China: Enough reasons to remain cautious for now

One of the interesting aspects of the return of the ‘risk on’ trade through the early weeks of the year has been the relatively muted participation of the Chinese domestic equity market.

While other Bric equity markets have led the charge (Brazil and India up over 15% so far this year), the Shanghai index has returned a still positive, but more modest 6%.

As a closer reflection of Chinese conditions, domestic equity market returns have to us looked at odds with the ongoing bullishness about China’s prospects for some time. Chinese markets peaked in November 2010, well before many Western markets retrenched last year and are still some 25% below recent highs.

So, should we be relatively constructive about Chinese valuations at this point? Is this the great buying opportunity that many suggest? Or is the behaviour of the Chinese market telling us something different?

The sheer size of the stimulus package in China through 2008-09 always appeared likely to incur unintended consequences. Rapid loan growth led to a lowering of lending standards and a subsequent rise in non-performing loans which seem likely to drag on the economy at some stage.

But as global conditions appear to be bottoming (the veracity of which is a debate for another blog), the more bullish of the investment community have hailed early signs of policy easing in China as the start of a series of moves, necessary to spur future growth and markets.

To us, though, it’s not widely apparent that this easing will be as meaningful as currently expected. There remain mixed messages from Beijing and a look at bank lending this year does not yet suggest a significant increase despite the apparent easing of credit conditions. Indeed, recent news flow continues to offer up more questions than answers – an uptick in recent inflation figures proving the most recent. A rolling over of local government debt in recent days also raises concerns. It seems less than certain that the tentative moves made by policy makers at the start of the year will be followed by a raft of measures. And without these, a spur for markets doesn’t yet appear obvious in the near term.

Equity markets have undoubtedly come a long way off their highs and the longer-term China growth and consumption stories remain intact. But, without needing to suggest a hard-landing at this point, there appear enough problematic developments to maintain a degree of caution as we await greater confirmation of true conditions.

Joe Le Jehan is an analyst for the Cazenove Multi-Manager Diversity Range.