More than meets the eye: Continue to accumulate Chinese stocks

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China’s CFLP manufacturing PMI dropped to 50.9 in June from 52.0 in May. The PMI was in line with what I expected on the basis of the seasonal pattern and what the stock-to-orders ratios pointed to in the previous month’s PMI.

Sources: CFLP; Li & Fung; Plexus Asset Management.

The PMI continues to be significantly lower than previous years’ seasonal patterns, though, indicating weakness in growth compared to other years (2008 and 2009 are excluded as a result of the global liquidity crisis).

Sources: CFLP; Li & Fung; Plexus Asset Management.

From a seasonal point of view new export orders held up very well compared to other “normal” years.

Sources: CFLP; Li & Fung; Plexus Asset Management.

Stocks of major inputs continued to head south as Chinese manufacturers remain in an overstocked position.

Sources: CFLP; Li & Fung; Plexus Asset Management.

The new orders index fell by less and resulted in a steady ratio of stocks of major inputs to new orders. (Please note the reverse axis.) The slight rise in the ratio in May failed to support the CFLP manufacturing PMI in June.

Sources: CFLP; Li & Fung; Plexus Asset Management.

Finished goods at the factory level continue to be a problem as the ratio of the stocks of finished goods relative to new orders continued to decline in June and points to further weakness in the manufacturing PMI in July.

Sources: CFLP; Li & Fung; Plexus Asset Management.

If I extrapolate the relative weakness of 2011’s PMI compared to that of other years through July and taking into account that July is an exceptionally weak month from a seasonal perspective, it seems to me that a figure of between 50.0 and 50.5 should be expected in July. The trend is consistent with what the stock-to-orders ratios are indicating.

In contrast to the drop in actual PMI figure from 52.0 to 50.9 my seasonally-adjusted CFLP Manufacturing PMI for June rose slightly to 52.04 from 51.96 in May. It therefore indicates that the growth in the manufacturing sector has stabilised at the lower levels.

Sources: CFLP; Li & Fung; Plexus Asset Management.

Even if July’s manufacturing PMI falls to 50 it will effectively mean that the seasonally-adjusted PMI for July will improve to 52.2, which means growth in the manufacturing sector is accelerating.

The impact of Japan’s twin disasters on China’s manufacturing sector is evident when my seasonally-adjusted manufacturing PMI for China is compared to Japan’s manufacturing PMI, which is seasonally adjusted. With the two series moving in tandem it is clear to me that the slack in production as a result of Japan’s crisis is been taken up, albeit slowly.

Sources: Markit; CFLP; Li & Fung; Plexus Asset Management.

The continued recovery in Japan’s manufacturing sector can therefore be expected to enhance the outlook for growth in China’s manufacturing sector from the third quarter of this year.

However, it is evident that based solely on the manufacturing PMI year-on-year GDP growth in China has slowed to approximately 9.2% in the second quarter from 9.7% in the first quarter.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Asset Management.

In my previous comments I argued that the significant slowdown in economic growth in the second quarter would to take the heat off the PBoC from tightening further. With inflation seen as under control it is likely that when they meet early this month the Chinese authorities may call a halt to the further tightening of monetary policy and may even decide to ease credit restrictions to engineer a soft landing.

The consensus among Chinese economists is that year-on-year GDP growth in the second quarter will be about 9.5%. I think 9.2% will be quite a disappointment for the economists but not the Chinese stock market players. They are in fact fairly good anticipators of the underlying economy as illustrated below. At the end of May the market anticipated a drop in June’s PMI. Currently the market anticipates a slight rise in July’s PMI.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Asset Management.

That to me is the greatest uncertainty – not only for China’s stock market but also for global equity markets. July is seasonally the weakest month as far as the CFLP manufacturing PMI is concerned. The Shanghai Composite Index leads the seasonal trend of the PMI by one month. Thus one would have expected the Shanghai Composite to end June significantly lower than 2763. Bear in mind that the market turned at 2622 on 20 June, though, and has rallied by more than 5% since then.

Sources: Li & Fung; CFLP; I-Net; Plexus Asset Management.

While there will undoubtedly be pullbacks in stock prices due to worse than expected economic numbers such as second-quarter GDP growth, I am of the opinion that, barring more unexpected black swans, Chinese stocks are offering value. I will continue to accumulate Chinese stocks on weakness.

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