Edward Smith, global strategist at Collins Stewart Wealth Management, discusses the prospects for China.

The dramatic underperformance of Chinese domestic shares is as striking as it is worrying. In a month in which the S&P 500 reached a four-year high, Chinese stocks hit three-and-a-half-year lows. The stock markets of Korea and other Asian nations have not suffered the same plight and the dispersion of performance here suggests that it is not simply a generic hike in the risk premium of export intensive nations due to a renewed global slowdown and fears over Europe. Similarly, a generic rise in risk aversion should affect all sectors, but a marked widening of sector P/E ratios within China also hints that internal fundamentals are also awry. In this note we examine current conditions and what we can expect over the next six months.

In 2011 China contributed 25 per cent to global growth. In nominal terms, it grew a new Greece every 2.5 months: clearly its macroeconomic health is paramount to the global outlook. In Q2, annual growth decelerated to 7.6 per cent, the lowest rate since Q1 2009. While the National Bureau of Statistics has taken much data collection away from local authorities who may have a reason to massage the figures, it is still worth checking some favoured coincident indicators for any sign that GDP isn’t capturing the true story.

While passenger traffic volumes and manufacturing employment seem consistent, electricity output has fallen sharply. In China, low electricity output tends to signal mothballed machinery. Although a volatile indicator (similar discrepancies can be observed currently in Korea and Japan), viewed alongside the record high levels of steam coal (used for power generation) inventories accumulated at the ports over the last few months – in excess of the incentive to stockpile while prices are cheap – we have reason to believe that China is slowing further still. The ratio of manufacturing stocks to new orders, as measured by the PMI business survey, is also reaching new peaks and represents a potentially significant drag on prospective GDP. Drawing some of these measures alongside other leading indicators such as consumer confidence, our macro model of GDP suggests that growth will edge lower in the next two quarters to year end.

China-watchers have noted significant outflows of foreign direct investment (FDI – investment directly into a country by a foreign entity, either by acquisition or expansion). But foreign ownership in China is rather difficult and represents a tiny proportion of capital. A little more concerning is the reversal of the portfolio flows. While not directly measured by the government, proxies still put cumulative portfolio capital at less than 15 per cent of foreign reserves. Moreover, China is clearly an enormous net creditor to the world: unless domestic demand and falling income completely exhausts the mountain of savings (foreign reserves stand at $3.2 trillion) it is in no danger of a financial meltdown. These flow reversals are however another worrying trend, expressing the sentiment of investors most intimately connected to the behemoth economy.

Another stimulus package

Betting against another stimulus package would be a bold move, but we believe that it will be far more muted than 2008/2009’s largesse. That the last effort left behind misallocated resource and bad debts is consensus in Beijing. We believe that the likelihood of an aggressive loosening of monetary conditions is low: no boon, then, for a stock market extremely sensitive to liquidity. Despite the mighty crackdown on the housing market, affordability remains poor and any demand-side stimulus would jeopardise the social agenda here – a subdued relaxation of restrictions has already led to a sharp uptick in residential transactions and household buying intentions. Even if the government were to ease credit conditions, it is not clear that this will boost growth to the extent seen in the past. Survey data asserts that loan demand has fallen to record lows, new loans from the four largest banks were issued at the slowest rate in 10 months. Finally, our model for inflation shows pricing pressures from supply-side forces, especially grains, could also make the government a little more cautious.

To our mind, government stimulus is likely to take the form of judicious investment in infrastructure. In early September the government “announced” RMB1 trillion of infrastructure spending, largely for underground metropolitan railways. However there was something of the unicorn about this announcement. Many of these projects were already written into the regional governments’ twelfth five-year plans, while others had been approved as far back as April.

The pervading tone of the incumbent national five-year plan maintains a commitment to reorienting the economy from investment-driven growth to consumption-driven, and stimulus should be directed towards infrastructure that could facilitate this transition (healthcare/welfare, transportation, and telecommunication). Infrastructure projects are also labour-intensive and are utilised as a de facto automatic stabiliser for a government intent on keeping employment stable and popular unrest at bay. With survey data pointing to the third month of mild payroll contraction, this sort of stimulus is likely to be imminent, but could fall short of market expectations. Remember, the official growth target is now only 7.5 per cent.