Ramblings of a Portfolio Manager 1-4-2009

Will China Do it Again?



It’s just about axiomatic on Wall Street that the top-performing market, sector, or asset class from one year seldom retains that title over the course of the next twelve months. Notwithstanding the marketing materials from the momentum or “trend is your friend” style of investing crowd, our research shows the old adage largely holds true when one looks within a particular geographic market. Here in the US one needs only to look at the tech bubble and subsequent wreck of 1999-2000, the real estate and financial services boom and bust of 1989- 1990 and more recently 2006-2007, and the commodities run over 2007-2008. There are many more examples and they all share the same basic life cycle: a catalyst—e.g. interest rates, currency exchange rates, disruptive product innovation, mania, etc., which starts the performance trend--a reaction, which is generally a big run up in prices during the latter stage of which the term “this time it’s different” is often heard--followed by an inhibitor –Central Bank actions, aging product life cycle, valuation concerns, someone standing up and yelling “hey, he’s just a big cockroach” (as in the old Far Side cartoon), which cools the trend or pricks the bubble as it were.



There has been much hand wringing over China, its stock market and economy of late. Many of the pessimistic charges levied against the US market and economy have similarly been aimed at China, often by the same cynics. The Chinese Shanghai Composite index rose over 75% in 2009 and Chinese GDP grew at a rate somewhere north of 8% according to most economists. The GDP growth rate compares to 11.4% and 9.6% in 2007 and 2008. The term “too far too fast” is beginning to be applied to the Chinese stock market while “bubble economy” or “stimulus dependent” are phrases one often hears regarding the Country’s economy. Sound familiar? Of course there is the whole cadre (that’s what Mao would have called them just prior to having them shot) who simply claim that China fakes the economic numbers and that the entire market run-up is a sham.



We can’t argue with the fact that the trend in China’s GDP is for slower growth each year—even we agree with the proverb that “trees don’t grow to the sky” and eventually the law of large numbers takes over—but we take issue with the fact that China is in a falsified or stimulus-induced bubble destined to soon burst. As with the US, government actions are indeed driving the economy in the short term. The 4.0 billion Yuan stimulus package passed by the Chinese Central Government last year is most certainly behind the Country’s impressive growth rate amid a slumping world economy. The State controlled banks kicked off the growth with a lending spree that produced a 30% jump in the Chinese money supply (M2) and this was followed by the spending package aimed mostly at infrastructure projects in the Country. Like the US, together these monetary and fiscal moves have been the catalysts that produced the desired jump-start effect to GDP growth and the stock market has followed. Unlike the US, however, we see no reason for the Chinese Central Government to yank the punch bowl any time soon, either through higher interest rates, spending reduction or higher taxes.

As we write this the Shanghai index has gotten of to a rocky start to 2010 on fears that the Government will cut stimulus spending and remove liquidity earlier than previously expected, cooling growth. Again, sound familiar? At last count there were something like 1.3 billion Chinese living in China. Metaphorically, that is certainly enough that if they all jumped off a chair at the same time, the Earth would indeed move—which means practically that they wield significant “weight” in the World economy. The nominal per-capita GDP of these masses (about $3200 n 2008 according to the World Bank) places them in the lower middle class by world standards yet collectively they comprise the World’s second largest economy after our own. It’s human nature that #2 seeks to emulate or surpass #1 which means all these Chinese want the same or better standard of living that we have—cell phones, cars, televisions, 17 flavors of potato chips, etc--.and that they have a long way to go to get it. And even though they don’t have the same voting or freedom of speech rights as we, they are quicker to carry pitchforks and torches when they don’t get what they want. The Chinese Government, in our opinion, has 1.3 billion reasons not to take its foot off the accelerator anytime soon and unlike the US, with no massive debt balance to cause them concern over spending or contemplate raising taxes to pay for it all, they have the flexibility to keep that foot down. In addition, China is keeping the value of it’s the Yuan pegged to the US dollar at very low levels with no incentive to raise the exchange rate ( due to all the money we owe them—they ain’t stupid, you know). With the greenback depreciating at a record pace over the last year, the trade-weighted value of Yuan is also declining, making Chinese goods cheaper to recovering consumers worldwide. That will spur exports, driving manufacturing and in turn keeping the economic engine running when liquidity is eventually withdrawn. As the Chinese economy begins to demonstrate that it can grow on its own two feet, we expect that its stock market will follow in lock-step. So even the Shanghai was fine in 2009, we can see it do it all again in 2010.