sacrifice growth, rather than risking any major market manipulations. In the midst of the 2008 Financial Crisis, the Chinese government was quick to inject cash through a variety of local level stimulus programs, handing out cash to cities and encouraging them to take on loans. Instead of driving economic growth, however, these programs resulted in a lot of bad debt being taken on by local level governments. The Chinese government is now looking to avoid a repeat.

For now, China's potential property bubble, as well as troubles in local government loans, create a lot of risk. Unless investors are looking to add risk to their portfolio, it would be better to wait and see how the housing sector, as well as other potential trouble spots, sort themselves out.

Source: Chinese Stocks Surge To 6-Month High, But Investors Should Exercise Caution