Analysis of China’s Economy and Stock Market – Key to 2016 Global Equity Markets

by the Curmudgeon

Introduction:

China is the second-largest economy in the world, or the largest based on purchasing-power parity. Its influence on the global economy is second only to the U.S. After decades of export- and investment-driven growth, China’s economy is slowing, with GDP now expanding at less than 7% a year. The country witnessed huge stock market volatility in 2015; a devaluation of its currency, the Renminbi; falling imports and exports; and rising concern about nonperforming loans.

John Pender wrote in Saturday's Financial Times (on-line subscription required):

In 2016 China will once again be hugely important in determining the path of the world economy and the direction of capital flows. But this time the story will not be about a slowing economy. As recent industrial production numbers indicate, measures to stimulate the economy are having an impact. Investment is picking up in response to stronger infrastructure investment, especially from local governments, reflecting the easing of financing constraints on them. State-owned enterprises have also been investing more heavily.

We have previously written that the Chinese economy and stock markets will be a leading indicator for global markets and we still feel that's the case today. We review 2015 and look at the critical issues for next year in this article.

China's Stock Market Rebounds due to Government Intervention:

After China's stock markets crashed this summer, the government took extraordinary measures to staunch the bleeding. The regulator banned stock sales by large shareholders, forbid short selling, while state-owned financial institutions — known as the "national team" — poured money into the market.

By September, the Chinese national team was estimated to have spent Rmb1.5tn to rescue the stock market. Police and regulators launched a crackdown on insider trading, market manipulation and malicious short selling. Authorities placed new limits on high-frequency trading.

A cautious recovery began in October, albeit with trading volume far below its peaks from early in the year. In early November the Shanghai Composite re-entered bull market territory. Despite the recovery, many analysts remain cautious about 2016, noting that corporate earnings are deteriorating as the economy slows. But the economy has been slowing for years while the stock market climbed.

Charts courtesy of the Financial Times

One analyst feels the worst has passed for the Chinese economy. Julian Jessop at Capital Economics argued that worries about a “hard landing” in China were misplaced.

“Our view is that the bulk of the slowdown that many still fear lies ahead has, in fact, already happened. We estimate that actual growth was only 4.5 per cent or so this year and expect economic activity to pick up pace again during 2016.”

China's Economy and Impact on Global Markets:

In a Barron's interview this week, Harvard Professor Niall Ferguson answered this critically important question: What is the biggest risk to global markets?

“China. It was so crucial as an engine of growth through the financial crisis. If there is a policy error in China, it could cause huge instability. The government could ease restrictions on cross-border capital flows, which would result in a great wall of money coming out of China. Money would be deployed in Western assets, and it might be difficult for China to cope. Imagine the devaluation impact on the Renminbi, and the effect on all other emerging markets, if China suddenly devalues by 20% or 30%.

On the other hand, if President Xi Jinping turns the clock back, this could lead to a big downside shock.”

Ferguson is uncertain about China's future:

“We don’t know whether China will be more of a market economy 10 years from now. It is risky for a one-party state to continue increasing the economic freedom of its citizens. President Xi Jinping, who is more interested in power than anything else, understands this well. Consequently, plans for privatization of state-owned enterprises, liberalization of the financial system, and the opening of the capital account will remain plans, but won’t be implemented.

China has created the biggest middle class in history, but middle-class people want property rights. That implies law courts and officials who aren’t corrupt. The moment you demand these things you are asking the one-party state to loosen its grip on power. The Chinese are terrified of anything like that.”

Chinese President Xi Jinping on the Road:

Xi Jinping is trying to be a global diplomat. The Chinese President visited 14 countries in 2015 – making him not only a top political globetrotter, but also China’s most traveled top leader since the Communist party took power in 1949. Experts say that Xi has embarked on a long string of ambitious foreign projects to shape perceptions of Beijing both at home and overseas. Domestically, he may hope that a dramatic foreign policy agenda will divert attention from widespread concerns about a protracted economic slump – China’s economy grew 7.3% in 2014, its slowest annual pace since 1990, according to official reports that no professional believes.

“Xi is absolutely a high-profile foreign-policy president,” said Xie Tao, a professor of international relations at Beijing Foreign Studies University. “Rather than only bringing in business contracts for Chinese enterprises, Xi wants to gain more political influence (abroad).”

Expert Opinion on China's Economy:

The LA Times recently interviewed Francis Cheung, head of China/Hong Kong Strategy for Hong Kong-based brokerage CLSA, for his thoughts on China’s economy for 2016. Here are seven key takeaways:

1. 2016 will be volatile

“The economy will be relatively weak in the first part of the year,” he said. “We believe the economy will stabilize at the earliest in 2017, but it could take longer.”

2. The currency could weaken

The Renminbi will be included in the International Monetary Fund’s Strategic Drawing Rights (SDR) basket next October. Capital account opening and Renminbi convertibility are explicit goals of the Chinese government between 2016 and 2020.

3. Consumer confidence needs to improve

China’s consumers are less optimistic than in previous years, but they are not pessimistic. CLSA’s survey of Chinese consumers showed most thought that business conditions would improve modestly in 2016.

4. The Internet as a bright spot

Investors should look to big Chinese Internet companies for growth, in particular Alibaba, Baidu and JD, all listed on U.S. markets, as well as Tencent.

5. Macau may start to rebound

The gambling mecca of Macau has been in a deep funk for about a year and half largely thanks to a nationwide anti-corruption movement. However, gambling revenue is set to return to positive year-on-year growth in the first half of 2016 after consecutive monthly declines since June 2014.

6. Two-child policy will have limited impact

China in October announced the end of the one-child policy. That could boost consumer spending and eventually help address China’s shrinking pool of workers.

7. One Belt, One Road will get off the ground

“One Belt, One Road”, also known as “OBOR,” is a new development strategy initiated by China in 2015 to promote its economic connectivity and cooperative relationship with nations in Eurasia by helping them develop infrastructure. The initiatives should also help Chinese exports. 2016 will a big year for OBOR, as the three main institutions lined up to fund its projects: The Silk Road Fund, the Asian Infrastructure Investment Bank and the New Development Bank. They will all be in full operation next year.

“One Belt, One Road is a brilliant strategy,” said Cheung, because it may have economic benefits as well as strategic upsides, pulling China’s regional neighbors closer into its orbit. But after some upfront investments in 2016, Cheung said there may be some “tough going” in 2017 and beyond for a number of reasons, including the fact that many Eurasian nations are sparsely populated and have economic issues of their own.

Conclusions:

We believe that the Chinese economy will continue to experience relatively slow growth, but better than the rest of the world. The People’s Bank of China will try to slowly devalue the Renminbi/Yuan (now linked to a strong U.S. dollar) to make exports more competitive. A sharp fall in Chinese producer prices is contributing to a real depreciation of the Yuan.

The key to China markets will be financial reforms and more transparency- something the IMF demanded to include the Renminbi in its SDR's. Yet that may spark major capital outflows according to the FT's John Pender:

Chinese officials fear that high unemployment in older industries would lead to social unrest that could pose a threat to the party’s grip on power…. Should those Chinese officials regain their appetite for financial reforms, another kind of shock may be felt outside China. As I have pointed out here before, a move to full capital account liberalization would free the vast pool of savings in the household and corporate sectors to head for foreign markets. The temptation to diversify into investments in countries with more secure property rights and stable governance would be overwhelming.

In summary, China will be hugely important in determining the path of the world economy and the direction of capital flows in 2016. That, in turn, will have a direct impact on financial markets and commodities.

Unicorn IPO Update (Addendum to Unicorn Year in Review, posted last week):

Saturday's WSJ (on-line subscription required) notes that four technology start-ups with billion-dollar-plus valuations (“unicorns”) are preparing for initial public offerings in early 2016. Nutanix Inc., Okta Inc., Twilio Inc. and Coupa Software Inc. are in various stages of preparing for IPOs, according to regulatory filings and people familiar with the matter. The article adds that “Tech IPOs in early 2016 will be closely watched by the more than 130 private start-ups valued at $1 billion or more. All told, these companies are worth more than $480 billion, at least as measured by private valuations, according to Dow Jones Venture Source.”

Again, all these and other unicorns are software companies that don't build real, tangible, hardware engineered products. We are especially entranced by Nutanix, which says they specialize in “invisible, hyperscale infrastructure.”

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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