Wednesday, June 15, 2011

Getting the China call right

In the current investment environment, getting the China call right can make or break a career. The bull case for China and the emerging markets is well known. For the bear case, just consider this CNBC interview with noted China bear Jim Chanos. In the wake of poor loan growth figures, Doug Tao of Credit Suisse now believes that the risk of a hard landing is rising.

So it is with great interest that I read some more balanced comments about China's excesses from Patrick Chovanec. Here is an example about the property bubble in China:
It will take a significant change in attitude for Chinese investors to starting bailing out of property. How and when that will happen, I am not sure. But of course, that’s the tricky thing about bubbles — since the beliefs that sustain them are not based in economic reality, but in economic misconceptions, psychology, not economics, is what finally tilts the balance one way or the other. If the market stumbles, and that stumble confirms growing fears on the part of investors, the turn in sentiment can be severe, all out of proportion to any real change in underlying conditions. Will this happen in China, now that property prices seem to be going soft? Possibly.
If the Chinese sell property, Chovanec rhetorically asks, "Where would the money go?"
If the Chinese do start pulling their money out of real estate, one reporter called to ask me, where would they put it? After all, one of my arguments for why people in China use property as a “store of value” is lack of attractive alernatives. Well, assuming they successfully find a buyer (which is always the problem when everybody decides to sell), there are three possibilities:
  1. They put it into other assets. Last spring, when Chinese investors got spooked about government plans to “cool” the real estate sector, a lot of them started putting their money into gold instead. Jade, artwork, antiques, or even stockpiles of commodities like copper or nickel are potential alternatives. We could even see a situation where Chinese investors bail out of real estate in some cities, which they see as vulnerable, only to buy property in others — in which case, we could see some markets drop while others continue rising, for now at least.
  2. They spend the proceeds. If Chinese investors decide to cash out of real estate, and try to turn the proceeds into buying power to improve their quality of life, expect a surge in consumer inflation. Given the explosion in China’s money supply (by more than 50% over the past two years), the question isn’t why inflation is treading 5%, but why we haven’t seen more inflation sooner. The main reason is because most of that new money went into investment rather than consumption, mainly fueling asset inflation. But if those inflated asset values are suddenly transformed into higher consumer demand, the CPI rates we’ve seen so far will look like small potatoes.
  3. They hoard the cash. If this happens, the velocity of money will drop and the money supply will decline — in effect, a lot of the money that was created the past two years will simply disappear. This is what happens during a credit crisis, and it’s called liquidation. The good news: no more worries about inflation. The bad news: a lot of financial assets people thought they owned will go up in smoke.
The post is well worth reading in its entirety. In addition to addressing concerns about the property bubble, he addresses other issues such as political unrest, Chinese foreign policy, etc.

Timing the turn
There is no doubt in my mind that China will both soar and crash, but timing the turns in China will not be easy. There are certainly signs of froth in China today. Consider, for example, this story from earlier this year about a Chinese multi-millionaire paying GBP 1 million for a dog because it's a good investment. Is this a sign of a major top?

When you are in a bubble or mania, the difference between the investment hero and goat is timing. During the internet bubble, I recall looking at the Netscape IPO and concluding that it was a sign of froth and it would be wise to stay away from the sector. That assessment eventually proved to be correct, but in the meantime, the markets saw the run up in internet stalwarts like AOL, Amazon, Yahoo! and a whole host of others, as well as the takeover of Netscape by AOL, before the whole house of cards collapsed on us. Yet others who timed the Tech Wreck top correctly are (rightly) hailed as heroes.

The lesson I learned from my Tech Bubble experience is that while it's good to be right, making money is more meaningful. While it is important to consider fundamentals, it's also ok to embrace the dark side and buy fundamentally overvalued assets with strong price momentum. These days, I depend on trend following models to spot intermediate term economic trends. Assuming that you have the right risk controls in place, these models should take you out when the trend reverses itself.
As for the question of making the right China call, I use commodity prices as the canaries in the coal mine of global growth and inflationary expectations. If and when they turn down, that will be the signal to exit the risk trade in general and China specifically.

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