More On The China Trade

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Includes: ASHR, FXI
by: Owen Williams, CFA

Summary

China slowdown fears are exaggerated.

Trade Chinese stocks, not the economy.

The “buy China /sell U.S. trade” is still in early stage.

Chinese A-share (Shanghai-listed) equities have come alive over the past 6 trading sessions, with the FTSE China 50 up close to +28%. While all the focus has been on U.S. stock performance this year (with the S&P 500 setting record highs almost each day), Chinese equities have been the stealth outperformer. Last June, we recommended rotating portfolio holdings into China A-share stocks and reducing U.S. stocks (see U.S. Stocks Too High? Don't Forget About The Other Economic Superpower). From the end of June through the close of markets today, the CSI 300 Shanghai Composite is up +46.4%, the FTSE China 50 up +48.8%, while the S&P500 (NYSEARCA:SPY) is up +5.75%. For those who rotated out of U.S. stocks and into China last June, that makes a roughly +43% relative gain. Not bad.

Today we reaffirm our call for continued outperformance of Chinese shares relative to U.S. shares. While the near-term spark for the move in Chinese shares was last week's surprise rate cut by the People's Bank of China (PBOC), we believe several dynamics will work together to power Chinese stocks significantly higher through 2015, including

  1. further government stimulus measures,
  2. anticipations of a bottoming economic cycle,
  3. the opening of the mainland market to off-shore investors,
  4. a continuation of the transition of the Chinese economy to more balanced growth drivers.

At the same time, contrary to the China A-share market which is beginning a new cyclical bull, we have been arguing that U.S. equities are a crowded trade and the U.S. bull market will sputter out in the coming quarters.

Stock Friendly Stimulus Measures

People's Bank of China (PBOC) surprised financial markets by cutting the benchmark one-year loan rate by 0.4 percentage points to 5.6 percent on Nov. 21 in order to shore up growth. Analysts see more moves in coming months as the economy continues to bump along. To maintain the official 7.5% growth target, Chinese authorities will likely intensify easing efforts in December to accelerate growth momentum.

Moreover, the success of Federal Reserve extraordinary monetary policy measures in inflating asset prices has not gone unnoticed at other central banks. The Bank of Japan (BoJ) is actively deflating and today the European Central Bank (ECB) moved towards asset purchases. In a world of competitive devaluation, The PBOC will not be left behind. And what monetary stimulus did for U.S. stocks over the past five years, it's certainly reasonable to expect a similar impact on Chinese stocks.

Trade the Stocks, Not the Economy

As in other countries, we also observe within China a disconnect between equity performance and the economy. Given that the economic malaise of China has been fully priced into share prices, the moderation of the Chinese economic slowdown argues for increasing exposure to China now. Those who wait for GDP growth to return to +12% will likely miss the majority of the upcoming bull market in China. Consider :

The slowdown in Chinese GDP growth has stabilized around +7.5% on an annual basis for about two years. With this relatively tepid growth rate priced in, equities are vulnerable to positive growth surprises.

The China PMI index eased to an eight-month low of 50.3 last month but still indicating a modest expansion in activity. At the same time, the downtrend in the Leading Economic Index has bottomed and may be reversing.

China's housing prices fell for a seventh straight month in November, but the rate of decline continued to taper off as government measures to revive the market are taking hold. It appears from the chart below that housing indicators have reached a cyclical bottom.

And the time to buy Chinese equities is BEFORE the housing market recovers.

Shanghai - Honk Kong Connection

Shanghai-Hong Kong Stock Connect is a securities trading and clearing links program between the Hong Kong Exchanges and the Shanghai Stock Exchanges aiming to achieve a breakthrough in mutual market access between the Mainland and Hong Kong. The upside of this initiative to open the mainland market is that eventually all Hong Kong and overseas investors will be allowed to trade Shanghai A-share securities. The long-awaited launch of the Shanghai-Hong Kong Stock Connect last month should, over time, increase aggregate demand for A-shares and arbitrage away the current divergences between dually-listed Chinese company A-share and H-share performance. As more foreign money flows into the Shanghai exchange, the net result will be a higher, liquidity-driven market.

Transitioning Chinese Economy Will Further Boost Stocks

In the meantime, China continues to rebalance its economy more towards domestic consumption. We previously evoked the comparison with the South Korean economy, which itself transitioned from an export-driven economy to a more balanced export-domestic demand model from 1984 to 2007. The chart below overlays the performance of South Korean equities during the 1984 with Chinese equities since 2003. While the path of the CSI 300 will not reflect perfectly that of the Kospi, we foresee Chinese equities also being characterized by sharp cyclical markets before the Chinese economy reaches a balanced, more stable composition of GDP growth. When this transition is complete, Chinese companies should reap the benefits of both a strong (U.S.-style) domestic demand plus full economic integration with the West. Investor should enjoy a multi-year bull market, perhaps on the order of the Korean market in the final phase (+1000%).

Our Favorite Sectors

We previously recommended using the A-shares ETFs in the U.S. (NYSEARCA:ASHR) or Hong Kong (2823 HK) and not the popular U.S.-traded iShares China Large Cap ETF (NYSEARCA:FXI) based on the Hang Seng China Enterprises Index, or H-shares. The A-shares ETFs are up nearly +50% since June, while the H-shares ETF is up only +10%.

However, we prefer to spread out and make sector bets in China. The private sector and foreign investments have been strong drivers of economic growth in China. The MSCI China broad market index, however, is made up of mostly - over 90% - state-owned enterprises. Financials, such as the big banks in China, account for about half of the market cap. To diversity into higher growth sectors, we recommend considering Consumer Discretionary and Tech stocks. As China moves to a domestic-demand driven economic model, these sectors should outperform.

Again, we see that the A-shares Consumer Discretionary index has largely outperformed the H-shares Consumer Discretionary index. For a list of liquid, investable ETFs on these indexes, click here.

Conclusion

The Chinese stock market cycles are highly decorrelated with both the Chinese economy and the U.S. stock market. The drivers are in place for a new equity bull market in Chinese A-shares, while the U.S. equity bull is getting tired. We recommend that asset allocators continue to move out of U.S. stocks and into mainland China stocks.

Disclosure: The author is long ASHR, ASHS.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.