Does China hold the winning ticket?

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The article below is a guest contribution by Frank Holmes, CEO and Chief Investment Officer of U.S. Global Investors.

The odds of winning tonight’s Mega Millions jackpot are 1 in 175,711,536. This remote chance hasn’t stopped people from lining up to buy a ticket, as the “what-if-I-win” idea seems so thrilling.

Some bears may think the odds of China being the winner among emerging markets in 2012 are also remote. Over the past few years, Chinese stocks have lagged compared to its emerging market peers. However, the Periodic Table of Emerging Markets perfectly illustrates: last year’s loser can be this year’s winner. Historically, every emerging country has experienced wide price fluctuations from year to year. Over time, though, each country tends to revert to the mean.

In the visual below, we highlighted China’s performance pattern over the past 10 years. Chinese stocks landed in the top half four out of 10 years—2002, 2003, 2006 and 2007. In 2003, China climbed an astounding 163 percent; in 2007, it was the top emerging market again, returning nearly 60 percent.

Since then, the country has fallen to the bottom half of the chart. If you apply the principle of mean reversion, history appears to favor China landing on top during this Year of the Dragon.

Unlike the lottery system, China won’t leave its success to pure luck. If the Dragon doesn’t breathe fire into markets, it may be a shot of liquidity injected by policy easing that could drive stock prices higher. Macroeconomic theory states that when a country’s money supply exceeds economic growth, the excess liquidity tends to drive up asset prices, including stocks.

BCA Research documented this trend in China over the past eight years. The research firm compared the difference between the change in money supply growth and nominal GDP growth and Chinese stock prices. In both instances when the change in excess liquidity fell to a low, so did stocks. Conversely, the rise of money supply growth compared to GDP growth “coincided with major rallies” for China’s stock market, according to BCA.

Today, it appears that the change in excess liquidity is just beginning to bounce off another low, as are stocks, indicating another potential inflection point.

BCA hedges China’s possible stock advancement in the short-term if signs of economic improvement continue because they “reduce the odds of aggressive policy easing.” A few weeks ago, I discussed how investors seemed to overlook China’s focused macro policy strategy, with its actions deliberate and purposeful. This year, the government has extra incentive to sustain meaningful growth as it transitions to a new leadership by the end of the year. As President Hu Jintao and Premier Wen Jiabao depart, Xi Jinping and Li Keqiang are expected to take over.

Looking at historical GDP growth per year since 1978, Deutsche Bank finds there’s precedence for this idea. During the fifth year of the leadership transition cycle, “high or stable” GDP growth was maintained, with the exception being the Asian Financial Crisis in 1997.

When I was in Singapore at the Asia Mining Congress this week, I was fortunate to be among a group of sharp and intelligent experts across the financial and mining industries. One China bull presenting an excellent case for the country was Jing Ulrich, JP Morgan’s managing director and chairman of China equities and commodities group. She’s the Oprah Winfrey of the investment world, as for the past three years, Forbes Magazine has ranked her among the 50 Most Powerful Women in Business.

Ulrich expressed similar views toward China and its political will in a recent “Hands-On China Report” following her attendance at the China Development Forum in Beijing. She said that the government ministers emphasized their commitment to rebalancing the economy toward consumption. While “fundamentals are currently sound, the nation must modify its ‘imbalanced, uncoordinated and unsustainable’ course of development,” says Ulrich. Importantly, the government had the financial resources to effect this change and considered it important to maintain sustainable growth, writes Ulrich.

The ups and downs of this road toward a consumption-led economy are topics I’ll cover in next week’s webcast on China. I will be joined by CLSA’s Andy Rothman. Together, we’ll discuss what investors should expect from China in terms of long-term GDP growth, fixed asset investment, exports and the housing market. Be sure to sign up now.

Source: US Global Investor, March 30,  2012.

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Appreciating China to its fullest

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The article below is a guest contribution by Frank Holmes, CEO and Chief Investment Officer of U.S. Global Investors.

Wine expert and social media guru Gary Vaynerchuk attributes his ability to detect subtleties in wine that others might not recognize because of his unique taste-testing as a teen. Because drinking wine was illegal, he says he tasted the flavors associated with wine instead. He not only ate fruits and vegetables, but also chewed on chunks of grass, dirt, tobacco and wood so he could learn to recognize the complex flavors that wine has to offer.

For investors, an appreciation of China requires a similar comprehensive analysis.

One significant subtlety that seems to be overlooked by investors today is China’s macro policy strategy. Professor Stephen Roach in the Financial Times thinks the country has been “doing a far better job in managing its economy than most give it credit.” Its actions have been deliberate and purposeful, and, most important, successful. He points to measures that China enacted to lower food inflation, along with the numerous times the country raised required reserve ratios and policy interest rates as illustrations of China’s increasing “prowess” in stabilizing its economy.

The positive results of the government’s actions have a delayed effect, only to be detected a few months later. For example, the chart below shows how the food and non-food consumer price index (CPI) have declined on a year-over-year basis over the past several months. CPI is now at its lowest level since July 2010, says CLSA.

With inflation now under control, China is stocked with other possible monetary policy actions to help growth in 2012, as opposed to the central banks of the U.S., Europe and England, which have run empty. “They have followed the Bank of Japan and taken their short-term policy rates down to the zero bound,” Roach says.

Perhaps the sommeliers have become the students: Rather than the developed countries’ central banks providing directives to China on ways to grow its economy, maybe it should be the other way around. Roach says that China “offers some lessons in macro policy strategy that the rest of the world should heed.”

Roach concludes that “long focused on stability, [China] is more than willing to accept the short-term costs of a growth sacrifice to keep its development strategy on track.”

Jim Rogers has also identified many attractive nuances of China, which he believes China Bears are missing. When the legendary international investor was interviewed this week by Business Insider, he pointed to the country’s long history of “entrepreneurship [and] capitalism, they have the brains, they have the know-how” as reasons to be bullish.

Its likely China will experience setbacks as it grows, says Rogers. After centuries of decline, the country just recently experienced a rebirth when Deng Xiaoping led China toward a market economy in 1978. Growth is still in its early stages. However, each time China data appears slightly off, bears are quick to doubt Beijing’s ability to successfully navigate its economic terrain.

When Premier Wen Jiabao announced this week that the government’s targeted GDP growth was expected to be 7.5 percent, it wasn’t a surprise to seasoned China followers. Andy Rothman of CLSA says it was consistent with his expectations. Premier Wen’s message came as “neither a surprise nor a signal that the Communist Party believes growth is decelerating beyond what we had expected.” Rothman also doesn’t think Wen’s speech signaled additional stimulus either.

Sometimes a target is just a target: China’s GDP has always grown more than what was projected. Take a look at the chart below. The yellow line shows how China has conservatively set its target GDP growth for the past decade. Every year, actual GDP growth has been higher and much higher in some cases. For example, in 2007, while the government projected GDP to grow 8 percent, actual GDP growth came in much higher at 14 percent.

While most analysts don’t expect another moon shot rise in GDP this year, a 7.5 percent growth rate still exceeds most emerging economies and all developed nations. Advanced economy growth is expected to be meager, slowing from 1.6 percent to 1.3 percent in 2012, according to The Conference Board.

Since the new year, the MSCI China Index has risen about 11 percent. This increase comes after a 2011 decline of nearly 20 percent. However, last year’s sell off continues to provide bargain basement prices for some Chinese stocks, as the index is trading at an attractive price-to-earnings level, says Deutsche Bank. While the 10-year P/E has averaged 12.5 times, the 12-month forward price-to-earnings for the MSCI China index is currently at 9.1 times.

Deutsche Bank strategists say with “very healthy” GDP growth and moderate inflation, the “macro fundamentals should easily justify a further rerating of the forward P/E to 10.5 times” by the end of 2012. This valuation suggests that the MSCI China could increase 15 percent from its March 8 level, says Deutsche Bank.

For long-term investors learning to appreciate the finer points of the country, we believe China is somewhat like fine wine; it only gets better with age.

Source: Investor Alert, US, March 9, 2012.

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China’s cut in reserve requirements – very bullish for stocks

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The PBoC’s announcement of a 0.5% cut in the reserve requirement rate (RRR) of Chinese banks has significant consequences not only for the Chinese economy but also for China’s stock market. The cut to 20.5% for large banks follows a similar cut in December last year after hikes since January 2010 that saw the RRR increasing in 12 increments from 15.5% to 21.5%. It is estimated that one half percent change in the RRR amounts to a change of approximately 400 billion yuan or roughly US$60 billion in liquidity. It therefore means that the jump in the RRR since January 2010 has effectively drained overall liquidity by approximately US$720 billion. That is equal to approximately 6% of China’s GDP in 2010 and 2011 combined.

Although the PBoC cited weak external demand as the main reason for the drop in the RRR, liquidity became very tight in recent weeks and forced interbank rates significantly higher. The CFLP Manufacturing PMI that I seasonally adjust continues to indicate lackluster growth in China’s manufacturing sector largely as a result of weak export orders. As in 2008 the PBoC held off on further increases in the RRR in 2011 when weakness in the manufacturing PMI became apparent. The first cut in the RRR last year was announced when the manufacturing PMI contracted – again similar to what happened in 2008. The latest cut therefore indicates that the manufacturing PMI for February is likely to again show abysmal growth.

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

The weakness of China’s economy is not only confined to the manufacturing sector, though. While still signaling growth, my seasonally adjusted CFLP Non-manufacturing PMI indicates that growth has slowed to about half of the average since the recovery after the 2008/2009 crisis.

Sources: CFLP; Li & Fung; BIS; Plexus Holdings.

The weakness in the non-manufacturing sector is driven by weak consumer confidence.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

My GDP-weighted seasonally adjusted CFLP PMI indicates that China’s year-on-year GDP growth has slowed to approximately 8 – 8.5% from 8.9% in the fourth quarter last year.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

The cut in the RRR is consistent with what happened in 2008 when GDP growth fell below 9%.

Sources: NBSC; BIS; Plexus Holdings.

Assuming that a 0.5% change in the RRR equaled US$60 billion throughout, I calculated the cumulative liquidity drain. It is evident that changes in liquidity lead GDP growth by approximately two quarters and the seasonally adjusted manufacturing PMI by three months.

Sources: NBSC; BIS; Plexus Holdings.

Sources: CFLP; Li & Fung; BIS; Plexus Holdings.

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Chanos: How China could fail the world economy

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Hedge fund manager Jim Chanos says slowing demand in China will continue and may have ripple effects around the global economy.

Source: CNNMoney, February 21, 2012.

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How best to play the China story

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Helen Zhu, chief China equity strategist of Goldman Sachs, believes the mainland will see policy normalization in 2012. In light of that, she reveals how best to play the China story.

Source: CNBC, January 29, 2012.

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China and India: Strategies for sustainable growth

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This post is a guest contribution by Chetan Ahya, Derrick Kam and Jenny Zheng of of Morgan Stanley.

Backdrop: Have Both Nations Been Living on Borrowed Growth for Too Long?

Following the credit crisis, both China and India relied on aggressive tactical measures to revive growth quickly. Given the pace at which the external environment was deteriorating then, policy-makers in both China and India had to act quickly and decisively to boost domestic demand.

• Specifically, in China, the key driver of domestic demand was an aggressive credit expansion – close to a 30pp rise in the ratio of bank loans to GDP (excluding non-bank loan lending by banks), in addition to some support from the expansion in the government’s budget deficit. Bank loans to GDP has been maintained at these high levels of close to 130% until recently.

• In India, the biggest driver was the doubling of the national fiscal deficit – from 4.8% of GDP in the year ending March 2008 to 10% in the year ending March 2009. By our estimates, the national deficit is likely to be 9.2% for the year ended March 2012 – implying that the government has now maintained this expansionary fiscal policy for four years in a row.

China’s Fetish for Investment, India’s for Consumption

As growth began to slip immediately after the credit crisis, China focused on supporting investment with the large rise in the ratio of bank loans to GDP. India focused on supporting strong consumption (particularly rural consumption) growth with its major fiscal stimulus. These stimulus measures were largely instrumental in helping China and India to recover quickly from the global recession. Indeed, this counter-cyclical response – a rise in bank loans in China and fiscal expansion in India, respectively – had also been employed during the 2001 US recession and global growth slowdown.

Macro Stability Risks – Only Symptoms of Low Productivity Dynamic

The stimulus measures helped to boost growth quickly – but they also brought macro stability risks. A major rise in property prices, inflation pressures and banking sector asset quality issues – symptoms which surfaced in China and India over the course of 2010-11 – are only a reflection of the low productivity dynamic of growth driven by tactical stimulus, in our view.

We believe that the aggressive policy stimulus was not based on what was truly needed for achieving a sustained growth trend in these countries. Rather, the stimulus measures were based on what both governments could do best in that short period in response to the sudden growth shock on account of the credit crisis. Given the sharp and rapid pace of the deterioration in growth conditions, we believe one can hardly question this move at the time the credit crisis was unfolding.

However, persistent reliance on tactical measures for such a long period (September 2008 to late 2010) was at the heart of the emergence of these symptoms of macro stability risks.

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