U.S. Overtakes China as Driver of Stock Returns

I wouldn’t normally just rehash something from Bloomberg, but think this is a very interesting article:

U.S. Overtakes China as Driver of Stock Returns: Chart of Day

2010-02-09 21:16:07.0 GMT

By Michael Patterson and Alexander Ragir

Feb. 10 (Bloomberg) — Shares of global companies that sell to U.S. customers are outperforming those that rely on Chinese demand for the first time since 2008. The trend will continue as America’s economic recovery quickens, HSBC Holdings Plc said.

The CHART OF THE DAY shows companies that get at least 33 percent of their sales from the U.S. are beating those that generate at least a third from China, based on stocks in the MSCI AC World Index. The U.S.-focused companies, which trailed the China-focused businesses every quarter since the period ended September 2008, have outperformed by 4.8 percentage points in 2010, according to indexes compiled by Bloomberg.

While “U.S. growth surprises on the upside, Chinese policy is more likely to tighten,” John Lomax, a London-based strategist at HSBC, wrote in a report. “This environment should, we think, be positive for U.S. equities and by implication markets which are sensitive to the U.S.”

Shares of companies that sell to China are underperforming as investors speculate policy makers will rein in stimulus programs and bank lending that bolstered the nation’s economy during the global recession. U.S. reports in the past month showed consumer confidence, economic growth and manufacturing are rebounding faster than economists estimated, while the unemployment rate unexpectedly fell.

The index of companies that sell to China has 184 stocks including Brazilian iron-ore producer Vale SA and China’s Bank of Communications Co. The gauge of U.S.-reliant companies has

248 shares including Canada’s Research in Motion Ltd., maker of the Blackberry, and Minneapolis-based retailer Target Corp. Both gauges are weighted by market capitalization and based on sales data as of Feb. 3.

Among 2,420 stocks in the MSCI AC World index, 617 disclosed the percentage of total revenue they got from the U.S., China or both, according to data compiled by Bloomberg as of Feb. 3.

Tighter monetary conditions set to come

It looks like the conditions in China are set for tighter monetary policy?  Why?

Well, this January the overall trade surplus China  is down US$25bn, to its lowest level since Jan 2006.  How has this happened? Domestic consumption in Jan grew much faster than exports.

Trade data in January illustrates a very strong recovery in both the domestic and export driven economies – in fact I would say it is in danger of overheating.

Exports were up 21% -, reaching at US$109.5bn (marginally below the record of US$109.64bn set in Jan 08). Thus one can comfortably consider the export economy out of the danger zone.

Simultaneously, imports jumped a phenomenal 85.5% year-on-year to a new record this January, reaching US$95.3bn (from the previous record of US$90.2bn also set in Jan 08).  Even if one accounts for the contribution made to domestic consumption by an earlier than usual Chinese new year, this data point is huge.

The difference gives the Chinese authorities an incentive to consider tightening their monetary policy.

Back to double digit growth

There’s been a lot of buzz in the media this morning about China’s announcement that GDP grew 10.7% year-on-year in the 4th quarter of 2009.  2009 GDP expanded 8.7% as a whole, which was higher than market forecasts of 8.4%-8.5% (though I note than the figures published for the first half of the year were slightly upgraded).

I would imagine 2010 is going to be strong, and might actually reach 10%, helped by a surge in exports, which could increase by as much as 35% in the second quarter of this year.

Infaltion in December jupmed 1.9% (against market expectations of 1.4%).  This was primarily due to food prices.  I can see the CPI increasing above the 2.25% deposite benchmark rate some time in the first quarter of 2010, which I would expect to result in an interest rate hike sooner rather than later.

Governmment sponsered spending on rail and highway projects slowed towards the end of 2009.  In conjunction with the macro tightening policies enacted last week (raising banks reserve ratio requirements) this is negative news for the raw material and construction segments.

People are asking what this means for the world economy.  Essentially growth can only be good.  On the back of this good news I would expect wall street to rally today, and perhaps for the dollar to continue strengthening (after its little fall last week) – though that could be affected by payroll data due out today.

Getting sector specific

In China, like most other markets, investors will have to focus more on individual companies and sectors rather than riding the general upward trend enjoyed in 2009.  The market has lost 1.7% this year on concerns that lending might be tightened to avoid asset bubbles.  This makes China the worst performing Asian market in 2010.  Nonetheless there are still opportunities, as today’s trading highlighted: for every stock that lost ground in China during today’s trading, about 2 were up.

Air and rail fared well today.  Air China, China’s largest international carrier, gained 5% reaching 11.13 Yuan, its highest level since June of 2008 on news that it may have swung to a profit in 2009.  Railways inched up on the prospect of improving orders , including Daqin Railway, the operator of China’s largest coal transport network.

However, without a macro catalyst it looks like the market is set to consolidate at current levels.  The upshot is that it will be more important to pick those sectors and companies most likely to benefit in the coming environment which is likely to witness the continuing tightrope of inflation (BNP forecast it could reach 8% this year) and the gentle tightening of credit (as per the increase in banks reserve ratios mandated last week).

Why has China sold off this morning?

BN    13:37    *ZHOU CITES SURPLUSES IN INTERNATIONAL PAYMENTS ADDING LIQUIDITY

DJA   13:37    *DJ PBOC: Pay Close Attention To Banks’ Reserve Requirement

BN    13:37    *ZHOU SAYS RESERVE REQUIREMENTS CAN SOAK UP LIQUIDITY   : PBCZ CH

BN    13:37    *ZHOU SAYS CENTRAL BANK MAY STILL NEED TO USE RESERVE RATIOS

BN    13:36    *PBOC’S ZHOU SAYS BANK RESERVE RATIOS ARE IMPORTANT TOOL

DJA   13:36    *DJ PBOC Zhou: To Use Lending, Deposit Rate Margin As Policy

SHCOMP tumbled by almost 2% in quick fashion since these comments. Market concerned that RRR hike may come in earlier than expected.

Go out and shop!

There were fears that a reduction in lending in the second half of 2009 would damage the Chinese economy. Yet, it looks like the stimulus and huge lending experienced in 1H09 might have been sufficient to buoy the Chinese economy after all.  Just look at the following three metrics:

1. Industrial output in 8/09 was up 11.8% (annualized).  That comes on the back of a 10.8% annualized increase in July.

2. Retail sales were up an annualized 15% in August

3. Alcoa (the largest aluminum producer in the US) has raised its 2H09e forecast of global consumption, citing the Chinese car market as a primary driver.  They estimate that in 2009 China will overtake the US as the largest car market globally with 12m unit sales.  Alcoa was up 3.45% (beating the S&P’s +0.88% performance).

All of this has been good news for the market – rising now for 6 consecutive days after dropping 20% in August.

Why has China bounced while the US is still limping?

Please send in your suggestions…

Here are a few reasons off the top of my head – I will add more when they come to mind:

1. China’s downturn was only partially caused by the US downturn.  In 2008 domestic spending was squeezed by higher food and oil prices.  These are a higher % of Chinese household expenses compared with the US and EU countries. In 2009, commodity prices are down, easing one constraint on private consumption.

2. Pre-US meltdown, China had a tight credit policy aimed at curbing inflation and preventing overheating (esp in construction and real estate).  The US had a lose credit policy.  Thus, in 1H09 China was able to increase lending by relaxing its stricter policy.

3. Chinese households have a lower debt burden than their US counterparts.  As a result tax reductions and stimulus measures are more readily spendable by Chinese consumers, whereas US households are more likely to save.

China’s still headed South – Baoshan Iron a good buy?

Shanghai continued moving South this week as I’d expected for the following primary reasons:

1) Less credit – Caijing magazine expects CNY200bn of lending this August, compared with CNY355.9bn in July, and a staggering CNY1.53tr in June.

2) Reduced company earnings – for example Baoshan Iron 1H09 profit decreased 93% to (CNY669m) as shipbuilding and car manufacturer continued to be hit globally.  The company said that “foundations for a domestic recovery are not solid.”  China Southern Airlines (China’s largest carrier) 1H09 profit decreased 97% to CNY25m.

Good news is that the index is now trading at a 29.2x p/e compared with a high of 38.75x on 4 August.  This compares with 19x for the MSCI EM index.  Nonetheless with potentially higher growth prospects in 2010+ than other countries Shanghai certainly deserves to trade at a higher thatn MSCI EM overall.

Goldman Sachs consider China a ‘bright spot’ in equities, and focus on that growth potential in 2010 and beyond.  GS sees the Government remaining pro-growth.  In addition, Baoshan remains one of GS top ten picks for China.  In fact of 35 analysts polled, 30 recommend a buy/add/overweight for the stock, with an average Target price of CNY9.33 (a third above today’s close).

Chinese moot reigning in lending

Chinese banks received a draft ruling that would require them to deduct existing subordinated and hybrid debt sold by other lenders from supplementary capital.  In addition, the new rules would limit the amount of hybrid and subordinated debt held by a single bank to 15% of core capital (and 20% for all banks in total).

The banks have been given until the 25 August to provide their feedback on the issue to the China Banking Regulatory Commission.

The upshot maybe to increase minimum capital adequacy ratios by reducing lending, or increasing capital by selling more shares to the market.  In fact, the regulator has asked small banks to increase their CAR to 12% (from 10%).

Chinese stocks have stuttered as investors are concerned that such a move would curtail loan growth. A significant portion of Chinese growth has been driven by increased lending and stimulus spending, in an attempt to plug the export hole.

In my opinion the commission is correct in focusing on ‘main-street’ and crafting a path of more sustainable growth, ensuring that asset bubbles are contained, and non-performing loans are kept to a minimum.  In this case the stock market should clearly play second fiddle.

Asian economies reliant on Chinese demand

More to follow…