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Good Time to Bet on China?

October 17, 2012

China is mindful of its fiscal and monetary resources and their ability to stimulate domestic demand. But it does not want to repeat the excesses of the stimulus effort following the start of the financial crisis, which led to wasteful spending and property inflation.
-David Joy, chief market strategist, Ameriprise Financial

Since reaching a post-crisis high in August 2009, the Shanghai Composite Index of Chinese equities has fallen 40 percent. During that same interim, the S&P 500 has risen 40 percent. Both indices reached their historic highs in October 2007. But, whereas the S&P currently sits just 9 percent below its high-water mark, the Shanghai index is currently 66 percent below its peak. So, is it now time to consider buying Chinese equities?

First, a little more background. During the two years of 2006 and 2007, the Shanghai Composite Index rose parabolically, delivering a staggering 350 percent return. At its price peak, the trailing price/earnings ratio was 44x, compared to the S&P at 17x at its high price. Clearly, a bubble had formed in Chinese equities, driven by euphoria over global growth rates and the voracious appetite for cheap Chinese imports. A newly minted class of Chinese domestic equity investors with few other investment options helped to fuel the rise. But the financial crisis dramatically dulled the appetite for Chinese imports, and growth in China has slowed from year-over-year rates of 10.4 and 11.2 percent in 2006 and 2007 to 7.8 percent currently. And many China watchers believe the actual current growth rate to be well below the official rate. The third quarter number will be released later this week and is expected to show a further slowdown to 7.4 percent.
 
The steady decline in the Shanghai Composite leaves it with a current P/E ratio of just 11.5x. The S&P currently is trading at 14.5x. So, with the excessive valuation having been washed out, on a relative basis Chinese equities arguably look cheap. But what are the prospects for improving economic growth and rising equity prices? The transition to a more balanced economy with rising domestic demand is a slow process. Savings rates remain high and the population is aging. And housing inflation remains an official concern. If the Chinese economy is still predominantly reliant on its export industries to fuel growth, improvement is likely to be slow with the developed world expected to grow at just a 1.5 percent rate in 2013, according to the IMF. The manufacturing Purchasing Managers Index has dipped below the 50 level in each of the past two months.
 
There is little China can do to alter that outlook, which means that it must look inward. Monetary policy has been loosened, as bank reserve requirements have been eased and interest rates have been cut. But the last move came in July and there is room to do more. Consumer inflation slowed to a rate of 1.9 percent in September. Domestic demand remains healthy, but has softened recently. Both the non-manufacturing PMI and retail sales growth have slowed, as have loan growth and the money supply.

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