May 13, 2014

Doug Kass warming to China ETF- FXI

As is very well known, the Chinese stock market has performed poorly both in a relative and an absolute sense over the last five years.

There is no reason to rehash the multiple reasons for the weak performance of China's stock market, such as slowing domestic economic growth, a property bubble, opaque reporting/accounting, etc.

I have spent the last week researching potential opportunities in China and I have concluded that the almost universal (and consensus) hatred for the region's markets and skepticism of China's economic growth trajectory could resemble the consensus (and wrong-footed) short bond thesis that existed at the beginning of this year.

I am seriously considering a meaningful long position in this contrarian play (FXI) based on the following 10 observations and conclusions.

-    The main risk to China's stock market and economy is a weakening property complex that leads to a 10% (or more) decline in construction activity, which will adversely impact related commodities, the industrial complex and local government finances, serving to lower real GDP by 2% (or more).

-    China's property downturn may be more manageable than the consensus believes. The valued economists I speak to are looking for more balanced economic growth of 7.2% real GDP in 2014 and about 6.7% next year.

-    The  probability of a property downturn that leads to real GDP declining to 5% or less (in 2015) is likely only about one in five (20%).

-    Despite general concerns, most indicators of the state of housing (prices/activity) in Tier 1 cities are fairly stable, but fears of Tier 3 cities' inventory-to-sales ratios have risen and have to be monitored.

-    An important positive relating to housing is that the Chinese household sector is not particularly leveraged as most Chinese consumers are using their homes as a vehicle for savings, given the better-than-10% wage growth trends and a favorable taxation of property income in China.

-    The threat of a financial crisis in China might be overplayed given the high degree of liquidity. Non-performing loans in the banking industry are only about 1%. In the public sector, the Chinese government is capable of issuing bonds to battle any liquidity problems at that level.

-    China's labor market has a lot of slack, even though stated unemployment is low, as nearly one quarter of the employed are in the agriculture market. These employed can be transferred into other sectors. Moreover, productivity is still low, leaving room for improvement and sustained economic growth.

-    China's political leaders will not allow too much of a slowdown as they fear social unrest. Property market weakness can be buoyed by easing credit.

-    Political corruption is slowly receding, serving to reduce business costs and improve profitability. Until recently, companies had no discipline on expenses with unlimited spending on corporate boondoggles and gift giving.

-    PBOC is lowering interest rates, doing unsterilized intervention and is comfortable with the current value of the country's currency. 

China price-to-earnings multiples are low.
The sectors within the Chinese market I am looking to buy are in services, e-commerce, automation and mid-level manufacturing. 

For now, I plan to initiate a small starter position in FXI (long) this morning. Probably the only thing keeping me more than my feet wet in China is my general stock market cautiousness.

Article originally published on May 9, 2014 via