China Watch: Is Goldilocks Waking Up?

Almost a year has passed since we issued a blog “International Stock Markets: Searching for Goldilocks” (May 12, 2010). Here we pointed out that recent steps taken by the Chinese government and central bank to cool their economy and tame inflation had halted the sharp advance of Chinese stocks in 2009. Some investors feared that the policy makers’ initiatives would prove to be too little and too late, resulting in an inflation spike and asset bubbles. Others were concerned that the government and the central bank would become excessively restrictive and cripple economic growth. We offered three views:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.
• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.
• The “soft landing” would spark a strong stock market rally. 

Since our “Goldilocks” blog, Chinese inflation has continued its ascent from 2.8% last May to its current 4.9%. In response, the Chinese government has responded with a succession of interest rate hikes and bank loan restrictions, and Premier Wen Jiabao announced recently that the highest priority of government was to reduce inflation. Our forecast for Chinese stocks was lamentably correct: since the end of 2009, the Shanghai Composite Stock Index (CSEX) has retreated -11.3% and the exchange traded fund for Chinese stocks traded in Hong Kong (FXI) is off -1.4%. For the same period, the S&P 500 Index has risen 14.7%.

We think the Chinese policy makers are making progress and will be able to pilot successfully a soft landing. We also continue to expect this soft landing to renew the bull market in stocks dating back to March of 2009. We are not alone in these forecasts. In a March 15 report issued by Deutsche Bank titled “Turning Bullish on China,” Chief Economist Jun Ma argues that “recent developments are increasingly supportive of our view that year-over-year CPI inflation will likely peak in June at around 5.8%, then fall to around 4% in December.” He expects the policy makers to take their foot off the brake and considers the risk of a hard landing to be minimal. He concludes with the prediction that in the next twelve months the Chinese stock market will “rise about 25% from its current level.”

If Chinese inflation peaks in June, will the Chinese stock market anticipate this development and rally before the data confirms the fact? Is this already happening? Since January 25, the Shanghai market (CSEX) has gained 8.6%, whereas the S&P 500 Index has slumped -0.9%. We are very aware that anticipating events that do not materialize, or are delayed, can be very painful, but is it better to be too early than too late?

We are continuously reviewing Chinese stocks to identify the most attractive candidates to participate in a renewed stock market advance. Our focus is on companies that would benefit from the government’s massive infrastructure projects and/or would prosper from the rapidly rising demand for goods and services by the mushrooming middle class.

Current Challenges to the Global Economy and Stock Markets

Recent developments in the Mideast and Japan convey scenes of human misery and loss of life that are sad and disturbing. The question for investors is whether they also constitute so serious a challenge to the global economic expansion and stock market advance that a substantive change in strategy is required. As alarming as these momentous events are, we do not think that they will tip the global economy into recession and trigger a new bear market. At this point, we advise clients to maintain their long-term commitment to global equities and ride out the storm.

The global economy entered 2011 with considerable momentum. The leading emerging economies were expanding above their sustainable long-term growth rates, the U.S. economy was accelerating towards a healthy 3.5% or higher GDP growth, and the Euro Area was weathering better than expected its sovereign debt woes and austerity budget imperatives. In our view, it would take a severe jolt to reverse this momentum. On the other hand, the twin threats are real. Oil at $100/barrel is already elevating global inflation fears and could retard international and U.S. growth, and in the near term the Japanese economy may slip from our previous forecast of 1.3% growth in 2011 into a modest recession. Nevertheless, we continue to anticipate global growth this year in excess of 4%. Further, we expect reconstruction in Japan will provide a boost to global growth later this year and in 2012.

We expect markets to remain volatile in the immediate future, but at this stage we do not anticipate a significant and lasting decline. Predictions of what will happen next in the Mideast and Japan are difficult, and even more threatening storm clouds may materialize quickly. A further jump in oil and gasoline prices resulting from violent political confrontations in the Arab world will roil global financial markets. Additional setbacks in the earthquake, tsunami, and nuclear power catastrophe in the world’s third largest economy will add even more turbulence to already fragile markets. There is also the possibility of a new geopolitical calamity or natural disaster.

Consequently, our optimism is wrapped in caution. Clients should be concerned but not alarmed, remain vigilant and flexible, and maintain a longer-term perspective.