Chinese Stocks Looking Like a Bargain

 

By Frank Holmes
CEO and Chief Investment Officer
U.S. Global Investors

With negative sentiment toward China reaching an extreme in recent months, patient investors have been rewarded with this week’s news of improving data from the Asian giant.

CLSA Sinology’s Andy Rothman reported that in September, retail sales growth rose 13.2 percent, which was the fastest pace of the year. Real urban disposable income grew nearly 10 percent and real rural disposable income rose more than 12 percent during the first three quarters of the year. And, while export numbers are weak, China has “so far avoided the large-scale export-sector layoffs that led to 2009’s massive stimulus,” says Andy.

There was strength in commodity imports, too. Copper imports into China increased 11 percent compared to the previous month due to increased demand from power infrastructure, white goods restocking and auto production. Iron ore rose a modest 4 percent compared to the previous month, which is encouraging. There was also a sharp rebound in oil imports most likely due to holiday restocking and lower international prices. In fact, Pareto Securities found that Chinese implied oil demand came in at an all-time high of 9.8 million barrels per day in September.

The markets also saw an increase in fixed asset investment (FAI), a measure of capital spending, which grew at “the fastest pace since October 2011,” says CLSA. According to Credit Suisse, “a surge in transportation spending in the month of September [is] starting to reflect the project approvals for highway, rail, airport, and metropolitan transport projects announced in May and June.”

While Credit Suisse says FAI growth was boosted by government investment stimulus, CLSA also notes that fixed asset investment and capital spending by private firms has been rising faster than state-owned firms for 30 of the last 31 months.

Money supply, a key lubricant of the economy and markets, also continued to increase, and this has historically driven Chinese equities. Take a look at the chart below, which shows the year-over-year money supply compared to the MSCI China Index over the past decade. Over the past 10 years, after the supply in money bottomed, stocks soon rebounded.

On January 31, 2012, money supply hit a near decade low of 12.4 percent year-over-year growth. Since then, the number has been creeping higher, rising sharply to 14.8 percent in September, and shortly thereafter, equities responded.

The Wall Street Journal recognized the improvement in Asian stocks and investor sentiment this week, suggesting that the “region’s economy could be nearing the end of a slowdown.” I’ve been trying to temper investors’ expectations of China as weak economic data caused investors to be skittish, telling Investor Alert readers that it wasn’t the time to be bearish. Now, “if the Chinese economy shows sustained signs of stabilizing, it would remove a major overhang of worry for investors in Asia, and may spur more capital raising and other deals as investors beco me confident enough to switch money out of bonds and back into equity markets,” says The Journal.

This appears to be a good time to be investing in China, as stocks are historically cheap. At the beginning of October, BCA noted that there was a “prevailing pessimism” around China and that the stocks were “currently trading at hefty discounts to world averages and even to euro zone stocks.” The firm indicated that Chinese shares had a forward price-to-earnings ratio of below 9 times; the world and U.S. benchmarks traded at 12 and 13 times, respectively.

Chinese stocks are also cheap compared to emerging markets. In 2007, China traded at a 75 percent premium to emerging markets. Today, Chinese stocks trade at a 20 percent discount. If you look at a comparison of price-to-earnings in China to those in emerging markets, you have to go back to 2006 to find that ratio as low as it is today.

The low price-to-earnings indicates to me that the negativity pendulum has swung too far. “Investors have turned from euphoria at the height of the ‘China mania’ five years ago to extreme pessimism,” says BCA.

Back in April, I listed three trends that global investors should watch in China: A rebound in the liquidity cycle signaling a rally in equity prices, a new leadership with an incentive to maintain growth, and Chinese stocks reverting to their mean, as history appears to favor Chinese stocks landing in the top half of emerging markets. Time will tell.

 

Index Summary

• The major market indices were mixed this week. The Dow Jones Industrial Average rose 0.11 percent. The S&P 500 Stock Index advanced 0.32 percent, while the Nasdaq Composite dropped 1.26 percent. The Russell 2000 small capitalization index closed the week with a loss of 0.25 percent.
• The Hang Seng Composite rose 2.30 percent; Taiwan fell 0.38 percent, while the KOSPI rose 0.55 percent.
• The 10-year Treasury bond yield rose 11 basis points for the week, to 1.76 percent.

 

Domestic Equity Market

 

The S&P 500 Index rose 0.32 percent this week even as the market sold off sharply on Friday. Earnings season is in full swing and technology shares have not fared well. Intel, IBM and Google all disappointed investors and built on other recent disappointments in the space.

Strengths

• The materials sector was the best performer this week, rising 2.10 percent. Steel and chemical names were particularly strong. Sentiment on cyclicals in general improved this week as investors are looking to strong growth in 2013, and steel companies are classic cyclicals. Within the chemical space, ethylene prices appear headed higher, helping margins for many chemical companies.
• The financial sector registered the second-best performance this week, rising by 1.95 percent. Citigroup rose 7 percent on earnings and on news that the CEO had been replaced. Insurance stocks also performed well as catastrophe losses have been lower than expected from a few companies that have already reported.
• Dean Foods was the best performing stock in the S&P 500 this week as the company rose by more than 22 percent after its WhiteWave Foods unit filed for an IPO.

Weaknesses

• The information technology sector was the worst performer, falling 2.42 percent. The sell-off was largely related to high profile names such as Intel, IBM and Google reporting disappointing earnings results or outlooks.
• The consumer staples sector also underperformed as several companies in the sector reported disappointing results, which often were driven by negative European sales and/or unexpected currency losses.
• Apollo Group was the worst performer this week in the S&P 500, falling by more than 28 percent as the company reduced its 2013 revenue forecast and announced it would close campuses and implement layoffs.

Opportunity

• While debasing the value of its paper currency in the long term, renewed money printing in the developed world may have the ability to send asset prices higher in the near term.

Threat

• The market is clearly focused on earnings announcements and the upcoming elections, which could cause some volatility.

 

The Economy and Bond Market

 

Treasury bond yields rose this week on better-than-expected economic data. Long-term yields hit their highest levels in a month before pulling back on Friday.

Housing starts and building permits in September were much stronger than expected, rising 15 percent and 11.6 percent, respectively, on a month-over-month basis. The chart below shows the long-term trend in housing starts and building permits. While housing is in recovery mode, we still have a long way to go before the housing market normalizes.

Strengths

• Housing starts reached the highest level in four years, continuing the recent trend of strong datapoints out of the housing market.
• Global central bank easing continues with Turkey and Brazil both cutting interest rates by 25 basis points this week.
• Retail sales rose 1.1 percent in September and, while boosted by iPhone5 sales, the gains were broad-based.

Weaknesses

• Initial jobless claims bounced higher this week indicating no improvement on the employment front.
• European Union new car sales fell 10.8 percent in September which was the twelfth straight month of decline.
• Consumer prices in the eurozone rose 2.6 percent in September, with austerity-led tax hikes as a partial driver.

Opportunity

• There remains considerable speculation about the prospects in China for near-term government policy action that would support the economy or stock market.
• Interest rates are likely to remain very low for the foreseeable future, both here in the U.S. and globally.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.
• China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.

 

Gold Market

 

For the week, spot gold closed at $1,721.75 down $32.73 per ounce, or 1.87 percent. Gold stocks, as measured by the NYSE Arca Gold Miners Index, gained 0.12 percent. The U.S. Trade-Weighted Dollar Index slipped 0.05 percent for the week.

 

Strengths

• Junior Colombian mergers and acquisitions are heating up. Billionaire Eike Batista’s private gold company, AUX, announced cash takeovers of two Colombian junior gold companies, Galway Resources and Calvista Gold, worth more than $300 million combined. Galway and Calvista provide AUX several projects in the California district including Calvista’s 450,000 ounces gold indicated, and about as much again in inferred resources, and Galway’s 424,000 ounces gold indicated and 666,000 ounces gold inferred, all within two kilometers of AUX’s larger La Bodega and La Mascota projects, according to Mineweb.
• This week aanalysts at BMO significantly boosted their gold and silver price forecasts and highlighted their bullish view on related stocks versus bullion as they see positive momentum for metals due to a “new and open-ended round” of quantitative easing. They now expect gold to average $1,950 in 2013, up from their prior forecast of $1,700.
• Despite a down weak for gold bullion, gold stocks, as measured by the Gold Miners Index, gained 0.12 percent this week, edging out bullion which slid 1.32 percent this week. The stocks of miners have shown relative strength versus bullion for the last three months and may be poised to continue to outperform bullion.

Weaknesses

• Gold bullion slid over $33 per ounce this week with much of the decline coming on Friday as weak economic data out of China caused a broad sell-off of stocks and commodities. Silver prices slipped over 4 percent for the week.

Opportunities

• India’s gold imports are expected to climb in the last quarter of 2012 which will mark the first gain in six quarters as a decline in domestic bullion prices stokes jewelry and investment demand ahead of major festivals. The World Gold Council sees imports jumping to approximately 200 tonnes in the fourth quarter, or about 18 percent sequentially and up 27 percent year-over-year.
• Gold Fields said most miners returned to work at its strike-hit South African operations this week, but a new walkout at Lonmin’s Marikana platinum mine dampened hopes of an end to the worst labor unrest since apartheid. More than 80,000 miners have downed tools since August in often violent strikes that are hitting growth and investor confidence in Africa’s biggest economy and raising questions about President Jacob Zuma’s leadership. In a surprise move, 4,000 workers at Lonmin’s Marikana mine stayed away from work on Thursday, disrupting operations once again at a plant where police killed 34 striking miners in August. “There have been disruptions at various shafts since yesterday,” Lonmin spokeswoman Sue Vey said. The company later said it believed the workers were protesting against the arrest of three miners as part of a police investigation.
• The Australian reported that “gold has soared past coal as Australia’s second most valuable physical export to China, with sales up a whopping 900 per cent for the first eight months of the year, bringing in $4.1 billion. Chinese buyers are hoarding the precious metal amid a slowing economy, property-buying restrictions and uncertain financial markets as its central bank increases its holdings. The unprecedented jump in gold sales, along with continued acceleration of export revenues for other commodities led by coal—up 80 percent to $4 billion—caused total exports to China to rise by 10.7 per cent for the year to August, according to Australian Bureau of Statistics figures. Shipments of Australia's biggest export, iron ore, were up 20 percent for the same period but the total value of $26.9 billion was down 5 percent compared to last year, because of the mid-year price slump.”

Threats

• Deutsche Bank analysts, who are longer-term bullish on gold, said this week that they expect that the gold market could trade in a range over the next couple of months as they see a vacuum in terms of monetary action due to upcoming transitions/decisions in government in both the U.S. and China. Additionally, they believe somewhat supportive economic data from the U.S. could also weigh on market sentiment for gold as conditions seem to be normalizing.

 

Energy and Natural Resources Market

Strengths

• Nymex natural gas futures edged up slightly this week to finish at an 11-month high price of approximately $3.63 per mmbtu on data released by the U.S. Department of Energy which showed gas going into storage continues to decline relative to last year.
• Chinese refineries processed a record amount of oil in September, countering data indicating the world’s second largest economy is slowing. Crude runs for September were 9.47 million barrels a day, passing January’s 9.38 million barrels a day and 6.2 percent higher than the 8.92 million barrels a day refined in August.

Weaknesses

• China’s coal imports fell 18.6 percent year-over-year to 18.63 million tonnes in September, the China Coal Transport and Distribution Association said.
• Bloomberg news reported that oil exporter Norway may miss production estimates. Jan Bygdevoll, the head of forecasting at the Norwegian Petroleum Directorate, released a statement yesterday that Norway may struggle to meet its output target this year due to a worker’s strike, technical problems, and delays to the start of new fields.

Opportunities

• Deep-water oil-drilling permits for the Gulf of Mexico have reached their highest level since 2007 as high crude prices revive exploration slowed by the 2010 BP spill. The U.S. Bureau of Safety and Environmental Enforcement, which regulates offshore drilling, has as of yesterday issued 89 permits this year for new wells in waters deeper than 500 feet (152 meters). The U.S. issued 76 permits for all of 2009, 32 in 2010, and 38 last year, according to the agency’s website. In 2007, 106 permits were issued.
• The head of Codelco, Chile’s large state-owned copper miner, is constructive on the copper market. “We expect to see healthier growth rates as we enter the new year,” Chief Executive Officer Thomas Keller said in an interview in London. China’s new leadership will “provide important stimulus for the economy and for the mining industry at large, and copper in particular,” according to Bloomberg news.

Threats

• In an interview with Bloomberg news, David Cohen, the U.S. Treasury’s undersecretary for terrorism and financial intelligence, stated that the U.S. stands ready to increase pressure on Iran to address concerns over the country’s nuclear plans. He stated that the country is able to intensify sanctions on Iran as it advances on its nuclear program. Iran, which once was the second largest OPEC producer, has cut output to 2.63 million barrels per day in September down from 2.85 million barrels in August. Exports in September decreased to 860,000 barrels a day, down from 2 million barrels a day in early 2012.
• Chinese demand for nickel, a key ingredient in stainless steel, is likely to lag growth in the country’s steel market considerably as producers turn increasingly to scrap for use in their products, the chief analyst at Beijing Antaike Information Development Co. Ltd. said Wednesday. Xu Aidong forecast apparent stainless steel production to reach 17 million metric tons by 2015, up from around 11 million tons this year. Nickel consumption, however, is only estimated to rise to almost 790,000 tons in 2015, from around 642,000 tons this year, she said. “The growth rate (for nickel usage) will be much slower than before…and lower than in the stainless steel market as more scrap is used,” she told a conference in Sydney.

 

 

 

Emerging Markets

Strengths

• China reported September and third quarter economic data that was better than market expectations and showed upside strength for the economy. Third quarter GDP grew 7.4 percent, in line with the market consensus, and believed to be the bottom for the year. September industrial production grew 9.2 percent versus the estimate of 9 percent. September retail sales were up 14.2 percent versus the estimate of 13.2 percent. September year-to-date fixed asset investment grew 20.2 percent, slightly better than 20.1 percent for the first half of the year. Money supply (M2) was up 14.8 percent, better than the 13.5 percent in August due to increasing corporate bond issuance and trust loan lending.
• China’s September CPI moderated slightly to 1.9 percent year-over-year from 2.2 percent in August.
• China September exports went up 9.9 percent versus the estimate of 5.5 percent, while imports expanded 2.4 percent after contracting 2.6 percent in August.
• Bank of Thailand, the central bank, cut the benchmark lending rate by 25 basis points to 2.75 percent, which is said to be a precautionary action to hedge potential slower economic growth due to weak external markets.

Weaknesses

• China’s foreign direct investment dropped 6.8 percent in September, 3.5 percent worse than the estimate.
• China’s September power consumption growth was at 2.9 percent on a year-over-year basis, down from 3.6 percent in August due to slower industrial consumption growth. The September Producer Price Index (PPI) continued a downtrend by decreasing 3.6 percent, indicating the de-stocking processing has yet to end.
• The Hungarian government has announced new austerity measures for 2013, increasing the tax burden for Hungarian banks in terms of both the financial transactions tax and the bank levy. In the Frank Talk blog, we recently discussed the effect that the taxes had on the Hungarian economy.

Opportunities

 

• The graph above shows Philippines’ monthly overseas remittance. In August, it was another record monthly high, rising 7.6 percent year-over-year. As more overseas remittance comes in, it helps domestic consumption and keeps Philippines’ current account in surplus.
• Greg Weldon of Weldon Financial points out that the Polish Central Bank has ample room to ease while maintaining positive real interest rates. He illustrates that by juxtaposing falling inflation with the previous rate increases.

 

Threats

• China’s September PPI was down 3.6 percent, which shows weak demand for industrial products. Further evidence of weak industrial activities is the producer purchase index in September which was down 4.1 percent, showing weak industrial demand for raw materials and commodities. However, the recent cement and coal price firmness from their lows in the summer may indicate an improving demand for commodities.
• This evidence of weak demand for industrial products has major negative implications for iron ore and coking coal companies and for vertically integrated steel companies in Brazil, Russia and elsewhere.
• In local elections last weekend, Communists together with Social Democrats won 44 percent of the vote and could control 10 out of 13 regions in Czech Republic. The ruling parties received only 12.3 percent ahead of a key parliament vote on a tax/pension reform package and a no-confidence vote in late October.

 

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