The discrepancy suggests China’s trade recovery in December was inflated by fake invoicing to skirt capital controls and profit from the difference between the yuan’s exchange rates in on-shore and off-shore currency markets.

In a twist to fake invoicing in 2013, when the government said export and import figures were overstated due to the phony trade to bring money into the mainland, the refreshed practice has more to do with capital outflows from China. Outflows jumped in December, with the estimated 2015 total reaching $1 trillion, Bloomberg Intelligence estimates show.
Offshore Affiliates

"The divergence of trade data indicates a potential use of the trade channel for financial arbitrages," said Raymond Yeung, a Hong Kong-based senior economist at Australia & New Zealand Banking Group Ltd. Given how the spread between the onshore and offshore yuan widened in December, exporters and importers "may move funds across the border through trading with offshore affiliates. By blowing up trade figures, traders may potentially receive a larger forex quota to move their funds abroad."

 

The above news of record capital outflows acted a drag on the stock market today with the A-Share Index dropping below the psychological 3000 level to extend the downtrend. 

Two, pessimism is setting in just when the city's benchmark interbank borrowing rate is climbing. To the extent Singapore banks' net interest margins in recent years have been hostage to the abundance of cheap money, investors had a reason to be optimistic. Clearly, China-related jitters are trumping any hopes of them being able to turn their low-cost deposits into higher-priced loans, especially without a revival in the property market:

Three, the pecking order has changed since China's shock Aug. 11 devaluation. Before that, UOB, the smallest of the trio by market value, had the lowest price-to-book ratio. Now it has the highest. Interestingly, this shift has occurred even as analysts have marked down their estimates of UOB's 2015 per- share earnings by almost 3 percent over the past four weeks. It seems investors are giving UOB the benefit of the doubt because of its lower exposure to Asia's biggest economy:

Ultimately, though, it's impossible to accurately assess Singapore banks' actual vulnerability to a China meltdown. All three are regional lenders with significant corporate loan books at a time when companies in Asia are facing deep distress because of the way China's flagging demand for commodities has caught them off guard. Ripples in the high-yield bond market are giving a strong signal that 2016 may well turn out to be a year of accelerated loan-loss provisions for them. Investors may be right to seek cover.

Singapore has benefitted enormously from its status as a private banking centre over the last decade. The rise of China, India and wider ASEAN has created plenty of demand for the strong governance and professionalism to be found in the city state. That’s worth remembering as the banking sector is buffeted by currency market volatility, China’s slowdown, the commodity bear market and rising interest rates. 

The city’s government bonds tumbled, pushing the 10-year yield to the highest level in 15 months and Hong Kong’s Hang Seng Index of shares dropped the most since Aug. 24 and as rising local borrowing costs threaten to further brake an economy reeling from a collapse in Chinese shares and the slowest growth in the mainland in 25 years. The yuan’s slide to a five-year low in the first week of January triggered weakness in emerging Asian currencies this month, led by a 3.4 percent drop in South Korea’s won.

 “It’s like an attack all fronts on Hong Kong,” said Nordine Naam, global macro strategist at Natixis in Paris. “Investors are getting more and more risk adverse, especially with regards to China and so they’re getting out of the region. For the time being, Hong Kong has lost its safe haven status.”
Hong Kong Monetary Authority Chief Executive Norman Chan said Monday he expects the local currency to decline to the lower limit and reiterated his commitment to keeping the linked exchange-rate system. It had traded at the strong end of the range as recently as Jan. 4. He said Wednesday that the International Monetary Fund is also a supporter of the mechanism.

Hong Kong brought in the peg in 1983 after a 30 percent plunge in the local dollar’s value led to panic buying of rice and other staples. Former HKMA chief Joseph Yam in 2012 called for a review of the peg, having in 1998 conducted $15 billion of stock purchases to fend off speculative attacks on Hong Kong’s equity and currency markets.

“The Hong Kong dollar is a victim of all the risk aversion across global markets given what’s happening with China,” said Tommy Ong, managing director for treasury and markets at DBS Hong Kong Ltd. “Dollar pegs across the globe are under pressure but I trust that the Hong Kong peg will stay in place because there are no better alternatives given the volatility we’ve seen with the yuan.”

 

Following a visit to Hong Kong in October I came away with the impression that housing was drastically overvalued and the impending change in the US interest rate cycle would be bad news for the sector. There is a running argument on the ability of the US economy to tolerate the strength of the Dollar but a consensus is evident in the belief a number of countries and regions maintaining Dollar pegs can ill afford currency strength at the present time. 

Bialas estimates that a “big chunk” of Aussie underperformance came from the unraveling of carry trades that involved, in particular, borrowing euros at near zero percent to buy a currency linked to a higher benchmark rate. The Reserve Bank of Australia cash rate currently stands at 2 percent and policy makers have signaled a reluctance to take it any lower.

Australia last month capped its strongest year for job growth since 2006, with the country’s services sector propelling gains as the mining industry cooled.

“I expect the Aussie-U.S. dollar to bottom sometime in the second quarter,” Bialas said, “as improved competitiveness of sectors unrelated to mining, a strong labor market and a recovery in inflation will give rise to speculation about the return of the RBA to raise interest rates later this year.”

 

Few developed markets are as exposed to China as Australia so the relative weakness of the Australian Dollar has been a reflection of stress in its largest export market. With Chinese government yields testing the lows seen in 2008 the potential for measures to support economic growth to be announced is growing and that may act to stem the Aussie’s decline.  

It’s clear that they have responded very poorly and very erratically so far, especially in the past year,” said Eichengreen, author of “Hall of Mirrors,” a book analyzing the crises of the Great Depression and the Great Recession. “They can’t quite decide if they want the exchange rate be more flexible or not, they can’t communicate clearly to the markets.”

The measures to shore up the Chinese currency and plug an outflow of capital risk setting back the long-held goal for an internationalized yuan. The People’s Bank of China said Monday that lenders in offshore yuan-trading centers will now have to lock away a share of deposits in its accounts, ending the exemption for foreign institutions in a push to curb speculation against the currency. That followed large-scale intervention in Hong Kong last week that sent yuan borrowing rates in the city soaring to a record as liquidity was temporarily crunched.

 

In the West we are accustomed to viewing markets through the lens of economics, fundamentals, technicals, and at this service the behaviour of investors. However with China we also need to have a view on the political machinations of the market and the uncertainty widely different personalities can have on the complexion of that market. 

“This rebound could be a sign that global markets are calming down a little,” said Pedro Ricardo Santos, a broker at X-Trade Brokers DM SA in Lisbon. “We expect to see a recovery for equities this week, though we’re not yet talking about a strong rally from here. Concerns about commodities prices will persist, and pressure on those sectors continues to be very high.”

Investor fear that turmoil in China’s stocks and currency will spread to the global economy has spurred declines in world markets this year, wiping about $5.4 trillion off the value of international equities. Mining companies have suffered the most in Europe, with a gauge of regional commodity producers sliding 15 percent so far in 2016. 

 

The Eurozone is not raising interest rates. In fact since the ECB has only one mandate and that is to achieve inflation close to, but not above, 2% it is looking more likely than not monetary will be looser rather than tighter for the foreseeable future. Despite turmoil on a number of fronts monetary policy is likely to be a tailwind more often than not over the coming years. 

Analysis by Bloomberg Intelligence Economics suggests a drop in the yuan to 7.70 to the U.S. dollar could return export growth to 10% year on year by end-2016 and add 0.7 percentage point to GDP growth. A slide to that level could also result in capital outflows of around $670 billion, though that appears manageable given the People’s Bank of China’s large foreign exchange reserves.

As I discussed yesterday China needs a weaker currency and the question is really in what way it is going to achieve that goal. Despite that fact, the last thing the administration wants is to engender panic so it is reasonable to expect some measures to support the currency will be implemented to allow the short-term oversold condition to be unwound. 

The only other leader to have given a precept speech to the military in the 67-year history of the People’s Republic of China was Mao Zedong, who did so in 1952 and 1953.

Xi, who is also chairman of the Central Military Commission (CMC), used the speech to call for his military reform plans to be fully implemented.

Xi’s ambitious modernisation plan would completely remodel the army, which was established in Mao’s era, and would therefore put him on a par with – or even higher than – Mao in terms of his military authority, said Chen Daoyin, an associate professor at Shanghai University of Political Science and Law.

“No other former CMC chairman – Deng Xiaoping (???), Jiang Zemin (???) or Hu Jintao (???) – has given a military precept before, which means Xi’s power and authority is even higher than them,” said Chen.

Zhang Lifan, a party historian, said the phrase “Xun Ci” suggested a sense of sternness and admonishment towards the lower ranks.

“It also signals Xi’s discontent and anxiety over the status of the army – the rampant corruption and the Soviet-style command structures,” he said.

Xi was showing assertiveness in the overhaul to remove any resistance from within the army, said Zhang.

 

Xi Jinping is head of state, head of the military, minister for foreign affairs and controls the economics portfolio. As if that is not enough he is also attempting to push through an aggressive reform agenda which would modernise the army and clamp down on corruption, trying to rationalise overcapacity in steel, coal, cement and managing a slowdown in the housing market. With so many ambitious targets he is stepping on a lot of toes and needs the military on side if he is quash dissent within the Party. 

“Investors rushed to the door during the level-one stage of the circuit breaker as they fretted the market would go down further,” said William Wong, the head of sales trading at Shenwan Hongyuan in Hong Kong.

Spiraling losses on the first day of China’s circuit breakers show how measures meant to help restore calm to one of the world’s most volatile equity markets risk doing just the opposite. The selloff could spur policy makers to “fine tune” the new rules, according to Andrew Sullivan, managing director for sales trading at Haitong International Securities Group Ltd. in Hong Kong. Unlike similar circuit breakers in markets including the U.S., the threshold for trading halts in China is low enough that they would have kicked in 20 times last summer alone.

Circuit breakers are the latest effort by Chinese authorities to tame swings in a stock market where the growing use of leverage by individual investors drove an unprecedented boom -- followed by a $5 trillion bust -- in the span of just a few months last year. The CSI 300 index of the nation’s biggest companies rose or fell by 5 percent 20 times from the start of June through early September, with daily moves exceeding 7 percent on half of those occasions.

Chinese shares began Monday with losses after data showed manufacturing contracted for a fifth straight month and investors anticipated the end of a ban on share sales by major stakeholders at the end of this week.

 

In the West we are accustomed to monetary policy decisions and economic statistics having an influence on the market and investor psychology. These also play a role in how Chinese investors make decisions but the fluidity of the regulatory framework and the government’s direct involvement in equity market have an even greater influence. 

Other measures suggested by the CSRC include forcing traders who use automated orders to provide a detailed description of their strategies to regulators and wait for a review before they’re allowed to execute trades. That proposal has raised concern among some international investors who don’t want to disclose their proprietary trading algorithms, according to Calvin Tai, the head of global clearing at Hong Kong’s stock exchange.

Clinton, the front-runner to win the Democratic nomination for president, called for a fee on canceled orders in October and explicitly linked the idea to curbing high-frequency traders. Her plan is designed to target “harmful” high-frequency trading that makes markets “less stable and less fair,” Clinton’s campaign said at the time. 

For every 27 orders placed on U.S. stock exchanges, about one is filled, according to data from the U.S. Securities and Exchange Commission. In other words, approximately 96 percent of all orders sent to U.S. equity markets are canceled.

China wouldn’t be unique in trying to limit canceled trades. Traders using Frankfurt-based Deutsche Boerse AG’s stock market are restricted from submitting an excessive amount of orders that don’t get executed. Borsa Italiana has a high-usage surcharge to prevent orders from getting too far out of whack with the number of actual trades.

 

China introducing a fee for cancelled orders will certainly put the brakes on spoofing. Demanding firms submit their strategies to regulators for ‘approval’ before they ever enter the market probably means China’s high frequency trading environment will remain a domestic affair. 

I can’t but think that the introduction of these rules is ironic since high frequency trading is in its infancy in China. The USA needs these types of rules while China needs better protections on insider trading and traditional market manipulation which it has been notably slow in introducing. 

To be sure, the current focus on supply-side reform isn’t unique. In 2013, the State Council published a list of industries it said were suffering from chronic overcapacity.

"China is slowing down rapidly, so giving up demand management is not an option," said Yao Yang, dean of the National School of Development at Peking University. "Supply- side reform is a long-term process and in the short term it can hardly show an effect. China needs more demand now, we need to utilize the capacity rather than simply cut it."

So while the pendulum has swung to the supply side for now, Xi must also keep growth ticking over to maintain political backing for policy changes ahead.

"Structural reforms will be undertaken, as long as growth does not collapse below the targeted levels," said Stephen Jen, co-founder of SLJ Macro Partners LLP in London and a former International Monetary Fund economist. "All of the reforms are meant to enhance the quality of growth, rather than ‘quantity.’"

 

China’s overcapacity in steel, coal, cement etc. represent major challenges but this is not new. These issues have been discussed at length by economists for almost a decade. What is new is the administration is finally talking about doing something about it. 

An adjustment of that scale cannot be undertaken without other areas of the economy providing support. Changes to the one child policy, the houkou registration system of residency and expanding social services are all aimed at enhancing the consumer and services sectors in order to mitigate the impact of rationalisation in the industrial sector.

The IMF endorsement is a bright spot in what has been a tumultuous year for the world’s second-biggest economy, which has been buffeted by slowing growth, a tumbling stock market and a shift by authorities toward a more market-oriented exchange rate.

Approval is unlikely to have much impact on short-term demand for the yuan, given the SDR’s minor share of global reserves, according to economists at banks including HSBC Holdings Plc and ING Groep NV. But the backing of the IMF, as well as the financial reforms required for China to secure and maintain it, could propel use of the yuan past the pound and yen over the medium term, said Viraj Patel, a currency strategist at ING Bank in London.

"We’re going to see sort of the emergence of a renminbi trading bloc," mostly composed of Asian countries, Patel said in a phone interview before the decision, using the official name which means “the people’s currency” in Mandarin.

The decision should boost efforts by Xi to open up China’s financial markets. China implemented a series of reforms to win IMF support, such as opening its onshore bond and currency markets to foreign central banks and reporting its reserves to the IMF.

 

This is a public relations success for Xi and his administration but is unlikely to have any influence on the Chinese intent to devalue its currency as it attempts to support its export sector. 

A record 974,926 international students were enrolled at accredited two- and four-year U.S. schools for the 2014-15 school year, a 10% rise over a year earlier, according to the Institute of International Education. About one-third of those students—304,040—are from China. 

A link to the full article is posted in the Subscriber's Area. 

While in China two weeks ago the media was abuzz with the USA’s “provocation” of China in sending ships into the South China Sea. There is no doubt the geopolitical environment is increasingly tense as China flexes its muscles and its neighbours are understandably worried. The question for us as investors is how much weight we should lend to these considerations? 

Margin financing, which shrank by more than half during the rout, has been rising for six straight weeks as the Shanghai Composite Index bounced back into a bull market. The decision to tighten investor access to the loans comes a week after regulators lifted a freeze on initial public offerings, removing one of the key measures of support for equities.

"That wasn’t expected by the market, so investors will probably react negatively," said Wu Kan, a Shanghai-based fund manager at JK Life Insurance Co. "The regulators want margin trading to increase in an orderly manner. Brokerages will probably bear the brunt." China stock-index futures dropped 1.9 percent in Singapore at 6:31 p.m. local time.

Margin debt and volume rose “rapidly” in recent weeks as some investors bought shares trading at high valuations, the Shanghai exchange said in a post on its Weibo account explaining the rule change. The move will help reduce leverage and ensure “healthy development” of the market, it said.

Officials face a balancing act: if they crimp margin financing too soon, it could derail the bull market and reduce household wealth in an economy increasingly reliant on consumer spending. If they wait too long, the build-up of debt could threaten stability in the financial system and magnify the next market downturn.

 

The Chinese authorities might have been reading Aesop’s fable of the tortoise and hare when they decided to double margin requirements. They have experienced the speed of both a climactic advance and decline and would much prefer to see the stock market advance but at a modest, less exciting pace. 

I have compared Shanghai in 2015 to Boston in 1970 with the genesis of the investment industry led by Fidelity and other major fund management houses. Apart from the US$3.5 trillion of China’s official reserves, there is another US$9 trillion in Chinese household bank deposits. In November, I expect that the IMF will certify the renminbi as one of the 5 global reserve currencies in the SDR (Special Drawing Rights). China must respond, by liberalizing its capital account over the next 12 months, and allowing its citizens to invest more overseas. Even if (a conservative estimate) 20% of the total savings in China were to be invested overseas, it will have the effect of a major wave of capital coming into global financial markets led by Hong Kong (which we see as the prime beneficiary), but followed by London, New York, and other major financial centers.

This time Chinese capital will not only target property, it will be invested in companies, in technology, in western consumer brands, and in good quality dividend paying shares in the US, Canada, UK, Australia, and elsewhere. The example of Li Ka-shing is not irrelevant. He has been criticized by commentators for taking money out of China and investing it in these Anglo-Saxon jurisdictions, in telecom, water, and power utilities. In my view, he is a very smart, canny, and far-sighted investor. (This month, our research team visited Mr Li’s flagship company, CK Hutchison and were encouraged that their Watson’s pharmacy chain is opening 365 new shops each year in China.)

I believe that the liberalization of the Chinese financial sector is the biggest thing happening in the global capital markets in the next decade. Comparisons may be drawn with Japanese capital in the 1980s, but this Chinese wave is 10 times bigger and will last a lot longer. As yields on RMB deposits are steadily reduced (and the same in Indian rupee deposits), so the thirst for yield will bring Chinese investors, as it once did Japanese investors (the famous Mrs Watanabe) into western equities.

 

A link to the full report is posted in the Subscriber's Area. 

The announcement last month that the wide difference between the Chinese lending and deposit rates would be liberalised is a major step for financial sector but if the below spread is any guide there has been little progress so far.  

At a spread of 275 basis points the banking sector does very well from this situation but depositors are de-incentivised from holding cash. This has contributed to the casino nature of the stock market and also to the growth of the shadow banking system. Allowing banks to compete for deposits by raising interest rates would be a positive development for the economy and would help dispel some of the opacity that plagues the sector. 

Spending time in China is always an educative experience for me and on this occasion I spent 10 days in Guangzhou and Shenzhen with a brief sojourn in Hong Kong. Mrs. Treacy and I celebrated our 10th wedding anniversary and in a decade of visits to China one takeaway is that costs have risen considerably over that time. 

I met one very interesting factory owner who highlighted that fact. He produces filters and papers for hand rolled cigarettes. Business is booming. With the continued expansion of the marijuana legalisation trend he has seen his USA business expand from 4,000 locations to 18,000 in two years.  He is Belgian and owns 50% of a factory in Shanghai producing these products. Wages are approximately €400 per month. They have tackled the issue of rising Chinese wage demands by hiring Vietnamese, Cambodian and Filipino workers. This was the first time I have heard of China importing cheap labour but it is a logical step. He also mentioned another Dongguan based factory he deals with which is Indian owned and is moving their entire operation to Indonesia where wages are closer to €150 a month. 

Chengdu Xingrong Environment Co. also jumped by the daily limit. China will promote price reform in water, oil, natural gas, electric power and transportation sectors, the Xinhua News Agency reported, citing guidelines on promoting price reforms released by the State Council.

“SOE reform is the catalyst that will ultimately drive this market and indications are that this is certainly ramping up,”

Douglas Morton, head of Asian research at Aviate Global LLP, wrote in a note. The measures will include commodity price reform, consolidation of excess capacity sectors, asset sales and asset injections, as well as mixed ownership, he said.

The Communist Party of China Central Committee will hold a key meeting during Oct. 26-29 to deliberate on an economic and social development plan for China over the next five years, according to Xinhua.

Official data due on Oct. 19 will probably show China’s economy grew 6.8 percent in the third quarter, the slowest pace since March 2009, according to the median estimate of 25 economists in a Bloomberg survey. The government’s growth target for this year is 7 percent.

It is a well-known fact that China has built up substantial overcapacity in a wide range of sectors which is contributing to fears the economy is in for a hard landing.  The Chinese administration knows this better than any of us not least because so many senior officials have vested interests. Above all else the Communist Party is interested in holding onto to power and the only way they are going to do that is to continue to deliver on the China Dream Xi Jinping talks about. Rising living standards can be achieved in a number of ways but more affordable housing and greater opportunities in the service sector are two major priorities. 

“There’s still pent up demand coming into the market, especially over holiday periods,” Vitaly Umansky, a gaming analyst at Sanford C. Bernstein, said by phone referring to arrivals in Macau. “It would be a bad indicator if there were no growth or a decline in visitation.”

There are also indications that betting volumes in Macau got off to a “strong start” during Golden Week, according to an Oct. 7 note by Daiwa Securities Group Co.

The picture in Hong Kong may be grimmer. Some retailers there saw sales shrink, sometimes by a double-digit percentage, during the first two days of October, compared with a year earlier, according to the Hong Kong Retail Management Association. And the comparison wasn’t coming off a high base because shops in the city last year were hit by pro-democracy protests that blocked key shopping districts and prompted some stores to shut.

Signs also point toward Macau and Hong Kong losing their luster among Chinese tourists. Though they were the top choices last year, Japan and South Korea became the most popular destinations for Chinese tourists during the first four days of Golden Week, according to a recent Credit Suisse Group AG report.

 

Hong Kong benefitted enormously from the Fed’s low interest regime but has been through a tougher time recently with democracy protests, Li Kai Shing taking flak from the Communist Party, the potential for interest rates to rise, the strength of the US Dollar and the slowing Chinese economy. Add to this the fact the Yen and Won, which enhanced their attraction as tourist destinations, and the domestic market has been under pressure. 

An Alibaba-Tencent tie-up in local services would mirror the creation of Didi Kuaidi this year via a merger of competing taxi-hailing apps they separately backed. That marriage was intended to curtail an aggressive expansion by Uber and marked a rare cooperation between companies that still compete head-to-head in entertainment, e-commerce and finance.

As fundraising becomes more difficult in China, the current merger could provide advantages for both sides. It would let the Alibaba and Tencent-backed startups avoid competition with their closest rival, potentially saving money on subsidies and allowing them to collaborate on future efforts.
“The two companies merging would allow them to have absolute dominance of the group-buying market, and require less cash burn,” said Wang Weidong, an analyst at Internet consultancy IResearch in Beijing. “They will be putting a lot of pressure on competitors.”

 

China’s online businesses represent an interesting situation because they have evolved without the direct patronage of the Communist Party.  Of course they have to toe the line in terms of sustaining the political apparatus if they want to survive but that has not stopped them from developing into major private enterprises in a society that is among the most internet savvy in the world. 

Capitalism tends to trend towards concentration and this is especially true of the online sector where the barriers to entry are defined by the ability to pay for placement and broad spectrum advertising. The proposed co-operation between Alibaba and Tencent is a reflection of this fact as well as their intent to hold onto dominant positions with their sectors.  

The track record suggests that brands that have focused on productivity already in past years – such as Hermes, LV, and Cartier – are already reporting sustainable outperformance in sales and profitability. Higher levels of productivity give room to invest in the brand equity for the long term and finally create unprecedented levels of cash flow. In this volatile environment, these qualities are even more valuable than catch-up opportunities, in our view. At the opposite side of the spectrum, brands that have lower-than-average productivity are likely to face increasing margin pressure: the risk is a short-term reaction, at the expense of the brand equity, with a potentially higher toll to be paid in the longer term.

We have therefore summarized into a unique Brand Power Index the weighted average combination of the quartile ranking across seven dimensions for each brand. Three quantitative measures have received a 20% weight each: retail productivity, brand productivity, and Return on Capital. Four more qualitative and therefore discretionary variables have received a 10% weight each: pricing discipline, exclusivity, brand momentum, and organic opportunity to improve margins. Based on the relative positioning across several variables, we have identified, as shown in Figure 5, the brands that rank in top quartiles. This provides a framework, as objective as possible, to evaluate brand productivity, margin sustainability, and opportunities to improve. An interesting fact about this index is that successful implementation of appropriate strategies can help companies improve their scores.

 

A link to the full report is posted in the Subscriber's Area.

Before Xi Jinping cracked down on extravagant displays of personal wealth among the Communist Party’s elite, there was high demand for just about all luxury brands and strong commonality was evident right across the sector. The more recent slowdown in the Chinese economy has exacerbated the issues facing luxury goods with the result that there are some clear winners and losers. 

Amidst a macro slowdown, Chinese consumer upgrades continued in 1H15, illustrated by the sustainable outperformance of high-end beer, high-quality infant formula, natural water, new premium beverages, high-end diapers, etc. This favours foreign brands, and we view premiumization as the most challenging trend for local brands.

1H15 review: volumes down, prices up, input costs down
In 1H15, the combined revenue/NPAT of HK-listed FMCG stocks under DB coverage (ex-meat) were down 4%/up 2% yoy, largely as volumes were down, prices were up and input costs were down. In the midst of the macro slowdown we saw premiumization, continuous channel destocking and channel shifts. After the completion of destocking, the revenue/NPAT of the major A-share baijiu companies rose 5%/3% in 1H15, Nestle (NESN VX, Hold) recorded mid-single-digit growth in 2Q15, and Unilever (ULVR LN, Buy) returned to modest growth in 1H15 in China. Premium foreign infant milk formula, high-end diapers and beer continued to outperform.

2H15 outlook: de-stocking to ease, yet no signs of macro bottoming out 
After 12 months of channel destocking, we expect pressure to ease in 2H15, while the input cost inflation risk remains low. However, headwinds from the macro slowdown and channel shifts remain strong. Longer term, we think the most challenging trend for local brands is premiumization (both branding and product), as foreign brands are more experienced.

 

The wealth gap is China has created a challenge for domestic brands because the lower middle class has not yet achieved the disposable income levels required to afford many consumer goods while the upper middle class demand premium products and the security of quality that comes with foreign brands. 

It would appear that the Fed might have a tough decision to make on Sep 16-17 – to hike or not?  Perhaps “not” due to the shaky ground of the current China stock market and the repeated pressure from the IMF & ECB not to raise the rates? 

But hypothetically, let’s assume that the Fed will really decide to hike the rates, even with a clear statement on slow increase of rates. In such a scenario, considering that China is the biggest holder of US Treasuries, would you expect China to start unloading/selling their positions immediately?, especially if they still need to further tighten their money market in order to shore/support their ailing stock market. 

Also in the interest of other subscribers, your view would be appreciated.  

 

Reading the Fed runes has the feeling of sports punditry at present and anything we think or say is not going to sway them one iota. The Fed is going to do what it is going to do. I can only think what I would do if I had bet my career and legacy on ensuring the US economy recovers from the biggest growth scare in a century. I’d be cautious, I’d want incontrovertible evidence and I wouldn’t want to take a risk. These are sober people and the last thing they want is to risk deflation. 

Onshore/Offshore Renminbi – Today’s announcement that the Chinese government is going to permit foreign central banks greater access to the Yuan market, so they can hold the Chinese currency as part of their reserves had a marked effect on the offshore renminbi. The ratio between the onshore and offshore versions of the currency compressed sharply and helps put a lid on fears that capital flight was fuelling the arbitrage. 

China, which has been investigating evidence of “malicious” short selling since July, stepped up curbs in the futures markets on Monday. The China Financial Futures Exchange now labels a position of more than 10 contracts on a single index future as “abnormal trading.” While the bourse said the restriction won’t apply to futures used for hedging purposes, it didn’t detail how it will identify such trades. Before last month, investors could have as many as 600 contracts.

The bourse also raised fees for settling positions opened on the same day to 0.23 percent from 0.0115 percent. Margin requirements on stock-index futures contracts were lifted to 40 percent from 30 percent. For those with hedging demand, the levels climbed to 20 percent from 10 percent. Exchange officials didn’t respond to e-mailed questions from Bloomberg News on Tuesday.

Futures trading on the CSI 300 Index, a gauge of the nation’s biggest companies, shrank to just 27,899 contracts on Wednesday. That’s down from 3.2 million at the end of June and compares with the 30-day average of 1.7 million. For the CSI 500 Index of small-cap shares, volumes have dropped to 11,820 from about 144,000 a month ago.

Banning short selling was a common practice during the financial crisis and there are still pretty strict rules on naked shorting in most of Europe and the USA. Removing leveraged traders with an interest in seeing prices falling further must appear a logical step for China’s decision makers. From an analytical perspective this removes a potent source of additional supply which is a positive for the market generally. 

Thank you for your excellent service, it’s so nice to hear a calm voice every morning these volatile days! I have a short question? I want to buy Hang Seng index, there must be some with a large discount today???? All the best. A subscriber for 27 years!!!!

Thank you for your kind words and support through the years. I am delighted you are enjoying the audios and I agree that China is a lot more interesting right now than it has been for the last month. 

I have posted a query twice on the future of the HKD in your “subscriber's forum” but I never seen any response so far ?  so I reiterate my question ...

With Hong Kong being closely linked to China's economy and financials, could it be possible that the HKD be unpegged to the USD, or have the peg revised downward ?  And this, for one part due to the uncertainty of predicting the magnitude of the continuing CNY devaluation, and on the other part due to the expected FED raising the interest rate either in Sep or later this year, or early next year ?

Your valuable view as usual would be always appreciated .

Thank you for a question of general interest and we are looking into why the system has difficulty with your email address. The G-20’s platitudes regarding no country actively seeking a competitive advantage through currency devaluation aren’t very well supported by the price action. Today’s news of a booming Germany economy versus the slowing Chinese economy highlight just how much the Eurozone has benefitted from its currency decline. 

“I’d expect the government to be reducing intervention,” Mobius, the Franklin Resources Inc. money manager who’s been investing in emerging markets for more than four decades, said in an interview in Hong Kong on Friday. “They realize it’s not working.”

Authorities may be more receptive to declining share prices now that the country’s World War II victory parade -- seen as a platform for President Xi Jinping to project China’s strength on the world stage -- has passed without incident. Mainland exchanges, shut since Sept. 2 for national holidays to celebrate the war anniversary, reopened today facing a range of indicators that suggest investors see more declines.

An important question that needs to be discussed is how much of the advance in Chinese stocks from November 2014 was predicated on bluster and hype and how much was based on fundamental value. There is no doubt that a great deal of the hype has been squeezed out of the market but there is incessant discussion about where prices for individual shares will find support. 

This is entertaining but the most worrying report that I’ve read about China’s economy.  Could the situation have changed so much since your visit? 

Thank you for this article highlighting how many commentators are now using Alibaba as a barometer for Chinese consumer sentiment. Here is a link to the report I wrote on my most recent trip to China in April. 

Ambrose Evans-Pritchard in his superb piece in the DT today designates the offshore/onshore Yuan rate as the key canary in the coal mine for further financial stress. Where can we find / how can we follow the offshore/onshore Yuan rate in the chart library?   

 

Thank you for highlighting this article which draws parallels with a range of historical events before highlighting that China is where the epicentre of risk lies. Here is a section from the conclusion of the article:  

Another stop-go cycle is picking up. Each time it is weaker, but it is still enough to delay the denouement until next year, and next year is an epoch away in market time.

Li Keqiang said on Wednesday that conditions are "bewildering" but that "the exchange rate will be kept basically stable at an adaptive and equilibrium level". He has many levers at his disposal but he is not omnipotent, and his own political future is suddenly in doubt.

Watch the offshore exchange rate for the renminbi. If that keeps spiraling further away from the inland rate, we will know that matters are out of hand, and then we really will have a global currency crisis. We are not there yet.

It has been a frightening summer. In the end you have to make a judgment call on whether this tangle of cross-currents in the world economy really is the start of another wrenching global crisis, or just a tremor. This time I refuse to join the pessimists.

The following article, seeking to explain China's recent missteps in handling its domestic stock market, is quite interesting: And congratulations on writing some excellent (& cool-headed) analysis this week

Thank you for your kind words and I’m delighted you’re enjoying the commentary. David and I have been working together since the winter of 2003 and I started filling in for him on Comment of the Day in the summers from 2004 when he used to embark on his annual Land’s End to John O’ Groats cycling holidays. Back then you could be reasonably assured of quiet markets during the sleepy summer months but that all changed in the aftermath of the credit crisis when the role of algorithmic traders took centre stage.

Historically, traders use public holidays and vacation periods to initiate counter trend positions in the hope of triggering stops for a quick profit. Computer programs have taken this process to the extreme. The most recent instance was in late July when gold sank to a new low during Asian trading while Japan was on holiday. All too often we now see times most people are on holiday and market liquidity is low fuels volatility and this is particularly true of moves in single stocks. 

The Shanghai Composite Index plunged 12 percent last week, erasing all bar one point of the rebound from July’s $4 trillion selloff. For CMB International Securities Ltd. and KGI Securities Co., the gap between the growth outlook and China’s stock valuations, which are the highest among the world’s biggest markets, means further declines are inevitable.

While the benchmark stock gauge still traded 57 percent above the levels of a year earlier through Friday, data from industrial output to exports and retail sales depict a deepening slowdown. China’s first major growth indicator for August showed the manufacturing sector is at the weakest since the global financial crisis.

The government is “trying to defy market forces at overvalued levels,” said Daniel So, a strategist at CMB International Securities in Hong Kong. Policy makers should “focus on helping the real economy instead of the stock market,” he said.

 

The Chinese administration picked the 3500 level on the Shanghai Composite as a level they were willing to defend in July. At the time the level coincided with the 200-day MA but other than that was an arbitrary figure which was high relative to the levels the Index had traded at over the preceding six years. The Index fell through 3500 this morning and the big question for tomorrow’s trading will be whether the government will continue to defend that level or pick an easier to achieve target lower down.
 

First, let's address the issue of overstating the GDP. Critics point to the country's weak industrial production, export and investment figures as proof that the country is fudging its number. Lardy, a senior fellow at the Peterson Institute of International Economics, points to a salient fact that many people choose to ignore: the biggest contributor to the country's GDP is now the services industry.

"the skeptics have taken insufficient notice of China's progress in transitioning to its new model of economic growth, one less dependent on expanding industrial output, investment, and exports and more dependent on expanding private consumption expenditure¡±, he says.

Between 2011 and 2014, the size of the service sector as a share of GDP rose by about 4 percentage points to 48 per cent and, at the same time, the share of the industrial sector dropped to 43 per cent of GDP. This is a marked change from a decade ago, when the industrial sector accounted for 47 per cent of the GDP while the service sector only accounted for 41 per cent of the economy.

Considering the size of China's economy -- it's a $US10 trillion behemoth -- the transition is even more impressive. Many services are booming in China, the e-commerce sector grew by 31.4 per cent in 2014. The entertainment sector has been growing at an average of 17 per cent a year between 2010 and 2015. In health care, McKinsey predicts the growth in spending will grow from $US357 billion in 2011 to about $US1 trillion in 2020.

 

Unfortunately the services sector now accounts for more than 50% of GDP because the industrial and construction sectors have declined so much. The services, consumer discretionary, information technology and healthcare sectors are most likely to lead the Chinese economy in a recovery not least because they are receiving a great deal of government support. However this was priced in by the impressive outperformance of the Chinext Index and Shenzhen B shares earlier this year. 

Surely a devaluation of the renmibi should be beneficial to non-Chinese companies that have their manufacturing facilities inside China. If they then export to the rest of the world they will earn other currencies and increase their profits. Which companies correspond to this scenario?

Thank you for raising this point but your question is a difficult one to answer since global companies tend to have manufacturing sites in a number of countries rather than solely in China. Until about five years ago you could have easily answered that garment and small goods manufacturers would fit your criteria but this is no longer the case since lower margin businesses have already migrated at least part of their operations abroad. 
 

The wave of declines is rooted in the problems in Taiwan's economy, Alan Tseng, vice president at Capital Investment Management Corp. in Taipei, said on Wednesday. "The electronics industry is facing the toughest competition in 10 years because of China. The index will fall below 8,000."
     
There is a "looming new bear cycle" in emerging markets, with the weaker yuan adding competitive pressures to Taiwan, Malaysia, Thailand and Vietnam because of their dependence on exports, Lim Say Boon, the Singapore-based chief investment officer at the private banking unit of DBS Group, wrote in a report dated Aug. 17. The MSCI Emerging Markets Index entered a bear market on Aug. 12.

 

China's economy is transitioning away from fixed asset investment. If it is to be weaned away from infrastructure development and housing, the value of other sectors of the economy has to increase. This explains the concerted push to develop the service and high end manufacturing sectors. In this strategy China is following the same path tread by its neighbours in their development. 

More than half of all demand for tin is accounted for by the solder which is used to assemble electronics devices such as smartphones and televisions, according to Fastmarkets, a metal research group.

China’s appetite for tin hasn’t fallen away in the way that it has for other base metals, such as iron ore, and China is tin’s biggest importer. Although this week’s devaluation of the yuan will make the metal more expensive in the Chinese market, electronics manufacturers are likely to be well-hedged and able to absorb price rises, said Ms. Bain.

Analysts see the biggest impact on prices coming from the supply side. Indonesia is the world’s largest tin exporter, with up to 35% of the global trade. New regulation this month bans all but refined products from legal mines leaving the country.

Myanmar, whose exports took off around 2011 after the fall of the ruling military junta led to the lifting of some sanctions, is a recent entrant into the tin market.

Now, though, output from Myanmar’s main tin mine is declining due to falling ore grades, and the challenges posed by the ethnic conflict raging nearby. The recent fall in tin prices also stymied investment in current and prospective tin mines, analysts say.

More than half of all demand for tin is accounted for by the solder which is used to assemble electronics devices such as smartphones and televisions, according to Fastmarkets, a metal research group.

China’s appetite for tin hasn’t fallen away in the way that it has for other base metals, such as iron ore, and China is tin’s biggest importer. Although this week’s devaluation of the yuan will make the metal more expensive in the Chinese market, electronics manufacturers are likely to be well-hedged and able to absorb price rises, said Ms. Bain.

Analysts see the biggest impact on prices coming from the supply side. Indonesia is the world’s largest tin exporter, with up to 35% of the global trade. New regulation this month bans all but refined products from legal mines leaving the country.

Myanmar, whose exports took off around 2011 after the fall of the ruling military junta led to the lifting of some sanctions, is a recent entrant into the tin market.

Now, though, output from Myanmar’s main tin mine is declining due to falling ore grades, and the challenges posed by the ethnic conflict raging nearby. The recent fall in tin prices also stymied investment in current and prospective tin mines, analysts say.

The era of yuan appreciation has come to an end with China’s move to lower the daily reference rate by 1.9 percent, said Yu Yongding, a member of China’s monetary policy committee when the currency was revalued in July 2005.

The yuan exchange rate will enter “a period of stabilization or even depreciation,” said Yu, now a researcher with the Chinese Academy of Social Sciences. The People’s Bank of China’s reduction to the daily fixing was a “symbol” for the change, although signs of yuan depreciation were evident before Tuesday’s move, he said.

The biggest slide of yuan since the peg ended a decade ago is a one-time adjustment, the PBOC said in a statement, adding it will strengthen the market’s role in the fixing and promote the convergence of the onshore and offshore rates. The move comes as sliding exports add to slowdown pressure and may add to concerns more capital will flow out of the nation.
While a weaker yuan may bolster exports in the short term, it’s a dangerous long-term way to increase shipments, Yu said.

“It would be a very wrong and stupid way to boost exports, and I don’t think China’s central bank will opt for that,” he said. “The depreciation is more of a recognition and respect of market forces.”
“The PBOC should reduce its intervention in the yuan,” Yu said. “If the market believes the yuan should be weaker, then just let it weaken.”

Yu said the yuan’s change will “for sure affect other currencies of emerging markets,” although the biggest deciding factor will be the policy stance of the U.S. Federal Reserve.

 

At The Chart Seminar in Singapore in April there was a great deal of interest in how one could hedge exposure to the Euro following its decline but not many people were interested in hedging the Renminbi since it was viewed as such a stalwart. Nevertheless, the time to hedge a currency is before the devaluation rather than after. Today’s move is not very large but it represents a powerful indication that the trend of Yuan appreciation is most definitely over. 

Do you really believe that China's propping up their stock market is any more different from the FED's Plunge Protection team's operations in the US markets?

Thank you for a question of general interest. I agree that China is certainly not the only country to offer assistance to its stock market in times of stress. The Fed has its Plunge Protection Team and Europe banned short positions during its sovereign debt crisis. Countries regularly allow their currencies to take the brunt of selling pressure with a number of commodity producers offering examples at present. Slashing interest rates and boosting money supply achieve many of the same goals. However what sets China apart is the scope of its support. 

The open-to-close strategy on CSI 300 Index contracts has returned 18 percent since July 8, when the mainland market bottomed. That compares with about 6 percent from buy and hold, after accounting for the rollover of contracts in the middle of this month.

“It seems to be an exploitable and workable strategy in the futures market, unless there is some unexpected big news,” said William Fong, an investment director for Asian equities at Baring Asset Management in Hong Kong.

The Shanghai Composite rose 2.4 percent at the close on Thursday, after opening with a 0.1 percent drop.

Like any pattern, its lifespan will diminish as more investors catch on, said Bernard Aw, a Singapore-based strategist at IG Asia Pte Ltd. There’s also the risk that state- backed buyers disappear as the Shanghai Composite approaches 4,500 -- a target Chinese brokerages cited when they unveiled a market support fund on July 4.

 

By loading purchases into the latter half of the day the Chinese authorities are buying a strong close which is what we continue to see in the chart below. On more than a few occasions since the low earlier this month the market has opened lower only to finish higher. This is achieving a rebound in the domestic market but the big question is to what extent the market can function without massive intervention. 

The year 2015 has thus far seen a frenzy of privatization offers to US-listed Chinese companies, some with an intention of subsequent re-listing back home. Questions, however, have arisen about the practicality of this scheme, with virtually no successful precedents yet. In this report, we analyze major hurdles like legal complexities, IPO procedures and timing issues. VIE set-up and unwinding, and the new foreign investment law may further hinder the privatization process. Even with early signs of relaxation of some restrictions, developments are at a premature stage. Nonetheless, we shortlist and assess 'likely go-through bids', those that screen well for a bid and "maybe not's".

Going home is more easily said than done: challenges in privatization and…
Privatization requires a significant amount of immediate funding for the share repurchase, repatriation tax and professional fees. Funding, usually raised through equity capital and debt borrowings from a consortium, largely depends on the target’s ability to generate cash flow, its franchise value and to a lesser extent, its balance sheet strength. Further, the entire process is lengthy (a minimum of 6-12 months) to complete. In addition, the offerors could face litigation from unsatisfied minority shareholders on matters such as abuse of super voting power that might even derail the whole programme.

….challenges in re-listing: complications with the VIE structure 
While some controls have been eased, there is still a long way to go for the Chinese supervisory bodies to continue their relaxation of key restricted areas such as ICP (internet content provider) license, which is a pre-requisite for almost all Chinese internet companies. Those intending to unwind these structures and return home face the risk of being disqualified on other key regulatory pre-requisites, including but not limited to: a) a continued track record of profitability after repatriation tax liabilities, b) unchanged ownership structure, c) consistent historical business operations for the entity intended for listing, d) autonomy of the company over its operations and decision-making power, and e) fairness in related party transactions.

A link to the full report is posted in the Subscribers' Area.

It is possible that the extreme volatility on China’s mainland market will deter executives from taking the decision to delist from the USA and relist in China in the same way that the surge in mainland prices encouraged them to make the decision to relocate in the first place. Generally speaking US listed Chinese companies did not participate in the run-up experienced by their mainland counterparts but have experienced declines though perhaps not as extreme as the mainland. The potential for greater upside potential for the owners is therefore perhaps the most likely motivation for relisting. 

It’s been a tumultuous month with China collapsing then staging an impressive rebound amid some extreme policy measures to stem the decline. This is not a normal situation and China is not a normal market because the state plays such a large role in controlling the trajectory of prices. In an effort to gain a greater insight into how the market is reacting to this situation I clicked through a large number of Chinese shares. 

I first started by looking for shares that might have bottomed early so performed a Bloomberg search for those that had hit 52-week lows between July 1st and 8th. The Shanghai Composite hit its low on the 9th. This gave me a list of 300 shares so I filtered it by those that still have a positive performance month to date. I then took a look at all 300 charts. 

Investors and traders headed for the doors in China related investment vehicles as mainland and Hong Kong shares crashed lower over the last month. Foreign flows reversing through the Stock Connect were a major influence in the speed of the decline and contributed to the panicky environment.  However the government is pulling out the stops and there were more than 100 shares on the Index up their 10% limit today. 

At The Chart Seminar we teach that “Acceleration is an ending of unspecified duration”. There is no doubt that the Chinese markets accelerated lower and that this has the look and feel of climactic action. Today’s strong rebound following yesterday’s steadying suggests shorts are under pressure and bargain hunters are active. 

The International Equity Library’s Performance Filter allows you to scan through the extensive lists of shares in the library and rank constituents by their performance over different time frames. Considering just how quickly Chinese shares have fallen and the impressive rebounds I thought it might be instructive to highlight some of the shares which have had the largest declines and perhaps more importantly those which have been resilient throughout. 

The outstanding balance of margin loans on the Shanghai Stock Exchange dropped for a ninth day on Thursday, sliding to 1.29 trillion yuan in the longest stretch of declines since the city’s bourse began compiling the data. A fivefold surge in borrowing had helped propel the benchmark stock index to a 150 percent advance in the 12 months through June 12.

The authorities are determined to shore up the $6.9 trillion stock market even if it means reversing reforms, according to Partners Capital International Ltd. The Communist Party’s Central Committee pledged in 2013 to make markets “decisive” in allocating resources and to limit the government’s role to maintaining stability.

“They have the whatever-it-takes mentality,” said Ronald Wan, chief executive officer of Partners Capital International in Hong Kong. “Early on Monday, the market may show a knee-jerk reaction to the measures but I am not sure how sustainable it will be. Whether it’s a rally or a decline, it’s policy driven, not market-oriented.”

And

There won’t be any new IPOs in the near future and the number and value of share sales will be significantly reduced once they resume, the CSRC said in a statement on its website Sunday.
The 21 brokers pledged not to reduce any proprietary investments in the equity market as long as the Shanghai Composite Index stays below 4,500, the association said. The measure closed at 3,686.92 on Friday. Listed brokers will actively buy back outstanding shares, while encouraging their parent companies to increase holdings, according to the statement.

The plan by trading firms to boost shares may have only “a fleeting effect” given daily turnover is nearing 2 trillion yuan, said Hao Hong, China equity strategist at Bocom International Holdings Co. in Hong Kong.

“This 120 billion yuan won’t last for an hour in this market,” Hong said by phone from Beijing Saturday. “It might benefit blue-chip stocks, as investors may see them as value, but the bursting of the bubble in small-cap/tech stocks is likely to continue.”

 

China remains a policy driven market but is presented right now with the unwinding of what has been an historically large build up in leverage. This is now declining and measures are underway to remove supply from the market in order to support prices. Allowing the state pension fund to buy shares, cancelling IPOs, funds and brokerages intervening to buy are all aimed at imposing a floor. 

“The margin call, forced sale, margin call vicious cycle can quickly develop a momentum of its own,” Cui, the head of China equity strategy at Bank of America in Singapore, said in an e-mail on Monday.

Doubts about policy makers’ ability to prop up the world’s second-largest stock market are spreading after a weekend interest-rate cut and speculation that regulators will halt IPOs failed to prevent the Shanghai Composite from tumbling into a bear market. The gauge would need to fall a further 13 percent to match its average downturn since 1990.

“Any support the government can provide would be short lived,” Chad Padowitz, the Melbourne-based chief investment officer at Wingate Asset Management Ltd., said by phone. “The only real support they can provide over time is providing a reasonably balanced, growing economy. That’s the best thing they can do. Anything they do short term, decreasing interest rates to support the market or things like that, are somewhat foolish.”

 

Expectations for future upside potential deteriorate within a range not least because they are boring and disappointing relative to the trending phases. We define ranges as explosions waiting to happen.  However, the conditioning process of these congestion areas means that the strength of the breakout is often surprising to people most familiar with the market. Following an impressive breakout from a medium-term range prices will rally for as long as it takes supply to overwhelm demand. The test of whether a new uptrend can persist into the medium-term is in the extent to which the breakout can be sustained in the ensuing period of consolidation. This is what we term the first step above the base. 

The battle will play out entirely online: The banks aren’t planning any warehousing of inventory, leaving that to the merchants. MYbank and Tencent Holdings Ltd.’s online WeBank, which launched in December, plan no physical branches.

WeBank started its consumer lending in May, where borrowers without collateral can get as much as 200,000 yuan at an annualized rate of 18 percent.

MYbank is to begin operating on Thursday as part of Alibaba’s finance arm, Zhejiang Ant Small & Micro Financial Services Group Co. It’s one of a wave of new private banks being licensed by the government to target small loans and aims to use facial-recognition software to let users set up accounts.

Alibaba already has expanded into e-finance, with its Alipay payments system and Yu’E Bao money-market fund.

“The potential of web-based services, be it financial or retail, is huge in China, so it’s not too late to join the game,” said Wang Weidong, an analyst at Internet consultancy iResearch in Beijing.

Established banks have been hamstrung by strict rules on deposit and lending rates that upstarts like Alibaba and more recently Tencent have been able to circumvent. This has allowed a new type of bank to develop online where savers are offered highly attractive rates. So far regulators have not ruled on the legitimacy of their money market funds which has allowed them to proliferate. Since major banks are precluded from this new business line they are trying to hit online merchants’ where it hurts i.e. retail sales. 

We believe part of the motivation for management teams to welcome going private deals is the belief by many investors that the China "A" share stock market may see a sharp correction within the next several months.

The Chinese "A" share stock market contains exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange, where shares of China mainland-based companies are listed. "A" shares are generally only available for purchase by China mainland citizens.~

Thus, ChinaHyrbid management teams and private equity firms may be scurrying to take advantage of the huge valuation gap between ChinaHyrbids and "A" share companies – before the "A" share market corrects – by going private and then eventually re-IPOing in China at much higher valuation multiples.

For example, the Chinex Price Index (SHE: 399006), which is the index that includes small cap growth companies in the China A share market, has an average P/E of 115 as of June 18, 2015. However, the non-binding go private price of QIHU of $77.00 is only 22 times of the analyst estimated EPS in 2015.

 

The Chinese government views the internet as just another organ of the Party’s apparatus like roads or TV stations. The challenge they have is that private sector entrepreneurs who have spearheaded the development of the Chinese technology sector have lower participation rates in the Party than other sectors. An effort has been underway to recruit more people from the technology sector into the administration. Wishing to see more companies take out listings on the mainland rather than decamping to the USA, Singapore or Hong Kong can be seen in these terms. It also helps explain the rationale behind the sweeteners currently on offer for returning companies. 

The rally in A-shares has been impressive, while the H-shares have been lagging behind in a big way. What is your view on this? I also attach a chart showing relative performance. I have lightened my position in the HSCEI but wonder if I should be looking to increase it again.

Thank you for this topical question. The Hong Kong Dollar is pegged to the US Dollar so zero interest rates have propelled property prices on the island to dizzying heights. There is a fear that when interest rates start to rise, Hong Kong will experience some pain. This is at least part of the reason the Hang Seng has underperformed but is less of an issue for the Chinese Enterprises Index (H-Shares). 

The answer is no, not yet, but it could happen before the next MSCI annual market classification review scheduled for June 2016.

On a posting on its website the MSCI noted that it “expects to include China A-shares in its global benchmarks after a few important remaining issues related to market accessibility have been resolved”.

Here’s Remy Briand, MSCI managing director and global head of research, on the decision announced this morning.

“Substantial progress has been made toward the opening of the Chinese equity market to institutional investors. In our 2015 consultation, we learned that major investors around the world are eager for further liberalization of the China A-shares market, especially with regard to the quota allocation process, capital mobility restrictions and beneficial ownership of investments. Because MSCI’s client base is so large and diverse, we have a strong interest in ensuring that remaining issues are addressed in an orderly and transparent way.”

 

The Chinese now have a blueprint for what they need to do to gain access to a massive pool of international liquidity. Considering the fact they have a vested interest in diversifying their domestic risk in sectors that drove the breakneck pace of development, we can expect measures to fulfil MSCI’s requirements over the next year. 

Since the answer was a ‘not yet’ instead of a ‘no’ the mainland stock market has been reasonably steady not least because it has been primarily driven by domestic demand. Nevertheless, the progression of higher reaction lows will need to hold if a deeper and potentially lengthy process of mean reversion is to be avoided. 

While ETFs are a small slice of the junk-bond market, they’re usually a telling gauge of sentiment, and the outflows are significant compared with the $6.7 billion of total deposits into these funds so far in 2015, Bloomberg data show.

Government yields in Europe and the U.S. are rising in the face of improving economic data and signs inflation is picking up (or, in Europe’s case, that there’s any inflation at all.) Yields on 10-year Treasuries have surged past 2.4 percent, reaching the highest level since Oct. 6, from 1.8 percent in April.

And now the $2.2 trillion world junk-bond market is losing steam, at a time of growing questions about how long stocks can keep rallying. The debt tends to be a leading indicator, and its deterioration bodes poorly for stock investors, Tchir said.

While the selloff is short-lived enough that it may just prove a blip in a market propped up by central-bank stimulus, it may also portend broader pain ahead.

 

Corporate bonds of every hue are priced against a government benchmark. This means when Treasury yields rise corporate yields follow. We see this in the yield of BB bonds which are now breaking out of a two-year range.

The spread, however, suggests that the yield on high yield is not rising faster than Treasuries.

The newly-announced Water Pollution Control Plan and the unprecedented government focus on environmental protection reaffirm our positive view on the water industry. Large-cap SOE stocks have been traded strongly, we now see more upside for smaller SOE players. They have a higher growth rate, more potential to surprise and beat market expectations, and a more attractive valuation. We initiate coverage on SIIC Environment (SIIC) and China Everbright Water (CEW) with Buy and designate them as our sector top picks.

Pollution control plan unveiled; over RMB1.9tr investment needed by 2020
The Water Pollution Control Plan released in April will lead to over RMB1.9tr of total investment in the water industry by 2020, as estimated by the Ministry of Environmental Protection. More detailed implementation plans and the 13th five-year plans will be announced by central and local governments in 2H15-
2016, unveiling tightening discharge rules, paving the way for water tariff hikes, and promoting the involvement of specialist operators.

Strong growth upholds premium valuation, leading SOEs to gain market share
New project wins should remain strong over the next few years, supporting premium valuations for the sector. Leading SOEs can gain market share in the currently scattered municipal water industry, leveraging on their better relationship with local governments and access to cheap financing. Management with a commercially-driven mindset, good employee incentive plans, and a wider footprint also help. BEWG, as the role model for the new SOE, has proven to be successful. We believe SIIC and CEW can emulate BEWG’s strong growth and emerge as leading SOE players in the sector.

 

A link to the full report is posted in the Subscriber's Area.

Southern China is a tropical region with abundant rain as well as snowmelt run-off from the Himalayas. Northern China on the other hand is semi-arid and is constantly in need of additional water. Deforestation over the last number of decades has only exacerbated this problem. The breakneck pace of industrialisation has put additional pressure on the country’s water resources and the government is finally taking heed of the dire environmental warnings it has been presented with.

On my return from China in April I created a list of Chinese water companies in the Eoin’s Favourites section of the Chart Library. 

How do you think the H-shares will be affected if MSCI (and later FTSE) add the A-shares to their emerging market indices?

The 2 futures which give easy access to the Chinese market at the moment are the Hang Seng China enterprise index and the FTSE China A-50 index.  Which of these do you think is the better bet?

China has been making efforts to open up its capital market to foreign investment. The Hong Kong Shanghai Connect is the most visible measure and the touted expansion of the system to Shenzhen suggests they are still open to additional expansion of the conduit. However it is open to question whether what has already been achieved is enough to warrant a positive decision by MSCI.  This article from the Wall Street Journal carries additional information. Here is a section:

The looming decision underscores the disconnect between the expanding role China plays in the world economy and the limited weighting China has in global investment portfolios.

In the MSCI All Countries World Index, a global benchmark, China has a weighting of 2.7%, although the country’s economy accounts for 15% of global gross domestic product.

The MSCI emerging-market index has a 25.7% allocation to China, but primarily comprises Chinese companies listed in Hong Kong.

For decades, regulatory restrictions and opaque rules set by Chinese authorities have kept foreigners away. In addition, concerns about the health of China’s economy, corporate governance and the earnings multiples that many Chinese shares trade at have led many managers to hold even fewer Chinese stocks than these benchmarks suggest.

As of 2014, foreign investors held about 3% of the Chinese market, compared with a 12% foreign stake in India, according to Qi Wang, partner at Shanghai MegaTrust Investment, an A-share fund manager based in China.

Why is China’s lurch into deflation on the GDP deflator, but not the CPI measure, so important? We have pointed out before (unfortunately we don’t have space for the chart here) that in Japan during the 1990s the thing to watch to see the havoc that deflation was wreaking on nominal revenues and debt/income loads was not the CPI, but rather the GDP deflator, which fell far faster than the CPI. Economic agents produce far more than just consumer goods and services and the GDP deflator is a much wider basket of goods and services and includes exports and investment goods. Clearly the descent into outright GDP deflation in China explains the more aggressive, even slightly panicky, policy easing measures there.

We also pointed out last week that China’s move into BoP deficit imposes a substantial monetary headwind on the economy. China may wish to keep the renminbi stable at this time while the IMF is currently considering including it in the SDR currency basket. But the economy is simply not in a position to withstand a major yen decline bringing down the currencies of its competitors in the region (and the additional deflationary impulse). I remain convinced that China must start guiding its currency down against the dollar and it can do that easily now it has a BoP deficit by doing absolutely nothing (ie not intervening any longer to hold it up)! China will also take the IMF’s recent declaration that the renminbi is no longer undervalued as justification for these actions - link.

Worrisome deflation is already being imported into the US, especially from Japan (see chart below). China (blue line) has yet to participate, but a further round of Asian devaluations will inevitably see waves of deflation heading westwards – as in 1997/98. Watch this data closely.

A link to the full report is posted in the Subscriber;'s Area. 

The Yen has been a catalyst for competitive currency devaluation across the Asian region since the BoJ initiated its QE program in 2012. As the Yen extends its downtrend there is potential that it will act as an additional incentive for regional competitors to devalue their currencies.

The US Dollar broke out against the Yen last week and a sustained move below ¥122 would be required to begin to question medium-term scope for continued upside. 

China’s most-wanted fugitive, an official accused of embezzling more than $40 million, is in U.S. custody, according to the Communist Party’s anti-graft agency.

Yang Xiuzhu, who fled China in 2003, was detained after entering the U.S. using a fake Dutch passport last year, according to the party’s Central Commission for Discipline Inspection.

In the first confirmation of Yang’s whereabouts in a decade, the commission’s International Cooperation Department said she escaped from detention in the Netherlands in May 2014 - - after being rejected for political asylum and before she could be sent back to China.

Considering the vast sums of money that change hands within state owned organisations my first reaction to this news was “Is that all?” $40 million might sound like a lot of money but is in fact very little when one thinks about the personal and family wealth accrued by the ruling cadres.

Nevertheless this is a PR coup for the Chinese administration. China’s anti-corruption chief and Politburo member Wang Qishan announced in March he will be visiting the USA this summer. Following today’s news we can now put that visit in a wider context. The Party wishes to throw media attention on members who have absconded with millions of Dollars while ensuring that the process of internal reform sustains the status quo. 

The yuan still has some way to go before it can become a major reserve currency, former Federal Reserve Chairman Ben S. Bernanke said Tuesday in Taipei. The IMF requires that a currency is “freely usable” to be included in its SDR basket.

Endorsement by the Washington-based lender would lead to about $1 trillion being switched into Chinese assets over the next five years, according to an estimate this month from Standard Chartered Plc. AXA Investment Managers estimated some 10 percent of the $11.6 trillion of global reserves would flow into yuan assets, though it didn’t give a timeframe.

China should allow greater flexibility in its exchange rate, with intervention limited to avoiding disorderly market conditions or excessive volatility, said the IMF’s China mission, which is led by the lender’s deputy director of Asia and Pacific Markus Rodlauer. The statement said it contains the views of the IMF staff involved and has not yet been endorsed by the institution’s board.

The yuan rose 0.6 percent versus the dollar in the past 12 months, while Brazil’s currency dropped 28 percent and Russia’s slid 32 percent. China’s productivity will probably rise more rapidly than the rest of world so its exchange rate will need to appreciate to take account of that, David Lipton, the IMF’s No.2 official, said at a briefing Tuesday in Beijing.

 

By remaining relatively steady against the Dollar over the last year, the Renminbi has appreciated against a wide basket of other currencies not least the Euro, Yen and Korean Won which account for more of its trade than the US Dollar. The currency has unwound almost the entire 1993 devaluation suggesting that the CNY6 level relative to the US Dollar is probably about as strong as the Chinese want to see the currency. 
 

Entering China would let Netflix, the broadcaster of “House of Cards” and “Orange Is the New Black” take advantage of what’s forecast to be explosive growth in online TV in the nation of 1.4 billion people. The market is estimated to almost triple to 90 billion yuan by 2018, according to Shanghai-based Internet consultant IResearch.

A local partnership would be essential given the Chinese government’s strict controls over licensing for online content. Netflix wants a partner that has licenses for content on all devices -- including mobile phones, computers and set-top boxes, according to the people. China’s State Administration of Press, Publication, Radio, Film and Television has given Internet TV licenses to seven companies, including Wasu.

Wasu didn’t respond to an e-mail seeking comment. Two phone calls to Wasu’s general line weren’t answered.

 

Gaining a foothold China would be a major prize for Netflix but it will have to tread carefully and approach the right partner if it is to succeed in this venture. Additionally there are a number of Chinese competitors it will need to face down regardless of which partner it chooses. 

Alibaba Group Holding Ltd. shares surged the most intraday since September as the company named a new chief executive officer, nine months after a record initial public offering.
China’s biggest e-commerce operator posted a 45 percent increase in revenue.

Daniel Zhang will become CEO on May 10, replacing Jonathan Lu, who will remain on the board as vice chairman, the company said Thursday. The change was announced as Alibaba’s sales rose to 17.4 billion yuan ($2.8 billion) in the three months ended in March, beating analysts’ estimates.
Zhang hopes to build a global platform beyond China, part of a strategy that is “a long journey,” he said in an interview Thursday on Bloomberg Television.

Alibaba’s market value had plunged as much as $90 billion from a November peak amid concern about slowing economic growth and criticism from the Chinese government about its business practices. Billionaire Chairman Jack Ma elevated Zhang after the chief operating officer helped turn the Nov. 11 “Singles’ Day” shopping promotion into the company’s biggest sales day.

“Perhaps Jack is sending a signal to the capital markets and the regulator that he’s willing to make changes,” said Mike Clendenin, managing director of RedTech Advisors.

Alibaba’s honeymoon period is over. Investors are now focusing on the success of its business model in delivering on the promise of international domination. One of the issues it faces with competing internationally is the long shipping times required to move goods from China to the end customer. Solving this challenge requires a great deal of investment in logistics and local warehousing within target markets. As a result progress is slow. 

The opening of the Shanghai-Hong Kong Stock Connect has acted as a catalyst for the revival of interest in the Chinese stock market since November. Since then the mainland administration has followed with market support measures including lower bank reserve requirements, cutting interest rates, removing obstacles to property speculation, opening the market for equity options as well as a politicians talking the market higher. 

The Shanghai A-Share Index began to rally from July and surged higher in October led by brokers, insurance companies, banks and railroads. Following consolidation between January and March it has rallied for the last eight consecutive weeks and is increasingly susceptible to consolidation of those gains. 

While Hong Kong had similar valuations to mainland China it did not rally in line with the mainland. Part of the reason for this is because of the civil unrest that roiled investor sentiment late last year. In fact while the stock connect is a two-way channel between the mainland and Hong Kong and has been open for six months, the mainland to Hong Kong avenue only hit its limit for the first time this month. Hong Kong is now playing catch up with the mainland listed market. 

The stock rally has prompted authorities to roll out measures this year that signal an effort to temper gains and prevent another boom-and-bust cycle after a record number of novice investors entered the market. China’s securities regulator started a campaign on Friday to crack down on stock- market manipulation and insider trading, the latest effort to reduce risks.

The China Securities Regulatory Commission will target trading by brokerage employees using non-public information, and market manipulation, including of futures prices, the CSRC said in a Friday statement on its website.

Chinese officials are trying to find a balance between weeding out speculators and encouraging the stock market to play a bigger role in helping companies raise funds as the government reins in credit expansion. The CSRC and central bank Governor Zhou Xiaochuan have endorsed the flow of funds into equities.

The speed and size of the breakout on China’s stock market creates a quandary for late comers because of the risk that a consolidation of short-term gains could be outsized relative to what one might be used to, but “normal” relative to the size of the breakout. 

As with any breakout from a long-term range there is a great deal of trepidation among those who were previously bearish because they are now either losing money or at least receiving margin calls on short positions. The response is either to switch sides and become a bull (Hugh Hendry for example) or to double down and become even more bearish. 

The increase in short interest may be a signal that long investors are hedging their exposure, the volatility of the move to date is fertile ground for options strategies and/or that bears are increasing their bets. We will continue to be guided by the price. 

Mere sales volume recovery would not improve profitability of developers
While we expect further recovery in the physical property market, given policy relaxations, the recovery could just be a "profit-less" or profitless one for some developers (like those with expensive landbank, high gearing, high financing costs). The strategy of high asset turnover to drive earnings growth has proven ineffective as earnings growth has consistently lagged behind sales growth in the past two years. This prompted some developers to start shifting away from the high asset turnover strategy that they had been adopting in recent years. Meanwhile, we see little scope for profitability to rise significantly in the near term without a marked correction in land prices or a sharp rebound in ASPs. 

Contracted sales growth not directly translate into corresponding profit growth 
Some market participants believe that strong contracted sales growth will lead to corresponding strong earnings growth. However, by comparing contracted sales with earnings, we found that earnings growth has consistently lagged behind contracted sales growth, especially for developers focusing on high asset turnover. Contracted sales for leading developers saw YoY growth of 30% and 17% respectively in 2013 and 2014, but the corresponding core net profit growth was only 21% and -7%, while core EPS growth was lower at 19% and -10% respectively. For developers focusing on high asset turnover, the discrepancy between sales and earnings growths was more severe, reflecting the key industry challenges – land prices rising faster than home prices and rising financing costs from higher debt levels (used to drive higher growth). For example, Country Garden had contracted sales growth of 123% and 22% in 2013 and 2014 but had core EPS growth of only 16% and 10%, while Sunac had sales growth of 61% and 30% in 2013 and 2014 but achieved core EPS growth of only 17% and 4%. Adjusting for some aggressive interest capitalization, core net profits of the key developers were on average 41% and 106% below reported figures, suggesting that actual profitability is even lower

 

A link to the full report is posted in the Subscriber's Area. 

There has been a great deal of commentary on the outlook for the Chinese property market over the last decade as prices soared. Two of the primary reasons for the outperformance were the dearth of other investment opportunities and the availability of credit. From 2009 the government clamped down on overbuilding in an attempt to rein in excesses. This had a major impact on property developer shares which spent much of the last five years ranging. 

The first time I visited China was in 2005 and I didn’t stop coughing until we got back on the plane to leave. The pollution was such that you couldn’t see more than 100 metres in any direction for the entire time we were there and I didn’t think to wear a face mask. It was November. 

Utilities burn large quantities of coal in North China between October and March for heating which results in heavy smog across a wide swathe of the country. From April the weather heats up so heating demand goes down and the air improves. I’ve been to Beijing in the summer and autumn but this was the first time in the spring and the air was cleaner than I’ve ever seen it before. Visibility was up to about a mile and there was a powdery blue sky overhead. 

Mrs. Treacy has often talked about the dust storms that hit Beijing in the spring as well as the willow catkins that fill the air. We experienced both on this occasion. The catkins in particular looked like snow on the freeway and delighted my daughters. 

Last week’s event was another enjoyable visit to Singapore and was an apt time to ruminate on Lee Kwan Yew’s legacy of turning a tropical backwater into a first world private banking and high end manufacturing centre. Delegates came in from Argentina, Australia, Japan and of course Singapore which led to some interesting and varied discussions.

Singapore’s stock market is being led higher by the banking sector and shares a high degree of commonality with Taiwan and South Korea. The Index is somewhat overbought in the short-term and some consolidation of recent gains in looking likely. However a sustained move below the 200-day MA, currently near 3400, would be required to question medium-term scope for additional upside.

As one might imagine the main topic of conversation was on the outlook for the Asian region not least following China’s explosive breakout over the preceding three weeks.  Delegates were also interested in the outlook for the European region and we also looked at the S&P 500. We looked at the oil price and a number of related instruments. We also looked at gold prices and a number of miners, select Singapore shares as well as a wide range of international bank shares. We also had a wide ranging discussion on currencies. 

Australia plans to join the Asian Infrastructure Investment Bank, it said on Sunday, reversing a previous decision to stay out of the China-led institution. But it has placed conditions on its future membership of the bank in an attempt to mollify concerns expressed by its main military ally, the US.

​“The government is today announcing it intends to sign a memorandum of understanding on the Asian Infrastructure Investment Bank, which would allow Australia to participate — as a prospective founding member — in negotiations to set up the bank,” the prime minister’s office stated.

The decision followed moves this month by the UK, France, Germany, Italy and South Korea to join the AIIB. US officials have privately urged allies to stay out of the new bank, at least until Beijing addresses concerns about governance standards. Some in Washington view China’s launch of the AIIB as an effort to undermine the influence of the US-based World Bank.

On Saturday, Russia’s first deputy prime minister, Igor Shuvalov, said his country plans to join the AIIB. Denmark, Brazil and the Netherlands will also participate, China’s finance ministry said at the weekend.

 

Money talks. Additionally, Europe needs investment and the ear of an emerging superpower. It was a miscalculation on the part of the White House to so vocally oppose participating in the Asian Infrastructure Investment Bank (AIIB) not least as it is quickly gaining critical mass without countries insisting on more detail regarding how it will function. 

To date, China’s overseas infrastructure deals, often in return for access to resources, have tended to be one sided, carried high interest rates and there have been issues with accessing funds. It remains to be seen just how the AIIB will function but it is looking increasingly likely that it will be able to do so with the full backing of countries that pride themselves on their high standards of governance.  

The facilities will be replaced by four gas-fired stations with capacity to supply 2.6 times more electricity than the coal plants.

The closures are part of a broader trend in China, which is the world’s biggest carbon emitter. Facing pressure at home and abroad, policy makers are racing to address the environmental damage seen as a byproduct of breakneck economic growth. Beijing plans to cut annual coal consumption by 13 million metric tons by 2017 from the 2012 level in a bid to slash the concentration of pollutants.

And

Nationally, China planned to close more than 2,000 smaller coal mines from 2013 to the end of this year, Song Yuanming, vice chief of the State Administration of Coal Mine Safety, said at a news conference in July.

 

I’ll be stopping off in Beijing on my way to Singapore next week and I’m looking forward to seeing first-hand what measures, if any,  have been taken to tackle the pollution problem. Replacing coal fired power stations with natural gas plants is a hugely positive development which is likely to have some far reaching repercussions. 

We have been positive on Chinese equities for 2015 but caution readers of a weak start to the year (see 2015 China Outlook). After H-shares’ underperformance vs. DM, AsiaPac ex Japan and A-shares YTD, we now see more upside risks than downside ones and turn more positive on the market, in view of the following:

We expect Chinese policy-easing efforts to intensify in 2Q15 (see policy easing cycle may start soon), including monetary, fiscal and property relaxation, given the below-target 1Q15 growth and the “bottom-line”- focused reaction function reiterated by Premier Li during the NPC. We see lower market rates and resumed credit growth ahead, and our economist forecasts GDP to bottom in 1Q15 and edge up to 7.2% in 4Q15. ? We believe the earnings cut cycle will come to an end by April, as the disappointing FY14 results season wraps up and consensus estimates get closer to our top-down forecasts. For FY15, we look for more evidence of cost reduction among mid-stream sectors to reinforce our expectation of a margin-driven non-financial earnings recovery.

We see loosening global liquidity conditions and funds inflow as catalyzing catch-up with A-shares, considering 1) the Fed finally joined forces with other major central banks on the dovish side and suggested “lower for longer” rates over the coming quarters; 2) still deeply discounted H-share valuations suggest light investor positions; and 3) improving cyclical outlook and expediting reform in China.

 

A link to the full report is posted in the Subscriber's Area. 

Liquidity is abundant. Any prospect of the Fed aggressively raising interest rates, however remote, was dismissed at last week’s meeting. If the Bank of England is any guide, the Fed’s balance sheet can remain at its current level for a prolonged period after the end of QE. With the ECB and BoJ engaged in QE and a host of other central banks cutting interest rates it is safe to conclude that there is no shortage of cheap abundant capital for investment. 

There has been a great deal of commentary in financial circles about how elevated cyclically adjusted P/E ratios are, with some concluding that stock markets are fully valued.  On one hand we could consider how likely valuations are to become overvalued, but the other way of looking at it is to ask what is still cheap. 

China’s capital outflows concern may be tempered after the Fed’s comments, and the PBOC will likely become more flexible as worries about a weaker yuan ease, Tommy Xie, a Singapore-based economist at Oversea-Chinese Banking Corp., said in an interview.

China is in talks with the International Monetary Fund to include the yuan in the institution’s basket of reserve currencies, PBOC Deputy Governor Yi Gang said in Beijing on March 12. The currency will decline 0.22 percent the rest of this year to 6.21 a dollar at the end of 2015, according to the median estimate in a Bloomberg survey.

“The fundamentals are still bullish for the yuan with the government’s plan to make it a reserve currency,” said Scotiabank’s Tihanyi. The PBOC fixings also send a “strong signal” that the authorities favor a stable currency, he said.

 

The Renminbi can be viewed from a number of different perspectives. For some it represents how much of an advantage China has gained from devaluing its currency more than twenty years ago. For others it represents the challenges experienced by manufacturers as its value has increased over the last decade. For still others its stability is a totem for the increasingly vital role China plays in the global economy. 

The Chinese authorities have made clear they want to make the Renminbi as international as possible. Opening up the financial markets, encouraging competition, insisting on the currency being used as a medium of international trade and other measures are all designed to achieve this goal. As the largest energy importer, the benefit of sourcing supply denominated in one’s domestic currency is obvious but for that goal to be reached the currency will have to be globally fungible which is not the case just yet. 

The following extracts from an article by Professor James Laurenceson, deputy director of the Australia-China Relations Institute at the University of Technology, Sydney should help subscribers have confidence in China investments.

“With China now having the world’s largest economy in terms of purchasing power, we should be cheering them on.

The World Bank says that between 1980 and 2011, the number of people living in poverty in China fell by 753 million. That’s nearly two and a half times the population of the US, and an outcome unparalleled in history.

The World Trade Organization says that China’s share of world’s goods exports has risen from 1.2 percent in 1983 to 12.1 percent in 2013. It’s now the world’s largest trader.

The Boston Consulting Group found that when utilities and other costs are added to sharply rising wages, manufacturing costs in China are now only four percent less than in the US.

To boost productivity, privatisation isn’t crucial; competition is the way that China’s government is currently muddling through reforming the financial sector.

In 2015, yes, China will muddle through. And it will do so again next year.” 

 

Thank you for this interesting article and the topical excerpts: Muddling through can also be described as being willing to both make mistakes and being committed to learning from them. If learning that competition is to be fostered is an abiding success, then the recent crackdown on corruption might also be viewed in that light. 

Some interpret the recent tightening of controls on the media and freedom of speech as well as selective punishment for moral and financial transgressions to be a retrograde step in terms of standards of governance. Others view it as a necessary process to improve the efficiency of the state owned sector not least versus their privately owned competitors. 

“The market seems to be pricing in that the possibility that the regulator would allow banks to enter the brokerage space,” said Gerry Alfonso, a China equity sales and trading director at Shenwan Hongyuan Group Co. in Shanghai.

Banks also gained after the government said it will allow regional authorities to convert some high-yielding debt into municipal bonds.

 

Liberalisation of the financial sector remains a key policy objective of the Chinese administration. Allowing the major banks to participate as brokers and perhaps more importantly as originators and underwriters is an additional step in that direction. The major banks have the heft in terms of their balance sheets to compete aggressively in financial markets. While it would be tempting to first think about the stock market, this development is much more important for the bond markets. Expanding the number of primary dealers not least for the still underdeveloped municipals sector is a major financial sector innovation. 

"At first, robots replaced workers who had jobs that exposed them to pollution, such as painting, or required that they repeat the same task," the equity manager said. "But gradually, robots have been used for trades requiring skilled workers, such as welders, because they are cost-effective."

Yet some companies have automated their factories simply because they cannot find enough people. A mid-level manager at an electronic manufacturer said that many businesses that are unable to fill positions have had no choice but to install robots.

"Workers quit every day," he said. "Physically challenging jobs under harsh conditions or jobs requiring repetitive processes are much less attractive to young workers than the older generation."

Zhang Fan, who oversees automation at a Midea factory in Wuhu, in the eastern province of Anhui, said the plant installed one robot in 2011 and another in 2012 to rapidly move 70 kilogram air conditioners on an assembly line – a job that was too strenuous for people.

 

China can no longer compete with some of its neighbours as a low cost manufacturing environment. Highly labour intensive, thin margin businesses such as textiles and jewellery manufacture have already migrated to countries like Vietnam, Cambodia, Indonesia and increasingly India and Africa. Some of the larger Chinese families will have operations in all of these countries as they manage their exposure to labour costs. 

The challenges in Taiwan and a Wall Street Journal report about Alibaba merchants paying people to pretend to be customers, called “brushing,” to pad sales figures have created some short-term negative publicity, Ji said.

“We don’t think those views will have a negative financial impact on Alibaba,” she said. “But PR-wise, it may have some negative impact on the stock.”

Alibaba, which connects consumers and businesses across its platforms, has a “credibility crisis” fueled by its failure to crack down on shady merchants, counterfeit goods, bribery and misleading promotions, China’s State Administration for Industry & Commerce said in January.

James Cordwell, an analyst at Atlantic Equities LLP in London, said Alibaba’s fourth-quarter results raised concerns about e-commerce growth and advertising revenue. There may also be a selloff ahead of the first major lockup expiration for insider share sales in mid-March, he said.

“Today’s weakness is no doubt also a result of strong results at key competitor JD.com and also the Taiwan withdrawal news,” Cordwell said.

Jack Ma is an adept stock market player. The first listing of Alibaba in Hong Kong was also met with fanfare but the share languished after the initial spike and was eventually delisted for its IPO price in 2012.

The issues with its platforms being the world leaders in the distribution of counterfeit goods are nontrivial. There have been anecdotal stories for years about the cottage industry in Hangzhou centred on gaining preferential positions on websites through a web of bribery. These are damaging issues and will need to be addressed if the company is serious about preserving the interests of its minority shareholders. 

Debt continues to grow. Since 2007, global debt has grown by $57 trillion, or 17 percentage points of GDP.* Developing economies account for roughly half of the growth, and in many cases this reflects healthy financial deepening. In advanced economies, government debt has soared and private-sector deleveraging has been limited.

Reducing government debt will require a wider range of solutions. Government debt has grown by $25 trillion since 2007, and will continue to rise in many countries, given current economic fundamentals. For the most highly indebted countries, implausibly large increases in real GDP growth or extremely deep reductions in fiscal deficits would be required to start deleveraging. A broader range of solutions for reducing government debt will need to be considered, including larger asset sales, one-time taxes, and more efficient debt restructuring programs.

Shadow banking has retreated, but non-bank credit remains important. One piece of good news: the financial sector has deleveraged, and the most damaging elements of shadow banking in the crisis are declining. However, other forms of non-bank credit, such as corporate bonds and lending by non-bank intermediaries, remain important. For corporations, non-bank sources account for nearly all new credit growth since 2008. These intermediaries can help fill the gap as bank lending remains constrained in the new regulatory environment.

Households borrow more. In the four “core” crisis countries that were hit hard—the United States, the United Kingdom, Spain, and Ireland—households have deleveraged. But in many other countries, household debt-to-income ratios have continued to grow, and in some cases far exceed the peak levels in the crisis countries. To safely manage high levels of household debt, more flexible mortgage contracts, clearer personal bankruptcy rules, and stricter lending standards are needed.

China’s debt is rising rapidly. Fueled by real estate and shadow banking, China’s total debt has quadrupled, rising from $7 trillion in 2007 to $28 trillion by mid-2014. At 282 percent of GDP, China’s debt as a share of GDP, while manageable, is larger than that of the United States or Germany.* Several factors are worrisome: half of loans are linked directly or indirectly to China’s real estate market, unregulated shadow banking accounts for nearly half of new lending, and the debt of many local governments is likely unsustainable. 

 

A link to the full report is posted in the Subscriber's Area.

The extent of debt deleveraging tends to be a subject that receives little press attention because it is so difficult to quantify. Some people are worried about the quantity of debt that has continued to climb since 2008. However the detail of who is responsible for this debt is more important. 

Quantitative easing is in many respects a transfer of debt from private institutions to government. This has allowed corporations to reduce their debt servicing costs and to lock in the lowest rates anyone has ever seen; often at lengthy maturities. Consumers have been spending less, refinancing mortgages and today’s news suggests more are getting back to work. The USA’s private sector has deleveraged and its government has become overleveraged. If the data in the above report is considered from a long-term perspective we can see cyclicality where credit contraction follows credit splurges and vice versa. 

The groups, which include the U.S. Chamber of Commerce, called for “urgent discussion and dialogue” about what they said was a “growing trend” toward policies that cite cybersecurity in requiring companies to use only technology products and services that are developed and controlled by Chinese companies.

The letter is the latest salvo in an intensifying tit-for-tat between China and the United States over online security and technology policy. While the United States has accused Chinese military personnel of hacking and stealing from American companies, China has pointed to recent disclosures of United States snooping in foreign countries as a reason to get rid of American technology as quickly as possible.

Although it is unclear to what extent the new rules result from security concerns, and to what extent they are cover for building up the Chinese tech industry, the Chinese regulations go far beyond measures taken by most other countries, lending some credibility to industry claims that they are protectionist. Beijing also has long used the Internet to keep tabs on its citizens and ensure the Communist Party’s hold on power.

Chinese companies must also follow the new regulations, though they will find it easier since for most, their core customers are in China.

 

China has unabashed ambitions of becoming a global economic and military superpower large enough to rival the USA. However if it is to close the technological gap with the USA it will have to invest a great deal of money, time and effort into technological development. Investment in science is already impressive but the commercialisation of ideas takes time. 

Like other emerging countries that have come before it, China has copied what it could not develop itself. Insisting companies that wish to do business in China to sign technology sharing agreements and engaging in corporate espionage are both aimed at achieving the goal of rapidly narrowing technological gaps.

Forcing government agencies and state owned companies to buy from Chinese vendors almost certainly sets the country on course for discourse with the WTO. However by the time a judgement is reached much of the transition will probably have been completed.  The majority of China’s leading technology companies have sought listings in either Hong Kong or the USA which creates a challenge when judging the performance of the sector. 

In new guidelines on online literature made public this month by the State Administration of Press, Publication, Radio, Film and Television, the government called for a system that would require all authors to register their real names with publishing platforms on the Internet.

Under the guidelines, creators of online content will still be allowed to publish under pen names. But unlike before, when some writers registered accounts under fake names, websites will know exactly who is publishing what.

Linking the identities of authors with their writings online, the guidelines say, will encourage them to “take better responsibility” for their works as well as strengthen their “professional moral education and training.” The aim is to promote “healthy” online literature and to root out problems like plagiarism and poor quality, the guidelines state.

“It is very clear that the government is taking these measures with the intention of suppressing online creativity,” the writer known as Murong Xuecun, whose real name is Hao Qun, said in an interview.

 

Anonymity on the internet is a touchy subject. On the one hand anonymous hackers have the ability to disrupt movie releases. Internet trolls might be in the minority but they take pleasure in insulting other people from the comfort of their own homes and totally free from retribution. On the other hand the use of anonymous profiles has allowed the spread of liberal ideals in a number of authoritarian regimes which has challenged the ability of the political apparatus to control news flow. This was particularly the case in a number of the Arab Spring revolts and is something China is now moving to ensure goes no further within its borders. 

Freedom of speech is only possible when backed by a robust legal framework and where the political establishment is subject to the rule of law. The Communist Party’s absolute control of the media was tight before, and this measure represents a considerable escalation of state control. Weibo and Sina blogs are incredibly popular in China. People document almost every aspect of their lives but they are also the modern equivalent of town hall meetings as friends, colleagues, relatives and old school friends actively discuss various topics. It strikes me as no coincidence that the push to implement real name profiles is coming so soon after the unrest in Hong Kong. The Communist Party has no intention of easing its grip on power. 

Cost savers: Mid-stream industrial sectors that could benefit from lower commodity prices and highly leveraged sectors that could benefit from lower financing costs.

Top-line growers: Increasing demand for better quality of life suggests a stronger appetite for healthcare, environmental protection, TMT, and child/senior-related consumption.

Reform beneficiaries: Look for potential beneficiaries from SOE reform, “Go Global”, financial reform and land/Hukou reform, but watch for potential losers from fiscal/tax reform.

MSCI inclusion: Select TMT and consumer discretionary names will benefit at the expense of the largest incumbents including financials, energy and telecom.

 

A link to the full report is posted in the Subscriber's Area.

In many respects the MSCI China Index is similar to the Hang Seng China Enterprises (H-Shares) Index. They certainly have a similar chart pattern and valuations. Mainland listed shares have so far been the primary beneficiaries of the opening up of the Hong Kong Shanghai Stock Connect with overseas investors dominating what has so far been one way traffic. 

Citic Securities Co., China’s biggest brokerage by market value, said it will push ahead with a plan to sell about $4.6 billion of stock even after curbs on margin lending triggered a record plunge in its shares.

The broker’s plan to sell as many as 1.5 billion new H shares remains unchanged, a Hong Kong-based press officer said in an e-mailed response to questions today. Citic Securities said in December it would sell the shares, valued at $4.6 billion based on today’s price, to develop capital-intensive operations including margin financing and securities lending.

Chinese brokerages’ shares plunged today after the securities regulator banned three of the biggest firms from adding new margin-finance accounts for three months. Citic, Haitong Securities Co. and Guotai Junan Securities Co. let customers delay repaying financing for longer than permissible, the China Securities Regulatory Commission said Jan. 16.

The business and operations of Beijing-based Citic Securities remain unchanged, it said in today’s statement. Citic Securities shares fell by the 10 percent daily limit in Shanghai and dropped 16 percent, the most on record, at the close in Hong Kong.

Haitong hasn’t changed its share sale plan, said a person with knowledge of the matter, who asked not to be identified discussing private information. It said in December it plans to raise about $3.9 billion from a sale of 1.92 billion new shares.

 

Today’s announcement clipped the wings of highflying mainland brokers with the three main companies falling the daily limit of 10%. Brokerages have outperformed by a wide margin over last three months with Citic Securities returned to test its 2008 peak. Consolidation of that accelerated move is now underway. 

The good news? We won't see high-yield debt defaults for a few years because everyone has refinanced their debt.

"There are lots of reasons to think rates should rise in five years, but not much in five days or five months."

 

There have been a number of articles over the last week taking the view that the bull market in China has gone too far and that it is time to sell. Unsurprisingly, investors are wary of the Chinese market considering how much bad news they have been fed over the last five years. However the fact that so much high yield debt has already been refinanced is a major tailwind in the short to medium-term. 

“The Swiss National Bank’s decision caught the market a little off footing, and gold gained as a safe-haven buy,” Frank McGhee, the head dealer at Alliance Financial LLC in Chicago, said in a telephone interview. “The Swiss are giving up on the euro at the end of a long and painful run.”

At The Chart Seminar we have long defined ranges as “explosions waiting to happen”. Over the last six months we have been presented with a considerable number of explosive moves, not least oil, copper, mainland China, the US Dollar and now the Swiss Franc. These are not small illiquid instruments but some of the largest most globally significant markets in the world. This kind of volatility is unnerving for investors; unaccustomed to such large swings in their portfolios. Demand for some form of safe haven has increased as a result. 

Some individual investors, of course, try to be more selective than just focusing on the price. Shawn Gao, a 27-year- old bank manager in Chengdu, looks for shares that will benefit from government policy changes while using volume and momentum data to help guide his decisions. Even he admits, though, that he’s sensitive to the absolute price level, staying away from stocks priced above 20 yuan.

What looks cheap to Chinese investors who focus on a stock’s price may actually be expensive. Equities in the CSI 300 index trading below 5 yuan are valued at an average 25 times estimated earnings for the next 12 months, versus 13 times for the overall index, according to data compiled by Bloomberg.

The market impact of individuals who ignore corporate fundamentals is driving away some of the region’s institutional investors, who are concerned speculative price moves will hurt performance, said David Gaud, a Hong Kong-based money manager at Edmond de Rothschild Group, which oversees about $158 billion.

“The market would need more institutionals and less leveraging on the retail side,” Gaud said. “This is not liquidity which is of good quality at the end of the day.”

 

The domestic Chinese investor has been absent from the market since 2008 and is only now returning. If we think about our experience of stock market tops and base formation completion, people are most worried about bubbles following a breakout when they are underweight. Following a multiyear advance when investors have so much confirming evidence of the bullish hypothesis and a vested interest in it continuing, there are fewer people proclaiming the existence of a bubble. 

Macro: Broad-based easing to bottom line ; watch CPI & RMB
We forecast lower-than-consensus GDP in 1H15, while 2H15 may see a minor pick-up thanks to rates and RRR cuts in 1-3Q15. We think the policy regime bottom line, but refrain from suggest closely watching the developments in CPI (esp. pork prices) and RMB depreciation to gauge how far the policy easing could go. 

Earnings: Non-financial earnings to recover at the expense of financials
We see a decent recovery in non-financial earnings growth to 8% in 2015 (vs. 0% in 2014), thanks to profit margin expansion amid softening commodity prices and falling financial costs. However, financials earnings growth may slow to 3% in 2015 (vs. 8.5%), sending overall H-share earnings growth to 5.5% (vs. 4.4%). This trend may extend in 2016 and H-share earnings could grow at a similar 5.4%. We believe cost cutting has its limit for Chinese corporate, top-line is still needed for a more sustainable earnings recovery. 

Liquidity: When G2 diverges the loosening PBoC vs. the tightening Fed
H-share liquidity conditions may weaken due to 1) further global capital outflows alongside the tightening Fed and strengthening US dollar, and 2) the mounting northbound while lukewarm southbound flows in the Shanghai Connect. A-shares may continue to benefit from the loosening PBoC and outperform H-shares, but in the near term, we would watch out for prudential measures given recent rapid leverage build-up, esp. via alternative channels. 

Valuations: 8-11x the fair range; market to enter
Modeling MSCI China with a three-stage DDM, we estimate 8-11x 12-month forward P/E as the fair valuation range. We expect the index to re-rate from the current 9.4x 12-month forward P/E to 10x by end-2015, based on 3.5% RFR and 6.5% risk premium. Also, considering around 5% rollover in 12-month the rising P/E and EPS boosting the index by 12% to 74 by end-2015.

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The Chinese mainland’s stock market remains in robust form despite the short-term overbought condition currently evident. This explosive breakout will roll over into a consolidation of gains at some point but a clear downward dynamic, held for more than a day or two, would be required to check momentum. 

Hong Kong Exchanges & Clearing Ltd. jumped the most in a month after a report that Chinese Premier Li Keqiang said a stock link with Shenzhen should be established.

The new exchange program should follow the Hong Kong- Shanghai connect that began in November, Shenzhen Special Zone Daily reported on its tetimes.com website, citing Li during a visit to the city. Shares of Hong Kong Exchanges rose 2.5 percent to HK$177.30, the biggest advance since Dec. 8. The Shenzhen Composite Index extended gains to 1.5 percent, while the Hang Seng Index slid 0.6 percent.

“A Shenzhen-Hong Kong stock link will have a positive effect on HKEx in terms of turnover and profitability,” said Sam Chi Yung, a strategist at Delta Asia Securities Ltd. in Hong Kong. “We still don’t know the timetable of the program, but at least we know that China intends to launch it.”
Shenzhen Special Zone Daily is the official newspaper of the Communist Party committee in the southern Chinese city.

The existing cross-border trading connect gives foreign money managers greater access to Shanghai-listed equities while allowing mainland investors a route to buy Hong Kong shares. The program usage has been slower than expected, with about 25 percent of the aggregate quota being used for Shanghai-listed shares, and less than 5 percent for Hong Kong stocks traded through the link.

The design of the stock link is scalable and replicable, and can be expanded to cover other markets or asset classes, Lorraine Chan, spokeswoman at Hong Kong Exchanges, said in an e- mail today. The bourse operator has “excellent working relationships with the Shenzhen exchange,” and will inform the market if there are material developments, she said.

 

The above headline is somewhat misleading if one considers the action evident on the chart below. Nonetheless, a sustained move below the 200-day MA would be required to question medium-term upside potential. 

The extension of the Hong Kong Shanghai Connect program to also include the Shenzhen exchange is a positive announcement. This helps to confirm the intention to internationalise the capital markets by attracting additional inward investment and allowing at least some domestically held capital to migrate. 

Chinese stocks traded in Hong Kong rose to their highest close in more than three years amid speculation the government will further ease monetary policy to support a slowing economy.

Mainland developers and financial companies jumped, with China Vanke Co. increasing 11 percent and People’s Insurance Company (Group) of China Ltd. reaching a one-year high. CSR Corp. and China CNR Corp. soared at least 16 percent, extending their Dec. 31 surge after the train builders announced a merger agreement. Kaisa Group Holdings Ltd. remained suspended after the property developer defaulted on a $52 million loan.

The opening up of the stock market connection between Shanghai and Hong Kong in the fourth quarter has acted as a catalyst for investments flows into mainland China. The market was depressed, valuations are still attractive and the promise of additional flows kick started investment demand. The underperformance of the property sector over the same period has acted as an additional catalyst for domestic investors to diversify their exposure. A number of financial sector shares have performed spectacularly. Citic Securities for example rallied from CNY 12 in late October to hit CNY35 last week. 

Facebook Inc. shares rose to a record as the social network caps a year in which mobile advertising increased and marketing initiatives expanded with applications and video.

The shares advanced as much as 2.5 percent to $81.88 in New York trading, the highest price since Facebook’s initial public offering in May 2012. The stock has jumped 49 percent in 2014, a year of rally for the Standard & Poor’s 500 Index, which increased 12 percent.

This year Facebook made further headway in mobile, a business that has flourished from a minor portion of ad revenue at the time of the IPO to a majority. Facebook’s acquisition of Instagram in 2012 for $1 billion has also been paying off: A Citigroup Inc. analyst last week said the photo-sharing app is worth $35 billion.

“While the shares have likely benefited from the recent market rally, we see growing confidence in the monetization prospects of Instagram as an impetus to the recent uptick,”

James Cakmak, an analyst at Monness Crespi Hardt & Co., said in an e-mail. He recommends buying the shares.

Facebook was trading at $81.57 at 11:57 a.m., up 2.1 percent, giving the company a market value of about $228 billion. The stock has more than doubled since the IPO. 

 

Smartphones and social media represent a symbiotic relationship since the roll out of mobile phones and broadband is fuelling the evolution of social media and vice versa.

Facebook has successfully monetised its portal and remains a leader within its sector with global reach. It is open to question whether Mark Zuckerberg’s overtures to China will be successful. Personally, I doubt whether China will allow Facebook access when it has home grown products such as Wechat (Tencent Holdings) or Weibo (Sina.com) over which it has a great deal of control. 

I emailed several weeks ago to ask that you include Prosperity REIT (808:HK) in the Chart Library, but I gave you the wrong ticker, so could you please add this again. And do you think you could review the Hong Kong REIT market at some point as well? It might prove interesting for us all. Thanks so much, and happy holidays.

Thank you for this question which highlights a high yield sector in Hong Kong, which is benefitting from the potential for additional flow of funds from the mainland. We have added the correct ticker for Prosperity REIT to the Chart Library. 

Metal’s flagship has got upside: Copper’s price has come under pressure late in the year, reflecting the energy sector sell-off and a perceived short-term metal surplus. Weaker, but the price remains well above its long-term average, and above the industry’s 90th percentile. Robust support of its value comes mainly from two drivers: China’s overwhelming dependence on imports (70% of supply); and the fickle nature of copper’s complex supply chain (mine supply; concentrates; scrap). Unlike other commodities, copper’s mine supply growth never quite matched demand growth during the Super Cycle, a condition that is unlikely to change over the medium term – underpinning our bullish price outlook.

Why so bearish? Consensus view: copper’s trade will now report persistent surpluses. Yes, current signals point to adequate supply: inventories are rising; key merchant premia are soft; backwardation may just reflect concentrated LME positions. Elsewhere, concentrate flows are adequate (TC/RCs are high); scrap flows are expanding. We acknowledge these bear signals. We’re just not convinced by the mine supply growth story. Low-risk re-rating of Escondida output over the past two years was actually unusual. To expect short-term green/brownfield deployments to proceed without disruptions at a lower price level (assuming unchanged demand growth) ignores the history of this industry.

Projects to watch: Key mine supply growth drivers to watch include Las Bambas, Toromocho, Sentinel, Cerro Verde; track Codelco’s ability to fund growth to >2Mtpa; Indonesia’s exports remain at risk, politically; in 2016, Escondida may de-rate again on lower grades; Rio Tinto has pared Kennecott’s supply outlook. We expect ongoing supply disappointments, simply because it is a feature of the industry.

 

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There are a lot of moving parts to the commodity sector but the biggest change by far to the economics of production has been the falling oil price. We do not yet know at what level prices will eventually stabilise but the fact remains energy costs have fallen almost 50% in six months. Considering how important energy costs are for miners, this move will improve the average cost of production and prolong the ability of marginal producers to increase supply.

However, the currency risk is the issue and we suspect a lot of companies have borrowed USD given low interest rates and on the expectation that the USD would continue to depreciate (Figure 19).

8) This is particularly true for China where BIS data shows borrowing increased an impressive 4.5x over the past five years (Figure 20). While external debt to GDP is manageable from a level perspective, the acceleration is a cause for concern in a world where exchange rates are driven by capital rather than current account flows.

9) Our analysis of Chinese corporate returns reveals that there is overcapacity through much of the listed sector, including the consumer space. Furthermore, returns on equity would have been even lower had leverage not sharply increased. Falling margins, falling asset turnover, falling ROAs, rising leverage, falling ROEs are not great combinations (Figures 34, 39 and 42).

10) We suspect it was weak growth and a strong USD that encouraged the PBoC to surprise the market and cut rates. Left to itself, Chinese policy making credibility is high enough that the work-out can be achieved. The risk is that external pressures, via a stronger USD, attracts capital away and we see downward pressure on the RMB. This keeps us underweight Chinese properties. We would be Neutral China.

 

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At the Chicago venue for The Chart Seminar in September a knowledgeable Peruvian delegate spoke at length on the repercussions for his country of a strong Dollar because there was such a dependency on Dollar funding. It’s easy to think about how this situation could have evolved. 

The Dollar had been weak for a long time. The funny thing about trends is that the longer they persist the greater the incentive to believe they will continue for even longer. If one had a company seeking funding for expansion, and credit in my home country is difficult to come by and/or has high interest rates, the relative attraction of the Dollar, which had been trending lower in nominal and real terms was powerful.  

I am currently long ASHR (yay!!), which is looking mighty parabolic and amazingly extended... 

But, what are the best US-traded ETFs for investing in China with some diversification across sectors, based on your (extensive) knowledge of China?

<change of subject>

I noted that HYG and JNK are moving down, which is a bit of a non-confirmation of the recent S&P performance (though, if I may say so, breadth still sucks). Any thoughts?
Hope you're staying dry. We call this "winter" in CA. :)

 

Thank you for the well wishes. The torrential downpours last week and more due this week certainly make a change from the endless sunshine of the last year. It also made the drive to Arizona last week particularly picturesque as the desert began to bloom.  

The Deutsche X-Trackers Harvest CSI 300 China A-Shares ETF (ASHR) is a useful instrument and offers direct exposure to China’s most liquid Index. Today’s downside key day reversal on the Shanghai A-Shares Index has checked the powerful breakout for at least the short term and some consolidation of recent gains is the most likely scenario. Considering how far the Index rallied in the last month, there is ample room for ranging. 

Environmental protection investment. China budgeted CNY3.4trn for environmental protection under the 12FYP, ie 140%/57% above the budgeted/actual for 11FYP respectively. The upcoming Water Pollution Prevention and Treatment Plan will assign CNY2.0trn in 2013-2017 for water projects, 45% above 12FYP’s numbers. This shows China's commitment at least until 2017 on this matter. 

Municipal waste water treatment, higher budget. The NDRC budgeted CNY430bn for municipal waste water treatment in 12FYP. This was 30%/14% above the budgeted/actual numbers under 11FYP. The huge investment was intended to raise the treatment rate for cities/counties/towns to 85%70%/30% in 2015 from 77%60%/20% respectively. Future municipal sewage volume is on an uptrend, backed by the ongoing urbanisation process. Near-term drivers are: i) the “go rural” (county/town) with still low treatment rates, and ii) a discharge standards upgrade.

Industrial waste water treatment, a more centralised treatment. Despite the already high treatment rate of 95% in 2010, industrial sewage still offers enormous opportunities via waste water treatment by third-parties, which have better cost efficiencies than manufacturers that treat sewage by themselves. China’s economy slowdown may drag down industrial sewage volume, but textile industry has better visibility due to the recoveries in the US. We prefer the BOO model for industrial waste water treatment as it charges higher, more flexible tariffs.

Sludge, a new market. Sludge is highly toxic, and its treatment rate was low in 2010 (below 25%). The NDRC plans to raise this rate up to 70% for cities in 2015, and budgeted CNY35.0bn for 12FYP, 7% more than its 11FYP budget. Guangdong has committed the most on sludge treatment and its market is large, accounting for 11% of China’s total new sludge treatment capacity for 12FYP. Sludge BOOs can deliver 20% IRR

 

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The current stock market rally in China is related more to the opening up of two-way investment avenue between the Shanghai and Hong Kong stock exchanges that began last month, than any other single factor. The fact that it has been accompanied by the first cut to short-term interest rates in a number of years has been an additional bonus. This move is being led higher by the banking and broking sectors not least because of their size, liquidity and that they benefit from an increasing number of transactions. 

While the move could limit systemic risks, it may fuel competition for deposits and drive up lenders’ borrowing costs as savers divert money to stronger banks or those that offer higher interest rates, according to Jim Antos, a Hong Kong-based analyst at Mizuho Securities Asia Ltd.

China may offer customers deposit protection as soon as the start of 2015, the official Xinhua News Agency reported, citing unidentified sources. The insurance would help to prepare China’s financial system for bank failures as the economy slows and authorities allow banks to pay higher interest on deposits.

“Competition for large deposits will clearly increase, with pricing and the perceived financial strength of the banks being the key factors for consumers,” Antos wrote in an e-mail.
“We expect to see a shift of large deposits to the megabanks which, being government-owned, are viewed as stronger institutions.”

The government may cap coverage at 500,000 yuan ($81,000) and set different premium levels based on a bank’s regulatory rating under the plan, Economic Information Daily reported today, citing a person close to regulators.

Multiple government departments, including the People’s Bank of China and the China Banking Regulatory Commission, are preparing the program, Xinhua said.

 

One of the challenges with assessing the outlook for the Chinese market is that there has been so much bearish commentary over the last few years that it is difficult to decipher which arguments hold water. What appears clear is there is an impending issue with bad loans coming down the pipe. As the economy slows and state investment priorities evolve it is reasonable to assume that not all loans taken out in the last decade are going to be paid back in full. 

The more important consideration at the present time is that measures are being put in place to deal with this eventuality. The creation of the deposit insurance program is a positive initiative and suggests the Chinese government is not willing to continue to engage in blanket bailouts of troubled institutions. 

Industrial profits in China fell 2.1 percent from a year earlier in October, the biggest decline since August 2012, government data showed today.

The halt to repo sales was “an expected move following the rate cut in the previous week,” said Zhou Hao, a Shanghai-based economist at Australia & New Zealand Banking Group Ltd. “Market interest rates remain sticky in general. This reflects a policy dilemma faced by the Chinese authorities as the rate cut alone cannot manage market expectations.”

And

There will probably be two more rate cuts by mid-2015, each by 25 basis points, and banks’ reserve-requirement ratios are forecast to be lowered by 150 basis points cumulatively next year, HSBC Holdings Plc economists Qu Hongbin and Julia Wang wrote in a Nov. 24 report.

 

In the environment of ultra-low interest rates and extraordinary monetary policy we have been accustomed to it is easy to forget that during this time China has been reloading its central bank’s arsenal of policy tools. 

Interest rate differentials are high relative to other major economies, bank reserve requirements are in the region of 20% versus low single figures elsewhere, the currency remains close to highs not seen in 20 years and aggressive measures are in place to withhold credit from property investments among other tools.

Full details of these trades are posted in the Subscriber's Area. 

In his 12 years as People’s Bank of China Governor, Zhou Xiaochuan has never stopped at a single shift to benchmark interest rates once prompted into action.

Zhou, who took office in 2002 when Alan Greenspan was still chairman of the Federal Reserve, has overseen two tightening and two easing cycles for a total of 22 moves to the one-year lending rate and 20 to the one-year deposit rate. Simple math suggests his latest cut is unlikely to be a one-off.

By joining Mario Draghi and Haruhiko Kuroda in the global stimulus camp, Zhou signaled deeper concern over China’s outlook and recognition that targeted measures alone weren’t going to be enough to revive growth. A Bloomberg survey conducted late Nov. 21 through yesterday showed economists forecast further monetary loosening by the middle of next year.

“Expect more interest rate cuts ahead,” said Shane Oliver, who helps oversee about $125 billion as Sydney-based head of investment strategy at AMP Capital Investors Ltd.

“China’s rate cut highlights that global monetary conditions are still easing with monetary easing in Japan, Europe and China taking over from the end of quantitative easing in the U.S.”

The one-year lending rate will be 5.35 percent in the second quarter of 2015 and the one-year deposit rate will be 2.5 percent, according to the median forecast of economists surveyed by Bloomberg. AMP’s Oliver has the lowest forecast, predicting the lending rate will fall to 4.5 percent by the end of next year; by contrast four of 15 economists see no further reduction.

 

China is one of the only countries in Asia where currency market volatility has not impeded capital market appreciation potential for foreign investors over the last year. However as the easing cycle in monetary policy reignites, the prospect of additional strength for the Renminbi is looking increasingly unlikely. 

While it is true that Zhou Xiaochuan has not stopped at one cut when entering an easing cycle, the above chart illustrates that the medium-term peak in lending rates was in 2012 at 6.56% and the recent cut is an extension of that easing policy following a hiatus. The lows near 5.3% have not previously been exceeded and it will be a measure of how much assistance the central bank thinks the economy needs whether they will cut rates below that level. 

Hi David & Eoin, I wanted to get FTM thoughts and opinion on where the best investment returns could be had over the next 12 months and what would be the key things to watch for? Thanks for an excellent service 

Thank you for your kind words and your question. This is a topic we cover almost daily in the written commentary and the audio but it is a good time to summarise our views. 

Let’s ruminate for a moment though on the timing of your question. Generally speaking, the last six weeks of the year is given over to thinking about the possibility of a Santa Claus rally and people don’t generally look at the outlook for the next year until the last week of December or the first week of January. It made headlines during the week that Goldman Sachs had released its prognostication for the coming year, which may have prompted your email. However I believe it is worth considering that the stock market is a discounting mechanism and as a bull market progresses we tend to want to discount cash-flows from increasingly further into the future. It is a measure of how strong the market has been over the last month that investors are already planning for next year. Five consecutive weeks to the upside suggest some consolidation is increasingly likely.

Noodles and drinks can be fashionable if consumers want it that way. Chinese consumers have had most of what they need, so we look into the discretionary side of consumer staples, i.e., what and how they want the beer and tea to be served. We think something new and/or chilled will help companies to put a stop on de-rating in 2015, and to prepare for the recovery ahead.

The myth: staples are no necessities?
YTD in 2014, Hong Kong-listed consumer staples under DB coverage and those we monitor underperformed the MSCI China by 20%. We think the de-rating is partly structural, including the reduction in corporate spending and diminishing channel advantage (as a result of the e-commerce boom); and partly company-specific due to weak product development capabilities and therefore absence of sustainable growth drivers.

Newness to connect with the ‘Post-90s’
We think the anti-extravagance campaign has driven a structural change in consumption, because consumers are now mostly paying out of their own pockets (instead of using pre-paid cards/coupons) for products they desire and from where they deem convenient (instead of whatever is available in designated locations). In addition, the ‘Post-90s’ shoppers have changed from traditional habits of consumption given a more global mindset, and are eager for continuous novelty in product and branding. Therefore we highlight UPC (220 HK; Hold) and Hengan (1044 HK, Buy) due to their proven track record in these areas. They either suffered or are suffering from price wars for different reasons, but we expect them to recover in 2015 with price wars ending/fading.

Putting ourselves into Chinese consumers’ refrigerator
Consumers in some parts of China still drink beer and milk at room temperature. We believe this will change, starting with pasteurised milk, as China’s expensive milk will accelerate consumer sophistication, and we believe the next thing they will ask for is freshness. Then we expect more fridge-pack beer and drinks, and chilled and frozen food. We think potential beneficiaries of this development include Mengniu (2319 HK, Buy), which aims to make chilled products one of its growth engines; and Tsingtao (168 HK, Hold), which has lagged behind in product mix improvement in 2014 – we expect the company to refocus on product upgrade and margin improvement in 2015.

 

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It is open to question whether Chinese consumers will be willing to consume chilled beverages if Mrs. Treacy is any guide. Many Chinese consider air conditioning unhealthy and cold beverages unsettling to one’s internal chemistry. Nevertheless, the penetration of caffeinated, alcoholic, spicy, salty, savoury and sugary food and drinks is unlikely to be curtailed by these cultural factors not least because they have addictive qualities and because they represent the growth in demand for convenient foods. 

Under Shanghai-Hong Kong Stock Connect, The Stock Exchange of Hong Kong Limited (SEHK) and Shanghai Stock Exchange (SSE) will establish mutual order-routing connectivity and related technical infrastructure to enable investors in their respective markets to trade designated equity securities listed in the other’s market. Hong Kong Securities Clearing Company Limited (HKSCC) and China Securities Depository and Clearing Corporation Limited (ChinaClear) will be responsible for clearing, settlement and the provision of depository, nominee and other related services for the trades initiated by the investors in their respective markets. This brochure provides information for investors who want to use Shanghai-Hong Kong Stock Connect to trade equity securities listed on SSE.

The opening up of the Shanghai-Hong Kong Stock Connect is a major undertaking. It represents a further easing of China’s closed capital market, with an additional $50 billion in market liquidity possible, under the terms of the agreement. (Please see this additional note from SocGen highlighting the conditions of the existing QFII, RQFII and new Stock Connect program) 

 

The program allowing a net 23.5 billion yuan ($3.8 billion) of daily cross-border purchases will begin on Nov. 17, regulators said in a joint statement today after weeks of investor speculation on the start date. Benchmark indexes in Shanghai and Hong Kong climbed at least 0.8 percent, while Hong Kong Exchanges & Clearing Ltd. surged 4.6 percent. The yuan strengthened as the central bank raised its reference rate by the most since 2010.

The exchange link is one of China’s biggest steps toward opening up the capital account, increasing use of the yuan and turning Shanghai into an international financial center. It will give foreign investors greater access to Chinese companies tied to the nation’s consumer market, which President Xi Jinping is counting on to reduce the dependence of the world’s second- largest economy on exports and infrastructure spending.

“It’s good to see a date,” Mark Konyn, who helps oversee about $92 billion as the chief executive officer of Cathay Conning Asset Management in Hong Kong. “It’s a great innovation. We understand it’s only the first step.”

Shenzhen Link
A Shenzhen equivalent of the Shanghai-Hong Kong link will probably follow within two years, letting more foreign investors buy shares on China’s smaller exchange, according to Bank of America Corp. and Templeton Emerging Markets Group. Japan would also like be part of a trading link with China, the chief executive officer of Osaka Exchange Inc. said on Nov. 5.

The Shanghai connect will expand access to Chinese shares from a limited number of institutions to anyone with a Hong Kong brokerage account. The $64 billion Qualified Foreign Institutional Investor program has allowed professional money managers to buy local securities since 2002, while a similar system using offshore yuan began in 2011.

Shanghai-listed equities are heading for the best annual gain since 2009, outpacing shares of mainland companies listed overseas amid speculation valuation discounts on domestic securities will narrow as China opens up. The Shanghai Composite Index has climbed 17 percent this year, versus a 1.9 percent drop in the Hang Seng China Enterprises Index of Hong Kong- listed shares

Many Western commentators have decried the upside potential of the Chinese market as ephemeral. The reasons for this pessimism are well known but include the unsustainable pace of fixed asset investment not least in property and infrastructure and the opacity of the financial sector where loans have been made based on national and regional interests rather than capacity to repay. As they say, “there is no smoke without fire” and the downtrend evident on the A-share Index lent credence to these arguments and was debilitating to confidence.  

And Alibaba is making money: Net profit tripled to $3.7 billion in the year ended on March 31. While net income fell 39 percent in the three months ended Sept. 30, in part as a result of the cost of integrating new businesses, revenue jumped 54 percent during the quarter -- beating analysts’ estimates.
     
“The growth potential of Internet companies in China is many multiples greater than in the U.S.,” says Shane Oliver, who helps manage $131 billion at AMP Capital Investors in Sydney. “Businesses which can take advantage of that, such as Alibaba, seem incredibly attractive.” In line with AMP policy, Oliver declined to say whether his firm bought the stock.
    
Ma isn’t the only billionaire tapping China’s Web-savvy consumers. Robin Li, 45, was China’s second-richest man as of Nov. 9, with a fortune of $17.2 billion, after founding search engine Baidu Inc. Ma Huateng, 43, who was worth $15.6 billion on that date, has expanded Tencent Holdings Ltd. into China’s top instant-messaging service.

 

The opening up of the Shanghai – Hong Kong Exchange link is a major event. It is tempting to think of it from the perspective of a Westerner gaining access to a new market but it is even more important for mainland Chinese who will for the first time have access to Hong Kong listed securities and by extension the wider global market. 

Contrary to popular belief, we believe Chinese life insurers should benefit from monetary easing at this point in the cycle. We note that our China economist now expects two interest rate cuts in 2015. We believe a lower rate environment could ease competitive pressure and allow room to lower liability costs, which should more than offset reinvestment pressure. We expect the sector to deliver robust EV and VNB growth in 2014-16, and see the current sector valuation as attractive, especially the major insurers’ A-shares, trading at 0.9-1.1x 2014E P/EV. We initiate coverage of the Chinese insurance A-shares, with Buy ratings on China Life, Ping An and CPIC, and a Hold on NCI.

Why are interest rate cuts positive? 
There are three reasons why we believe potential interest rate cuts are positive for Chinese life insurers. Firstly, we believe insurers’ investment yields could be resilient, despite lower interest rates, thanks to the availability of higher yielding assets. We note that the listed insurers’ net investment yields of 4.8-5.1% in 1H14 are relatively low compared with the 6+% yields offered by new investments, such as preferred shares and other non-standard investments. Secondly, while asset duration is shorter than liability duration, we believe the sector’s liabilities could be re-priced faster than assets, due to the dominance of participating and universal life policies (~77-92% of reserves), which allow insurers flexibility in adjusting liability costs. Furthermore, we believe a lower interest rate environment could ease competitive pressure for the sector, and is positive for growth. Last but not least, an easing monetary situation should ease asset quality deterioration, which has been a key concern for investors.

Expect robust EV and VNB growth in 2014-16 
We forecast robust EV and VNB growth for Chinese life insurers, with average EV growth of 23.7% and VNB growth of 18.3% in 2014, helped by strong investment markets. We forecast EV growth to be sustained at around 14.3%/13.9% in 2015/16, and VNB growth at 15.6%/14.6%, supported by stable market conditions and an increased focus on protection policies. As such, we see current sector valuations – at 0.9-1.1x 2014E P/EV for insurance A-shares, 0.9-1.3x for H-shares – as unjustified and yet to price in any recovery.

 

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China remains a nation of savers. A major contributor to this state of affairs is the underdeveloped insurance sector. If you need to hold large cash balances to provide for accidents, home repairs, healthcare, retirement and death you will need to adopt an inherently cautious attitude to personal finances. Sharing the burden for these eventualities with an insurance company reduces risk and allows for a more productive use of capital. Insurance remains a growth industry in China for these reasons but this is not a new story. The healthcare sector is where the majority of investors currently have their attention trained while the more established insurance companies remain largely rangebound. 

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Russia (P/E 5.66) and the Hong Kong Enterprises (H-Shares) Index (P/E 7.3) have similar valuations but couldn’t be more different. Russia represents the degradation of an economy due to adventurism by the ruling oligarchy. The H-Shares represent a market which has been constrained by tight monetary policy for three years and is only now emerging from it. 

More favorable supply-side dynamics According to NBS, nationwide new home prices have fallen 4-6% since April, and sales have responded positively to such price cuts. On our analysis, overall residential inventory period (including properties under construction but with  presale permits) has already peaked out and fallen to 16.5 months in Sep (down from a high of 21 months early 2014). As developers maintain price cuts and discounts, inventory period should continue to fall. Given significant falls in land sales (-26% YoY) and construction starts (-14% YoY) in 2014 YTD, new supply should fall further in 2H15, by then we see a return of pricing power.

Key concerns: margin pressure, corporate governance events, financing risks
Given more price cuts and slower decline in land prices than property prices, we see more downward margin pressure. And with on-going anti-corruption  campaign of central government and recent corporate governance events for  some Chinese developers, we see higher risk premiums and deeper valuation  discounts to be applied to certain non-state-owned Chinese developers.

Our positive industry views are supported by the current cheap valuations of the China property stocks. Our top picks are those with: 1) favorable landbank vintage (i.e. management has good market expertise in timing market cycles); 2) the ability to obtain cheap financing; 3) good revenue diversification (like a sizeable and growing investment property portfolio); and/or 4) very attractive valuations. 

 

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China is unwinding a property led investment policy and has been squeezing property prices for more than two years. They know as well as anyone else that to keep squeezing when prices are already falling would be a mistake which is why we now see signs of easing. A greater willingness to open up the domestic capital markets is an additional sign that credit expansion will once more be tolerated. 

HKEx is at the “completion stage” of preparation for the link, Li said in a conference call with reporters yesterday, declining to speculate on a timeframe for the start date.

“While the market will always appreciate advance notice, which we will strive to give, I’m not at this point stipulating any particular days,” Li said.

The Hang Seng Index (HSI) slid 0.7 percent at today’s close in Hong Kong. HKEx tumbled 4.7 percent, its biggest loss in six months, while brokerages First Shanghai Investments Ltd. and Shenyin Wanguo HK Ltd. each lost at least 8.8 percent. The Shanghai Composite Index declined 0.5 percent, its lowest closing level in a month.

Authorities said in April they may make further announcements on timing, yet they haven’t given any more details beyond their original statement that the link would start in about six months. Hong Kong’s Securities & Futures Commission declined to comment and the China Securities Regulatory Commission didn’t respond to a faxed request for comment.

Chinese regulators need to address whether foreign investors will pay capital gains taxes on mainland shares before the link can begin, Mark Mobius, who oversees about $40 billion as the executive chairman at Templeton Emerging Markets Group, said in an interview in Hong Kong.
Charles Li, Chief Executive Officer of Hong Kong Exchanges and Clearing Ltd.

“Unless they get all these issues straightened out and clarified, nobody is going to invest,” Mobius said.

 

The opening up of a link between the Shanghai and Hong Kong stock markets would be a very meaningful catalyst for capital flows between China and the international markets and vice versa. However until it is in fact initiated, uncertainty about mainland commitment to the venture will remain, not least because of political uncertainty in Hong Kong. 

A key issue as the Party confronts flaws in the legal system — one that has risked getting lost in the swirl of opinions around the specifics of judicial reform — is the disconnect between local governments and the central government: Local mishandling of problems arising from illegal land expropriations, tolerance of environmental pollution and disregard of product safety problems have led to widespread discontent that undermines the party’s legitimacy. The question underlying the current reform effort is whether the mentality of local officials can be shaped to guide their adherence more closely to centrally promulgated laws and policies.

An article in the progressive journal Caixin recently commented on “bureaucratic lethargy [that] is especially evident in local government departments.” In addition to modifying central-local financial relations, changing the criteria for evaluating local government performance, and simplifying administration, the article identified “setting up a system that is based on the rule of law” as an important remedy.

That’s easier said than done, and many of the legal reforms proposed so far appear to skirt around the issue. What is needed is a more explicit commitment to strengthen the discipline required for the courts to enforce laws consistently and reasonably. More attention needs to be focused on how judges should interpret and follow legal rules, and on how they should exercise their discretion.

 

Much of the debate about the impact of the Communist Party discussing how the law should be interpreted have focused on the difference between “rule by law” versus “rule of law”. However this misses the wider point. The Communist Party is grappling with the challenge of imposing accountability on several hundred thousand officials while also maintaining an iron grip on power and keeping a lid on political dissent. This debate suggests a desire to improve standards of governance.