ARE FEARS ABOUT CHINA OVERBLOWN?

We’ve expressed concerns over the recent declines in Chinese shares mainly due to liquidity concerns (see here and here).  China has been a superb leading indicator during the bear market of 2007 and the new bull market that began in China in late 2008.   The recent dip in Chinese shares has sparked fears over potential global equity declines.  JP Morgan, however, believes the fears over China are overblown:

We do expect loan growth to slow in 2H but mostly because of seasonal factors, as more loans come to maturity and few new projects start in winter, rather than policy tightening. Potential exclusion of subordinated debt in regulatory capital is unlikely to have a material impact on loan growth, as bigger banks have high tier-1 ratios, and as it will take time to implement such a measure.

Chinese policymakers look for stability rather than a correction, and have a diverse and effective set of tools to control supply and demand of both the equity and the property
markets. A stable domestic equity market is particularly important, as it is a precondition for the successful resumption of IPOs and the ambitious capital market reforms planned in the near term, such as the first red-chip listings in Shanghai and A-share listings of foreign companies.

We believe that the Chinese authorities will take measures to put a floor under stock prices in the event of further correction. Indeed, the local press reported that the authorities had approved the issuance of new equity funds to channel investment funds into the stock market, and the central bank has kept open the market operation yield flat this week, after seven consecutive months of increases.

We think that fears about China are overblown; we see no reason to alter our strategy. We look for equity markets to rise 10-15% into year end. We see two catalysts for a continuation of the equity rally. First, economic data will likely continue to post positive surprises driven by developed economies. We track economic surprises using our Economic Activity Surprise Index, which remains firmly in the positive territory. Second, retail investors will likely start deploying a greater portion of their excess cash into equities rather than bonds, as slower declines in corporate bond yields will make the capital gains on their bond holdings
look less impressive than in the past months.

I don’t disagree with their big picture outlook, but I believe it’s foolish to ignore the recent market action in China considering the huge run we’ve had.  This market gave early warning signals in both 2007 and 2008 and appears to be giving a similar warning signal now.  I’d prefer to be a buyer of China and U.S. equities at lower levels….

Source: JPM