I recently took a small position in the UltraShort FTSE/Xinhua China 25 ETF (FXP). This is the inverse fund corresponding to the FTSE/Xinhua China 25 ETF (FXI). After peaking in October, FXI has been moving down. It now appears to be forming a wedge-shaped chart pattern (see chart below). Price action on FXI has been narrowing as the ETF begins to get close to the point where the downtrend line meets the horizontal line. It has seemed like we are overdue to find out whether FXI was going break out to the bullish side or to the bearish side. On Thursday of this past week, it looked like the outcome had been resolved in favor of the bulls. Then on Friday, the ETF fell back inside the wedge. We remain waiting for the breakout.
Well, I'm no expert on China so I have been relying on the charts. What are others saying about the economic outlook in China?
According to academics from Wharton, China's economic situation is fairly positive though it is harder to predict the direction of stocks. Rather than focusing on the US impact on China, management professor Marshall W. Meyer feels that China's impact will be felt by the rest of the world.
He makes the point that China's huge demand for oil, metals and other commodities has pushed commodity prices up around the world. Now Chinese officials are taking significant steps to slow their economy to control inflation, Meyer says. That should stop the spike in commodity prices, but it also will likely cause a slowdown in growth worldwide in 2008. Referring to skyrocketing food prices, Meyer says that "the central government is adamant about restraining credit and, where they can, restraining prices, because the failure to do so creates social dynamite."
To stem inflation, Chinese officials have moved to tighten credit. Regional bank branches have been directed to assure that money is lent only to borrowers likely to pay it back. In addition, in a move meant to deflate the Chinese stock-market bubble, regulators have told Chinese mutual fund companies to stop buying Chinese stocks.
Meyer says that "the assumption has been that global growth will be driven by China and India." In addition, Meyer says he can't predict a recession in the U.S., "but I can see a slowdown in global growth because of the tightening in China."
Andy Xie, an independent economist and former managing director of Morgan Stanley's Asia/Pacific economics team, has a somewhat more positive outlook. He feels a US recession is a definite but in spite of that, the outlook for emerging markets remains robust.
Despite his positive outlook, Xie feels that China will see some challenges. Many analysts have discussed the vulnerability of China's export-led economy. "The Chinese are going to suffer," Xie predicts. "Whereas in the past, the U.S. used to absorb Chinese savings and products, it will now want to turn the tables and export to China. "It's going to be an enormous challenge for us. Next year is the first year of this new world."
What will save China, however, is increasing trade with other emerging markets. Xie notes that China's exports to the West are already winding down. He predicts a 10% to 15% growth rate in these exports over the next year compared to a growth rate of more than 20% in recent years. This trend is partly due to market saturation, he says, and partly due to the loss of some cost advantage to countries like Vietnam and Bangladesh.
Emerging market trade already accounts for half of China's trade growth, says Xie. These economies export precisely what China needs -- commodities such as oil, copper and iron ore. In return, they buy cheap Chinese-made consumer products and capital goods. "In the short term, this is going to be a huge cushion for China," says Xie. "Next year, exports will continue to grow."
Appreciation of the yuan has been much discussed in the financial press and has been something that has been encouraged by western governments. Scott Chu, Pioneer Funds' China representative, thinks it will have little impact on East-West trade. "When the yuan gradually appreciates, those low-margin, labor-intensive, heavily polluted and low-value-added industries will be forced out of China, and enterprises will start upgrading themselves into high-value-added businesses while also trying to improve their efficiency. That's why in recent months, you see that China's trade surplus number is actually going up instead of going down."
Chu also sees "real estate consumption... going up steadily. In short, China's consumption, exports and investments are all healthy, which suggests a 10% or above growth for 2008." Adds Xie: "My hunch is that next year is okay," but he cautions that it would be an altogether different story if the U.S. falls into a deep recession, with 2% or 3% negative growth for the year."
This is despite the central government's efforts to cool investment in real estate. Property prices will only fall when the U.S. dollar strengthens and liquidity starts to flow out of China, according to Xie.
What about Chinese stocks?
Touching on expectations for Chinese equities, Xie is upbeat. Following the subprime crisis, money that would have flowed to the U.S. will instead come to China, he predicts. "Wall Street financiers, ... are arming themselves with funds and taking aim at China... So the asset bubble you are seeing here is probably going to become bigger" next year.
Meanwhile, Chu, when asked whether the P/E ratio is too high for China's listed companies, notes that "in certain periods of emerging markets, concurring currency appreciation and excessive liquidity, it's common to see a high P/E ratio. You can't simply compare China to Japan, the U.S. or Hong Kong, since the capital flow in those mature markets is free and is looking for the lowest P/E ratios with the highest profit growth companies. But in China, it's a different story because the country has relatively tight regulation on foreign exchanges and there are limited choices for investment."
In general, he concludes, China's stock market is more expensive than those in the U.S. and Europe. But there is logic behind it. "First, it's an indicator of high growth... Some companies in China are in a monopoly position and therefore it's understandable to see high P/E ratios.
"From the perspective of demand," he continues, "you can see that with an inflation rate of 6% to 7%, the ordinary Chinese people are moving their bank deposits to the assets market. As long as the actual interest rate is negative and the yuan keeps appreciating, the money from both home and abroad to buy these assets will keep on growing, and growing fast."
Chu suggests taking a cautiously optimistic approach to China's A share market in 2008. "It will be very good if you have a return of between 10% and 30% next year. My view is that after the first quarter of 2008, the market will have a deep correction."
Meanwhile, in early December, China's government announced a "tougher" economic policy for 2008, which is a rare and significant change in its official stance. Chu says that the biggest risk for China now is inflation. "The actual inflation rate is far exceeding the official number of 6.7%. If inflation expands to a certain point, it will be a disaster for the whole economy and the stock market as well."
Zhou Qiren, an economics professor at Peking University, noted in a speech in Beijing in early December that the main challenge China's economy faces comes from its currency. "Excessive liquidity is reshaping the price level and pushing up all the [basic] costs." Adds Zhou: "It's unprecedented in the history of [mankind] that labor, information, technology and capital can be flowing freely and be re-organized around the globe. This forms the basis for a big transformation. China has experienced tremendous growth in the past three decades. But I see 2008 as a major turning point for its economy."
It seems that the experts see continued strong growth in China. "Decoupling" is more real than many of the US pessimists think. Trade with other emerging markets will support economic growth in China. A strengthening yuan could actually benefit China.
On the downside, inflation is becoming a serious issue among the populace. Food prices are soaring. Petroleum prices are rising and are being held in check by government decree. Prime Minister Wen Jiabao announced that China would freeze energy prices in the near term. Banks are seeing limits put on lending. The government is raising interest rates.
What does this all mean for Chinese stocks? It is difficult to say. Chinese stocks are clearly showing a rich valuation but, as described above, there are valid reasons for that. Others are saying that we are witnessing a bubble and that eventually the stocks will come back to earth. The experts are expecting a moderation in growth from a previously torrid rate but are wary of risks from domestic inflation and a potential severe recession in the US.
Will all this be sufficient to cause a breakdown in the FTSE/Xinhua China 25 ETF? I'm back to watching the charts.
Sources: What's Ahead for the Global Economy in 2008? Reports from the Knowledge@Wharton Network
Disclosure: author owns shares of FXP
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