China and You II

Fresh news out of China is not that encouraging. I talked to several contacts in China last week and it seems that Chinese officials may attempt to dampen stock market growth. The Shanghai Composite Index slumped the most since June 2008, sinking a monstrous 23% since August 4th of this year.

Rumors that Chinese state-owned companies will be permitted to default on their commodity derivatives contracts have also hit the street. This in turn, as we know the world’s third largest economy and major commodity consumer, has sent resource-based currencies into a tailspin.

There are signs that Chinese companies remain cautious, as the economy may take a slower path. June PMI increased slightly to 53.2, firmer than expected. The forward looking new orders index, however, was down 0.7pp to 55.5, reflecting slower infrastructure investments. Local government’s outstanding debt exceeded RMB4 trillion by end 2007 and given the large amount of infrastructure spending and increased reliance on debt financing, I believe their outstanding debt could reach RMB12 trillion by end 2010. Combined with treasury debt, public debt-to-GDP ratio could hit 55%.

The amount of excess liquidity (measured by the gap between M2 and nominal GDP growth) available to the stock market is now more abundant than at any time from the early 90s onwards. Without either monetary tightening and/or a sharp rise in nominal economic growth, it could be very difficult to prevent a huge and damaging bubble from emerging.

The level of retail participation in the market, reflected in the number of new accounts opening, is showing not sign of abating while the valuations of the Shanghai A-share index is now well above the long-term average (the index will need to drop over 20% to get back to the average) based on all four yardsticks: forward P/E, trailing P/E, trailing P/B and the forward yield gap, and approaching or having passed the +1 standard deviation (SD) level based on both trailing and forward P/E.

I believe that there is a good chance that A and H-share premium set to shrink. After the 20% outperformance in the last few months, A shares are now trading at a 50% premium to H shares. With no obvious difference in the cost of capital plus the A-share market being far from the bull market of 2007 (when retail investors dominated), it is difficult to see how this premium can further widen.