Bulls And Bears On China - Look Like The Bears Are Winning

Morgan Stanley's desperate attempt to be bullish on China stocks.

But Deutsche Bank is all like "No, dude, Chinese stocks are cheap for a reason - the growth model is broken."

Even though Chinese data has proven to be a disaster, there are bound to be delusional China bulls along the way who are willing to say that the worst is over, while the worst is clearly not over.  Far from it.

The latest attempt to declare that the worst is over is made by Morgan Stanley, who came up with a presentation which titled “China equities – a new bull market begins amid macro-uncertainty”.

The reason being that Chinese stocks are very cheap, bloody cheap, and absurdly cheap (among some other things).
(among some other things).

“HSCEI is trading on 7.5x trailing P/E (98th percentile) and 1.41x trailing P/B (91st percentile)” according to Morgan Stanley. 

Policy is easing, according to Morgan Stanley. 

Real Estate sector is stabilising, according to Morgan Stanley. 

Earnings revisions breadth has stabilised, according to Morgan Stanley.

Just how desperate it is too make such bullish claim?

… while in this morning, we learned that the biggest 4 Chinese banks aren’t really making any new loans overall.

the big 4 banks’ (ICBC, China Construction Bank, Agricultural Bank of China, Bank of China) new loan for May is almost zero for the first two weeks.  According to their sources, two of the big 4 banks have had new loans of RMB10 billion and a few billion, while another banks have net new loans in negative territory, brining the overall net new loans for big 4 banks more or less at zero.  This suggests that demand for credit is extremely weak, perhaps much weaker than anyone could have thought.

They think earnings revisions breadth has stabilised, and the top-down EPS growth of HSCEI is 10.9% for 2012, while bottom-up HSCEI EPS growth is 9.1%…

But just yesterday, there was a report saying that almost half of Chinese companies are expecting weaker earnings: 

Nearly half of China’s listed companies that have so far issued forecasts for the first half expect weaker earnings or losses for the period, according to a Tuesday report in China Daily, which cited financial data provider Wind Information Co. About 45% of reporting companies listed on the Shanghai and Shenzhen stock exchanges expect weaker results, according to the report.

Are the remaining half of the companies doing so well, or are they all cooking their books, or what?

(Okay, the consensus is even more optimistic…)

Are stocks cheap now then? Well, what if they get even cheaper, just like what  other markets did after the bubbles?

Deutsche: China’s cheap for a reason

Another growl from Deutsche Bank’s emerging markets bear, John-Paul Smith. This time he’s had a close look at Chinese corporates – and doesn’t like what he sees.
He’s worried about the overcapacity created in the recent huge investment wave, compounded by Beijing’s failure to maintain discipline over its free-spending regions or enforce loudly-touted consolidation plans in key industries, eg steel.
Investors should therefore be wary of the apparent cheapness of Chinese stocks. Far from being a buying opportunity, low prices are signalling “a major break in the growth model”. Caveat emptor.
Smith argues that the state is the dominant influence in the Chinese economy, and in the activities of leading Chinese companies. So investment decisions are often made for non-economic reasons, notably in strategic sectors, including banking.
Even though listed companies are generally efficient in terms of their operating ratios, they function in an economy with widespread misallocation of resources.
The key driver of Chinese growth over the past thirty years has been rising productivity. But the pace of improvement has slowed, so the authorities have increased investment to try to maintain economic growth.
Beijing responded to the 2008 global crisis with an even bigger economic stimulus than has been generally realised, argues Smith. The combined boost in the fiscal deficit, bank loans and bond finance over 2008-10 reached 27.5 per cent of GDP – far in excess of Beijing’s original 12.5 per cent aim (which was itself significant by global standards).
Smith says the central government has now realised that it lost control over policy implementation as regional administrations pursued pet projects and the financing created fiscal liabilities backed by assets “of questionable financial viability”.
And Beijing is now trying to restore discipline – as highlighted in the Bo Xilai affair. And to give market forces a bigger role in the allocation of capital.
Smith says that’s good in the long run. But in the short-term such reforms – if they go ahead – would be disruptive for companies, and for equity investors. Global conditions will make life very difficult for Beijing:

Against this discouraging backdrop, we expect the authorities to proceed extremely slowly, to the extent that for relatively long periods of time, it may not even be obvious that there is any coherent policy direction. There is also the possibility that if there is a major shortfall in growth, we may see the sort of policy easing, which investors were anticipating at the start of 2012, or even in extreme circumstances a reaction against a more market oriented economy, which would shift the balance of power within the ruling elite away from those favouring market oriented
reforms.

Chinese companies, which have already seen return on capital declining because of overcapacity, will struggle.

Source: Deutsche Bank

Chinese stock prices are low by historic standards and diverging from the upward march of GDP, as the charts below show.

But Smith says that investors should not be tempted. He draws parallels with apparent cheapness of US stocks in 2007 – which was followed not by a stock market recovery but by economic turmoil. Smith writes:

The implication… is that China, like the US five years ago, faces a major disruptive economic event, though at this stage it is too early to tell whether this is more likely to take the form of a lengthy transition period, or a major financial crash.

Smith concedes there could be some bullish surprises that might influence his general bearishness. In the short term, oil prices could fall or Beijing could engineer a stock market rally. In the medium term, China’s legion of private companies could grow faster than expected. Longer term, the huge state-led infrastructure investments of recent years could pay off (though, naturally, Smith doubts this will happen).
Smith’s arguments dig deeper than the standard macro-economic debate on whether China faces a soft or hard landing, or something in between. He may not be right – but his corporate level analysis begs a response from the China bulls. Any horned beasts care to comment?