Why You Shouldn’t Get Too Excited for China Yet

Stock Market Analyze
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Shares were down in the US overnight, with both the Dow and S&P500 falling just shy of 0.5%. Gold’s come under pressure, but continues to hold above US$1,300. Was the weakness due to additional US and EU sanctions placed on Russia, or is the market positioning ahead of tomorrow’s interest rate ‘decision’ from the US Federal Reserve? We’ll tackle that question in a moment.

But first, let’s look at the Aussie market. It’s been very resilient lately. Earnings season kicked off this week, and results from large caps like Leighton Holdings and QBE Insurance haven’t inspired. In fact, they’ve been ordinary.

What’s lifted the market recently is the performance of the iron ore majors, BHP and Rio. Check out their recent performance in the chart below…


Iron ore majors on fire…


AU BHP and RIO


Click to enlarge
Source: bigcharts

 

Since mid-June, BHP (blue line) is up over 10% while Rio is up nearly 15%. Both majors recently reported record iron ore production. At the same time, economic data out of China has improved on the back of targeted stimulus. The result? Time to get bullish on iron ore again!

Maybe for a few weeks, but I wouldn’t get too excited. First, consider the Australian funds management industry. At the larger end, it basically plays the game of relative value and momentum, regularly increasing and reducing weightings in the banks and the resource majors. These are the only stocks big and liquid enough to allow the fundies to play this game.

Given the June quarter weakness in Chinese property and iron ore, no doubt many fund managers would have moved to a ‘tactically’ underweight position in BHP and Rio. After peaking in February, both company’s shares prices fell considerably into mid-June.

When evidence emerged that recent Chinese stimulus efforts had resulted in a pick-up in growth and a rising iron ore price, these fund managers would’ve moved back into the sector.

Despite the recent rally, BHP is yet to better its February high and Rio is still well below it. Both are due for a pull back now. But to see a good deal more upside, you’ll want both stocks to break out above their long term trading ranges, which means BHP above $40 and Rio above $70. If not, they’ll remain stuck in the range.

Their performance from here all depends on China and the iron ore price. The rapidly deteriorating Chinese property market in recent months spooked the Communist party, and in recent weeks, they’ve moved to prop it up. This involved measures such as removing the restrictions on buying second homes in some cities.

This might provide momentary support, but it also ensures greater malinvestment, given the main focus at the start of the year was to direct capital away from property investment and into more productive enterprises. But who said gently deflating a bubble was easy?

The recent rally in Chinese and Hong Kong stocks, as well as renewed bullishness on the prospects for iron ore, begs the question: Is China’s reform agenda on hold, and have they resorted to their old stimulus tricks to generate growth? As far as I can tell, the answer is yes and no.

China’s credit bubble is clearly too big and fragile to enact fast-paced reforms. They will have to take their foot off the accelerator very slowly, and then put it back on occasionally, to generate economic growth and employment. The upshot of this is that much of the growth they’re producing will be of low quality. This will impact future growth levels as the rate of credit expansion inevitably slows.

But one area of reform still in full swing is the crackdown on corruption. I doubt it’s possible to have an historic credit boom and no corruption, but China is trying to give it a go. The latest target of President Xi Jinping is Zhou Yongkang, one of China’s top nine leaders until he retired in 2012. That such a powerful figure (Zhou previously oversaw the police, courts and intelligence agencies) is not immune from the corruption crackdown sends a very powerful message.

Xi Jinping believes corruption on a grand scale (the result of a huge mis-pricing of credit and mis-allocation of resources) threatens to bring down the party and ignite civil unrest, so he is doing all he can to rid that culture from the party.

He seems to be doing a decent job. Dirty money is flying out of China. The New York post reveals that ‘So much money is fleeing China — $10 billion a month — that it’s distorting the global economy, particularly in the art market and with real-estate booms in cities like New York.’

It’s also distorting the Aussie property market, particularly in Sydney. Wonder why credit growth remains low by historical standard yet house prices are flying? Money seeking a hiding spot would have something to do with it.

I don’t begrudge global capital parking itself where it pleases. And if it wants to sit in Aussie property, go for it. But we need to ensure as best we can that the capital arrives here through the right channels. Otherwise, it will lead to societal tensions.

Against this backdrop, yesterday The Australian reported on a trip to China by some Aussie politicians who, amongst other things, will suss out growing Chinese investment in Australian residential property:

ONE of the most influential federal parliamentary committees will today begin a week-long visit to China where it will canvass the growing investment in Australia’s residential housing by cashed-up Chinese investors.

Influential? You’re joking right? I’m tipping this trip will influence nothing. Let’s get this straight: Taxpayers are funding a trip to China so these clowns can investigate investment in Australia? The incompetence is astounding. Why not canvass real estate agents who targe these investors…why not head out to auctions on any given Saturday.

And I thought Senator Nick Xenophon’s idea to let first home buyers access their super to buy property was the height of idiocy for the day. When it comes to politics, you can never be certain.

And I wouldn’t be certain about China’s ongoing stimulus led recovery either. Xi Jinping seems intent on stamping out corruption and that includes continuing to let the air out of the credit bubble. This is no late 2012 massive stimulus replay. Xi’s focus is on maintaining the strength of the party, and that includes slowly returning to balanced (and therefore much lower) growth.

Before signing off for today, a quick word on Russia. The US and EU just announced a new round of sanctions. This is apparently for supporting Crimean separatists who voted in a referendum to break away from Ukraine and join Russia, and for supposedly downing MH17, an accusation the West has provided no concrete evidence for, apart from flimsy social media evidence and repeating over and over that Russia was behind it.

While not anything major, in time, the sanctions will begin to bite…and Russia will likely respond. Why is the West intent on spoiling for a fight? Is the US concerned about an emerging Russian/Chinese power bloc and wants to weaken Russia now while it can?

I don’t know. But applying economic sanctions without having concrete evidence or genuine humanitarian concern is a dumb strategy. The situation in Ukraine/Russia threatens to escalate quickly.

That can’t be good for markets hovering around all-time highs. But markets don’t seem to care right now. All eyes are on the Federal Reserve, who will tell us tonight (our time) when they plan to start ‘normalising’ interest rates. Markets aren’t prepared for an early tightening. Boss Janet Yellen will have to choose her words very carefully.

Regards,

Greg Canavan
For The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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2 Comments on "Why You Shouldn’t Get Too Excited for China Yet"

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slewie the pi-rat
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“All eyes are on the Federal Reserve, who will tell us tonight (our time) when they plan to start ‘normalising’ interest rates.” maybe. but i honestly think the FED knoweth not when the rate raise cometh. but, they have surprised me before. once. L0L!!! Treasury rates are going down, now, on the long end. so the FED may talk out of various venues in various ways about it. talk. talk. talk. talk. the checks are in the mail. in slewienomics, that is what has been “normalized”, and nothing else. others say “risk” is not “correctly priced”. so what? nobody is… Read more »
Jason
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It is a good thing the Chinese leader is cracking down on corruption, I hope he ends up cracking down on these money flows from China to Australia, which a lot of it has been stolen from the Chinese taxpayer. Australia’s state and federal governments are breaking their own laws that prohibit money laundering by allowing ‘wealthy Chinese invsetors’ funnel mony into Australian property without checking to see if the money was lawfully obtained. What next, will they allow Mexican drug cartel’s buy Australian property? Will they allow a drug baron to buy citizenship with the ‘investors visa?’ How would… Read more »
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