China: No Time for Complacency
|Our Correspondent||Aug 29, 2008|
Chinese financial markets are unlikely to respond positively to growth-boosting initiatives despite the declining trend in the consumer price index because the economy appears to be near or close to its potential output, given evidence of a sharply rising producer price inflation trends over the past few months ‑ such that policymakers have very little scope for boosting growth without quickly risking another round of higher-trending consumer price inflation.
With upside surprises on growth unlikely to materialize, and with underlying inflationary pressures dampening earnings growth, the best case scenario for China’s stock market seems to be a highly volatile sideways trend similar to US stock markets in the 1970s.
No Soft Landings
Any light we see at the end of the tunnel for China’s economy is a long way off. We have consistently argued that the accumulated distortions in China’s economy and financial markets caused by record foreign capital inflows will eventually require a painful unwinding; only when the excess liquidity-induced distortions are unwound will Chinese asset markets be poised for another bull market cycle.
That is likely to take some years because it won’t happen until Chinese policy makers find their analogue to Paul Volcker ‑ and they are willing to let him or her fight inflation unimpeded by political intervention. Thus, our best-case scenario for China’s economy is “protracted stagflation with Chinese characteristics”. This means a combination of growth below the roughly 10-11 percent trend we’ve seen over the past couple of years (e.g. say below 9 percent), and above recent-trend inflation (say CPI at about 3 percent) that proves a toxic combination for stock valuations and corporate earnings over the foreseeable future.
Dead Cat Bounce
China’s SSE Composite Index rebounded by a headline-grabbing 7.6 percent to 2522 on August 20, reversing slightly more than half of the 14.9 percent plunge that the main index had suffered since the Olympics opening ceremony on August 8. The stock surge brought with it a glimmer of hope that the worse might be over for what has been an epic collapse of China’s stock prices over the past 10 months as measured by the roughly 60 percent decline in the SSE Composite Index from the intraday high of 6124 hit on October 16, 2007.
We don’t buy it. The market’s roughly 4 percent slide since Wednesday tends to support our skeptical take.
Margin Shrinkage to Persist
In our view, the Chinese stock markets are likely to continue facing downside pressure as underlying inflation undermines corporate earnings through various channels. These include: 1. by bloating inventories (such as automobiles) as inflation eats into household purchasing power; 2. by increasing input costs and shrinking margins as producer prices continue to face upward pressure; and finally, 3. by continuing to force government price controls in major sectors like the oil sector, which is causing enormous losses by state companies.
Word on the Street
The word from traders in Shanghai last week suggested that there were two key factors leading to the rebound in market sentiment. First, there were rumors that securities regulators are planning an important meeting with China’s major stockbrokers to discuss market-boosting measures. Second, Frank Gong, JP Morgan’s chief China analyst, sent a note to clients in which he claimed that China’s leaders are considering a RMB 200-400 billion stimulus package (roughly 1 percent of GDP) and further easing of monetary policy.
In the absence of a more suitable explanation, this take on the market’s surge last week seems plausible enough; however, we see little scope for either regulatory or economic-growth boosting policy to provide a durable source for sustainable gains in market sentiment going forward.
Same Old, Same Old
Regulatory jawboning and promises of market relief measures have proven toothless several times already this year in reversing the downward direction of the market’s torturous slide; whatever regulators come up with this time is unlikely to suddenly prove to be the silver bullet for putting the market back on track. As Michael Pettis, a professor at Peking University's Guanghua School of Management, reported on Wednesday in his blog: “Regulators actually made announcements over last weekend (August 16-17) about steps they were taking to support the market, but these had almost no positive effect on the market at all – on the contrary they were judged to be so disappointing that Monday’s (August 18) market was down 5.3 percent. In fact none of the measures announced during 2008 have affected the market by more than a few days.”
Nothing New Here Either
As for speculation that the note by JP Morgan’s Gong boosted the market, it is hard to argue that higher growth will lead to higher stock prices for a couple of reasons. First, for weeks, key Chinese policy makers have been all over the local and Western press indicating an economic policy priority shift from “inflation-fighting” to “boosting growth” as justified by a continued declining trend in headline CPI.
Second, the market went on its 14.9 percent Olympic plunge coincident with a flurry of macro data releases that came in much better than expected, indicating strong underlying economic growth dynamics in China—and providing a strong contrast to the widespread conventional wisdom that China’s economy is in the midst of a slowdown. Macro data releases indicated robust growth across all three main drivers of the Chinese economy (i.e. consumption, investment and exports), as reflected in unexpectedly strong performances in July for retail sales, fixed asset investment and exports.
It seems to us that markets already had plenty of evidence over the past several weeks to respond to positive news on the growth front, including from policymakers already clearly promising in prominent quotes all over the local newspapers a reversal of tight economic policy as well as from positive economic data releases showing strong underlying growth dynamics.
One might argue that the market ignored the positive macro data and the previous government jawboning because investors have been distracted by the Olympics. However, if markets weren’t paying attention for the first 10 days of the Olympics, why would they all of a sudden pay attention to the market rumors about easier government policy that supposedly boosted markets last Wednesday? Wednesday’s market surge, if we are right, will turn out to be a typical example of the old investing aphorism: buy on rumor, sell on fact.
No Easy Cures from Chinese Medicine
Unfortunately for Chinese stock investors and Chinese policy makers, China’s macro story and the underlying reason behind China’s epic stock slide is not a simple story of a slowdown in economic growth; therefore, a simple prescription of growth-boosting fiscal and monetary stimulus is unlikely to fix what ails Chinese stock prices.
We know for sure that growth concerns were conspicuously absent in China in early January 2008 because we were in China then as part of our latest week-long research briefing trip to three major Chinese cities, including Shanghai, Wuhan and Beijing. At that time—roughly a week before the epic 2008 blizzard—the SSE Index was already off 10 percent from the peak hit in October 2007. Yet, not one speaker on our week-long agenda in China worried about the economy slowing.
In fact, the speakers we met on our entire trip itinerary across three cities in China—to a person— believed that the underlying momentum built into the Chinese economy made any kind of a meaningful slowdown highly unlikely for the foreseeable future. Pettis played his usual role as the vocal contrarian, arguing that the China boom would one day turn to bust—and that he was looking to lighten up on Chinese stocks sometime in the spring ahead of the Olympics—but even he saw no evidence of any imminent downside risk to China’s robust growth prospects.
Inflation is another story. Monthly CPI prints spiked between May and September, doubling from the 3 percent level to above 6 percent. With the benefit of hindsight it seems safe to assume rising headline CPI numbers leading into the October 2007 market top was an important trigger in the Chinese stock market correction—and that concerns about growth were NOT a trigger.
We would also like to suggest that the market declines in the wake of the back-to-back natural disasters in China in January and again in May with the massive earthquake had at least as much to do with concerns about rising inflation as about slowing growth.
Versus Growth Myth
The conventional wisdom seems to be that China’s stock market swoon in the wake of the January 2008 blizzard came from concerns over slowing economic growth caused by weather-related production shocks. The insidious thing about supply-side shocks, however, is that they fuel inflationary pressures at the same time they dampen economic growth. Natural disasters like China’s blizzard are a classic example of the kind of major supply side shock ‑ same as the oil shocks of the 1970s ‑ that reduces productive capacity in an economy and thus fuels inflation despite a coinciding slowdown in economic growth.
With CPI trending down in China, it is easy to jump to the erroneous conclusion that macro stresses are abating, such that policy makers can safely boost economic growth and as the economy recovers so too will the Chinese stock market. In China’s case, however, we would argue the declining trend in CPI could be bad news for stocks. Declining headline inflation means that companies are less able to pass on input price increases to consumers as reflected in the continuing surge of producer prices.
Another concerning trend related to rising inflation in China that is easily missed if one is only looking at the favorable trend in headline CPI, is the sharp rise in inventories (such as the 50 percent rise in automobile inventories in the first half of 2008 that I highlighted in a recent Asia Sentinel article). I stressed slowing auto sales trends through June 2008. The July numbers continue to paint the same negative picture for auto sales as evident through June. The continued weak performance of car sales despite much-improved macro data in July, suggests that sluggish growth caused by the natural disasters is not the primary cause of slowing car sales and rising inventories.
We believe automobile inventories are rising in the face of strong macro data because inflation is eating into household disposable income and curtailing overall car sales. Evidence to support this thesis is provided by data indicating the least expensive models are showing the largest percent decline in unit sales. The sales data overall for the automobile sector in July continue to show negative trends, with sales growing a paltry 4 percent year-on-year. According to the China Association of Automobile Manufacturers, sales of commercial vehicles contracted 3 percent annually in July to 177,600 units, the first contraction since January 2006. Passenger vehicles sales managed to grow 7 percent year-on-year to 488,200 units, but this was the first single digit growth since August 2006.
Growth Ain’t the Answer
In a very provocative op/ed piece for the Financial Times, Kenneth Rogoff argues that the United States ‑ and by extension the world ‑ is unlikely to grow its way out of the current financial crisis. The same can be said for China and its declining stock market: faster economic growth is unlikely to be the answer for a sustainable turnaround.
Rogoff explains that “the huge spike in global commodity prices inflation is prima facie evidence that the global economy is still growing too fast.” In China, the prima facie evidence for “inflation” is apparent in the continued surge in producer price inflation, which spiked 10 percent in July compared to a year earlier.
We believe China’s big stock market day last week is unlikely to prove a turning point event as Chinese policy makers continue to face complicated challenges dealing with inflation-related macro stresses and distortions that are evident in stock market weakness. Continued weakness in stocks will only further complicate Chinese policymakers’ challenge to maintain macro stability in the months to come.
Policy makers will continue to face increasingly constrained policy choices and least worst policy options as underlying distortions in the economy and financial sector —caused by several years already of enormous foreign capital inflows— continue to manifest in elevated inflation and below-trend growth.
Sam Baker is director of Asia research for Trans National Research Corporation, a US-based political and economic consultancy specializing in global emerging market research.