Chinese equities have risen steadily higher in 2017 in a stealth bull markets, despite $700 billion in capital flight last year, a fall in the renminbi to 6.90, periodic liquidity squeezes in the Shanghai money market, draconian credit controls, a 166% corporate credit/GDP ratio and President Xi’s consolidation of power over the Beijing Politburo. The world’s smart money, stung by horrific losses in Chinese equities in August 2015 and January 2016, is still underweight China. Fund managers in New York, London and Singapore own the lowest holdings of Chinese equities relative to benchmarks since 2006.
The macro bull case for China makes tactical sense. As producer price inflation and industrial commodities prices rise, the cash flows, profits and collateral value of China’s state owned enterprises also rises. The National People’s Congress rubber stamped Premier Li’s 6.5% GDP growth target. The renminbi has stabilized at lower levels. Beijing has achieved a geopolitical rapprochement with Washington after Trump’s Taiwan gaffe and threats to launch a trade war. The Yellen Fed’s de facto temporary tolerance for US inflation above 2% at the March FOMC is US dollar bearish and thus bullish for the MSCI emerging market index, which is 27% weighted in China. Chinese bank loan growth and EPS momentum has begun to accelerate Capital controls and PBOC rate hikes have also stabilized the renminbi. No wonder the Chinese large cap index fund (symbol FXI) is 39 as I write. The Middle Kingdom is making money for investors even as Hong Kong’s Hang Seng index broke out above 24000. As the world’s largest crude oil importer, China even benefits from the recent 9% fall in Brent and West Texas black gold.
I find the risk reward calculus in Chinese bank shares, the cheapest international lenders in Asia (with good reason) compelling at current levels. Chinese Big Four banks are on the eve of a multi year earnings cycle as net interest margins improve and corporate non-performing loan ratios decline, primarily in China’s rapidly consolidating industrial sector. As the PBOC tightens monetary policy in response to Fed moves, a steeper yuan money market yield curve will fatten Chinese bank interest rates spreads and weaken “shadow banking” rivals. With minimal dependence on international wholesale funding markets due to its 25000 plus branch network in the Mainland, a loan/deposit ratio of only 65% and a valuation of less than 6 times forward earnings makes the Agricultural Bank of China, founded by Great Leap (famine) Forward and Cultural Revolution iconoclast Chairman Mao Tse Tung, a no brainer.
I agree with Morgan Stanley and Dr. Mark Faber’s enthusiasm for China Construction Bank, thanks to its cheap valuation (6X earnings, 5% dividend yield, 0.9 times book value), strong balance sheet above peer 15% returns on equity and vast retail banking network.
Other than banking, Chinese Internet shares offer some of the world’s most profitable online media and growth e-commerce franchises. Tencent Holdings (700 Hong Kong) runs the world’s biggest mobile messaging and social media platform, with 800 million users (no type here. 800 million users) We Chat network. As in the West, online advertising is migrating from desktop PC’s in China to smartphones. Nomura estimates online advertising on social media networks will grow at a 62% compound rate in the next three years. Tencent, with at least a 50% market share of Chinese online ads, is the hyper-growth social media of the zeitgeist, not the overpriced, moronic, overhyped Snap IPO I dissed a month ago that has flamed out on Wall Street.
I was fascinated by Morgan Stanley’s comparative valuation of Internet cloud storage firms, given that cloud will be a foundation technology for the human race in the coming decades akin to electricity. I was not surprised to see Morgan Stanley flag Alibaba (symbol BABA), given its 50% market share in the Chinese public cloud, now a mere $2 billion or 2% of the global market, clear evidence that is one of technology’s embryonic hypergrowth niches. Alibaba could well grow its public cloud business by 80% per annum in the next five years. Alibaba cloud revenues were $1 billion in 2016 but could rise ten times in the next four years. Is this scenario remotely priced into Alibaba shares on the NYSE even at $100? Absolutely not. Jack Ma rocks!
Macro Ideas – The Indian rupee and the NSE Nifty Index are both overvalued
The Indian rupee’s rise to a 16-month high against the US dollar at 65.40 is not surprising given the smoke signals that emerged from the momentary conclaves of Big Daddy (as the Reserve Bank of India is known in the money markets) in Mumbai and the Federal Reserve Board in Washington. Dr. Yellen indicated that the Fed was willing to tolerate a temporary rise in US wage inflation above its dual mandate level of 2%. This is the reason the US Dollar Index tanked from its 102 high to below 100 and the yield on the US Treasury note fell from 2.61% to 2.40%. This was a green light to own the Indian rupee as one of the world’s most attractive high yield currencies. The RBI made the trade a no-brainer once Dr. Urjit Patel decided not to cut the repo rate and keep monetary policy neutral to hedge inflation risk. A hawkish RBI in Mumbai, a dovish Fed in Washington. How could the Indian rupee not appreciate against the US dollar?
Two, the Uttar Pradesh polls were a game changer in Indian politics. The BJP’s landslide win reinforces the relative collapse of the Samajwadi Party and its Congress ally in India’s most populous state. The UP win means Modi will probably win reelection as Prime Minister in the 2019 general election and remain at the helm till 2024. This is hugely reassuring for foreign investors who have staked untold billions of dollars on Modi’s pro-market, reformist agenda, despite his selection of the odious Yogi Adityanath as UP chief minister.
Three, contrary to prognostications of macroeconomic doom after Modi’s shock rupee banknote reform, India delivered 7% GDP growth in the December quarter, the highest in the emerging markets. Three, the Union Budget also demonstrated that the BJP government is willing to commit to fiscal discipline, with a 3.2% budget deficit target.
Four, the fall in oil prices in the past two weeks is positive for the Indian current account deficit, as is the fall in the price of gold since 2011.
Five, Modi’s reforms to boost foreign investment in aviation, insurance, banking etc. reinforced India’s balance of payments and reduced Dalal Street’s reliance on offshore hot money portfolio flows. The surge in FDI in 2016 is unquestionably rupee bullish, as is the implementation of the Goods and Services Tax (GST).
Six, India’s equities market is once again the consensus darling for Wall Street’s emerging market fund managers. The Indian rupee has been positively correlated to a Nifty that has now risen above 9000 and is the most expensive stock market index in Asia. For now, the Indian rupee is on a roll. Yet strong US data a hawkish Federal Reserve could again resurrect King Dollar and the Indian rupee could well depreciate to 67. At Nifty 9000, MSCI India trades at 17.8 times forward earnings, at least 2 full points above its historic average of 15X. Indian equities are also now two sigma (standard deviations) above their mean valuations in the last decade. India also trades at a 34% premium to the Morgan Stanley emerging markets index. I cannot forget that Nifty 9000 proved to be a short term market top in the both March 2015 and September 2016.