“Sometimes, a question is easier to answer if it’s inverted.” Me (channeling Chazza Munger).
China stocks rose in 2017, but weren’t in a ‘bull-market’; they were continuing a recovery from a crushing begun in August 2015 that reached its maximum intensity in January 2016.
As we head into 2018 it seems reasonable to ask; is this a year in which a ‘proper’ bull-market for China stocks can develop? I’ll have an answer, together with thoughts on why the question doesn’t really matter, at the end of this note.
Let’s first remind ourselves where we are now and..
What’s Held Sentiment Back For So Long?
There’s an industry that’s made a living in recent years scaremongering about China’s prospects and, despite the serial failure of this cynical complex to correctly predict just about anything useful, it’s been influential.
The underlying analysis of pessimists has a common thread and is usually some extension of an ‘if-present-trends-continue’ argument. As I’m sure you’re familiar with most of these I’ll be brief here. There are five themes that have cropped up most, and, in no particular order, they are:
1) Bank balance sheets. If present trends continue with rising NPL’s China’s banks will, at the very least, need recapitalizing. If this process accelerates a full-blown credit crisis could be triggered.
2) Property. If present trends continue with overbuild, an increasing stock of unsold residential property will lead, inevitably, to collapsing developers which will trigger domino-effect industry failure and financial system contamination.
3) Shadow banking. This is what did for, among other things, the Western system and led to the Global Financial Crisis. From virtual non-existence this has become huge and, being opaque, is where deep credit problems are gestating. If present trends continue, watch out.
4) Debt. China is awash with it and no economy has ever taken on so much, so fast without there being a systemic implosion following. From the GFC China’s total debt to GDP has ballooned and, if present trends continue, well, we all know what happens next?
5) Growth. All problems are addressable when your economy is growing strongly; but that’s a progressively harder trick as your base rises. If present trends, now with official sanction, continue at what speed do we stall out; and, BTW, isn’t ‘controlled-descent’ an oxymoron?
Mr. Perception, Meet Ms. Reality
As kind-of-right as most of the above sounds, it’s mostly wrong. Yes, there have been times in recent years when some parts of the if-present-trends-continue argument has had stronger currency; but now, arguments are either weakening considering hard data, or, they’re just plain wrong.
Let’s review our bogey-man check list from above:
[If you need longer arguments let me know. For the sake of brevity you’ll have to trust me on the below. Promise, I’m not making any of it up!]
1) Bank balance sheets. Bad trends haven’t continued. NPL ratios (remember gross NPLs will be at all-time highs for some time) in H117 went down. Profitability, at many banks, also grew and I expect those trends to have continued into H217 and persist into 2018.
2) Property. There may be some overbuild in smaller towns; but the picture in the main conurbations is one of strong demand and tight supply. Property developers will post their best year for profits, ever, in 2017; and these trends are set fair into 2018.
3) Shadow banking. Moody’s pointed out (November last year) growth in the sector’s assets fell, for the first time in H117. They spoke with confidence as it’s become a very un-shadowy and well documented space. Both trends, growth and high transparency, will persist in 2018
4) Debt. The rate of growth moderated over the course of 2017. We also know that China’s government have made containing this a priority; we know how? Planners from the President on down have been unequivocal; a trend we have no doubt will continue in 2018.
5) Growth. There isn’t a stall-speed. Yes, there was a bao ba (保八) or ‘protect 8% growth’ policy; but that’s history. Since 2012 the government has been crystal clear, quality not quantity is the goal. Most seem to now agree; lower ‘new’ growth is better than the old, higher variety.
Now, to invert the question that forms the title of this note..
What Will Prevent China Stocks Progressing To A Bull-Market in 2018?
There are some fresh negative arguments doing the rounds. The currency is strengthening and this will lead to a lack of export competitiveness, slower growth makes debt repression harder, abandoning the rust-belt too soon may trigger hard to fix social problems, delivering a cleaner environment is a promise that can’t be kept and rising affluence will surely lead to a difficult, or impossible, to handle new class of entitled political agitators [And etcetera].
China-bashing has been a lucrative business for quite a while and incumbent operators will be unwilling to give up established business models; but, as arguments for not investing become thinner and thinner, rooted farther and farther from reality investors are likely to give them less, and less weight.
What Can We Be Sure Of This Year?
Of course, nothing; but we can talk about issues as having high and low probabilities. Returning to lists above, with a couple of extra observations, here’s how I’m looking into 2018:
1) Banks. Highly likely; NPL ratios fall further and profitability maintains or improves. Highly unlikely; balance sheet quality deteriorates or systemic problem-loan issues surface.
2) Property. Highly likely; government keeps a tight leash on developers and supply-demand dynamics persist. Highly unlikely; inventory build leads to industry domino-effect problems.
3) Shadow banking. Highly likely; growth continues to moderate, players keep authorities well informed. Highly unlikely, balance sheets are consolidated into establishment lenders.
4) Debt. Highly likely; efficiency of lending takes precedence over volume and growth again moderates. Highly unlikely; bad habits continue as government commitment quietly fades.
5) Growth. Highly likely; top line GDP growth for 2018 will be no less than 6%. Government continues to foster development of the smarter type. Highly unlikely; crude stimulation to achieve targets.
6) Stock valuations. Highly likely; modest valuations will attract global investors considering the above. Highly unlikely; a 2015~2016 wilt and attendant large downward re-pricing.
7) Flows. Highly likely; emerging markets see more with China the largest beneficiary. Highly unlikely; outflows; because? The current low level of international participation.
In conclusion and to return to the question..
Can China Stocks Progress To A Bull-Market?
The answer is, yes, they can. I believe this because I can’t see what stands in the way. The question I can’t answer is will they progress to a bull-market in 2018?
Valuation-tinder is dry, potential flow-kindling plentiful and sentimentally we’re not being asked to imagine fire in a hail storm. What’s missing is the spark that produces a market where investors participate in greater numbers and with more enthusiasm than we see now; the condition, when and if it arrives, more familiarly referred to as a bull-market.
The knock-out argument for participation though is how stock valuations continue, despite last year’s leg up, to present a heads-you-win-tales-you-don’t-lose (much) proposition. Moreover, being less prone to buyback-EPS-jockeying, China stocks offer great what-you-see-is-what-you-get dividend yields.
The most comfortable way to be positioned in any market is not to be (too) fussed about prospects and that’s where I find myself presently. A bull-market develops; good, I’m bases loaded. It doesn’t; fine, I’m happy to bide time in coupon-clip alley.
Can China stocks progress to a bull-market in 2018? Yes. Will they? Who knows; but for the long-term value investor it’s less important to answer the question than to be confident upside is priced at bargain levels and downside limited by those same levels. The literal and figurative bottom line here is investors are rarely offered the favorable risk-reward terms that can still be found in China stocks today.