Ramblings of a Portfolio Manager

Which Asylum is Being Run by the Inmates?

Over the weekend the Chinese Central Bank ordered the State’s banks to set aside more cash reserves in an effort to curb lending and escalating inflation. This is the 4th such reserve increase this year alone and China’s largest banks will now have to hold 20.5% of their capital in cash reserves. The move comes on the back of the Bank’s April 6th benchmark interest rate hike, the 4th since the beginning of 2010, and was in response to Friday’s report that the Chinese economy had grown 9.7% year over year, higher than the projected 9.5%. Since the PBOC began its efforts to slow the Chinese economy in 2010, through a series of rate and reserve hikes, the economy has shown little to no signs of easing its rapid growth. The one sector of the economy that has shown some response is the Chinese property market, which was ostensibly the PBOC’s initial primary target. Since the tightening cycle began, the Chinese property market has cooled from its torrid pace of 2009-2010 yet it is still growing. The latest report shows residential property values up 6% so far in 2011, less than the 7% annual growth of 2010, and that number is expected to decline further into 2012.

One would expect, with such restrictive monetary policy, the Chinese equity markets, along with their Asian counterparts, would be heading south daily in anticipation of much weaker economic news ahead. Instead, the Shanghai Composite was up 22bps overnight and most other Asian markets were essentially flat. European markets, however, are down over 1% and US equity futures are pointing to a much lower opening. In fact, this is a pattern that has been repeated since late January and since that time the Shanghai Composite is up nearly 14%, besting both Europe and the US, all while China has been applying the brakes. Now, to the astute US equity investor, this might seem perverse. Surely, from past experience, we know that rising interest rates in the US are almost always associated with a decline in the stock market so why is the same not happening in China? In fact, a larger question is why are rate hikes in China having more of an effect on European and US markets than on its own?

There are several answers to this conundrum (we use this word purposefully). First, looking back at history, even in the US an initial round of rate hikes does little to bring down the equity markets. There are many explanations for this phenomenon but the reason is probably a combination of several factors: first, most rate hikes in the US are well telegraphed so the first few hikes are never a surprise; second is investors’ initial belief that that rate hikes will be modest and short in duration (remember “one and done?”); third is the inevitable initial cash flow out of fixed income securities and into equities, which serves to prop up the stock market in the short term; finally is the belief among many investors that the Federal Reserve is often late and can do little to effectively apply the brakes once the economy has begun to run—the old “Genie out of the bottle” analogy. Much of these same reasons may well apply to the current Chinese market. Surely, the PBOC’s tightening has come as no surprise and even though there is no Chinese Treasury money to flow into stocks, the currency has appreciated less than rates, keeping the export economy relatively strong and that, of course, feeds into the belief that the rate hikes will be ineffective in slowing economic growth. And even if the tightening is effective, what will be the new growth rate-- 8%? Still not bad given the valuations of Chinese equities. Chinese investors, as well, may not recall the PBOC’s last tightening cycle, which went overboard, throwing the economy into a recession, and so continue to doubt the efficacy of the Bank’s policies.

The ultimate question, of course, is why are the monetary policies of China having more of an affect of US markets (at least in the short run) than they are on Asian equities? We see this every time the Chinese Central Bank makes a move—miners, mineral and capital equipment stocks in the US get hard hit on fears that China will stop buying while Korean, Hong Kong, Japanese and Chinese equities often charge ahead. Are US portfolio managers the inmates running the great casino, er, asylum that is the US market? Or do they know something Asian investors do not? Probably a little of both. China is growing at nearly 10%; we are barely eking out 2% and much of that growth is thanks to Asia and other emerging markets. Should China successfully put the brakes on to a 7-8% growth rate, the economy in the US may well stall or even contract. Just think about where the miners, commodity and industrial companies have been getting their earnings growth of late—most of it has been in the Pacific Rim, not here. So we are tied to the hip with China but they are wearing a flotation vest while we still have a brick (called the National Debt) tied to our feet. If the PBOC is successful in curbing inflation, China may well keep its head above water but we could find ourselves drowning nevertheless. The lesson here is twofold: first, we had better hope that the Chinese are successful in engineering a soft landing and secondly, we should not extrapolate the behavior of the Chinese market during its tightening cycle with what might happen to our own once the Fed decides it is time to put on the brakes—remember, the drop from 10% to 8% is a lot less both in terms of percentage and economic impact than that from 3.5% to 2%.