Japan leads China out of soft patch: Buy Chinese stocks

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The fourth consecutive monthly drop in China’s CFLP manufacturing PMI to 50.7 in July from 50.9 in June was a huge disappointment to the market. What some market players fail to understand is that July is the weakest month of the year from a seasonal point of view. On a seasonally adjusted basis (my adjustment) the PMI actually rose from 52.0 to 52.9 in July!

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

The impact of Japan’s recovery from the 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 Japan being the biggest source of Chinese imports it stands to reason that China will be a main beneficiary of Japan’s recovery as supply lines are restored.

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

The PMI was stronger than my expectations of 50.0 to 50.3 based on 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 relative improvement of the PMI compared to previous “normal” years (2008 and 2009 are excluded as a result of the global liquidity crisis) and especially 2005 and 2010 is clearly visible.

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

From a seasonal point of view new export orders are continuing to hold up well compared to other “normal” years.

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

Stocks of major inputs continue to mirror last year’s decline as manufacturers continue to deplete stocks.

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

The new orders index rose while stocks of major inputs continued falling, resulting in a diminishing ratio of stocks of major inputs to new orders (please note the reverse axis). The slight rise in the ratio in June impacted negatively on the CFLP manufacturing PMI in July as the ratio leads the manufacturing PMI by one month. The decline in July’s ratio to 0.931 from 0.955 indicates that the PMI in August is likely to improve from the current barely growing 50.7.

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

Stocks of finished goods at the factory level have become less of a problem as the build-up gave way to shedding stocks. With new orders rising the ratio of the stocks of finished goods relative to new orders fell for the first time in five months to 0.96 from 1.00 in June. It too signals an improvement in the manufacturing PMI in August.

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

If I extrapolate the relative weakness of 2011’s PMI compared to that of other years through August, and taking into account that August is a somewhat stronger month than July from a seasonal perspective, it seems to me that a figure of around 51.5 should be expected in August. This is consistent with what the stock-to-orders ratios are indicating. Japan’s continued recovery from the disasters may lead to an upside surprise of the PMI.

In the middle of July I argued that the Shanghai Composite Index at 2 787 ran ahead of itself as it anticipated a jump in the PMI to in excess of 52 while the seasonality suggested a fall towards the 50 level. I also warned that Chinese stocks could retreat which subsequently happened (admittedly also as part of a global sell-off).

Looking at monthly closing levels of the Shanhgai Composite Index compared to the PMI, I found that the monthly levels in fact lead the PMI by one month. July’s closing level suggests the PMI in August is likely to be unchanged or slightly lower than July’s 50.7.

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

On the other hand, the monthly bar chart suggests the market is currently anticipating a PMI level of around 51.5.

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

The PMI’s seasonal trend I identified has a narrow relationship with the Shanghai Composite Index. It can therefore be expected that the Chinese stock market is likely to rally through end September and that a level of 3 200 is attainable – almost 22% higher than  today’s level of 2 626!

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

What does it mean for emerging-market stocks? Severely oversold relative to China’s manufacturing PMI!

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

I reiterate that, barring more unexpected black swans, Chinese stocks and emerging-market stocks offer excellent value. So buy!

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