Strategy Bocom June 2013

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10 June 2013

China Market Strategy Hao Hong, CFA

[email protected]

Outlook 2H13: Auguries of Turbulence (A Preview)

“To see a world in a grain of sand, and a heaven in a wild flower.” -- William Blake

The surge in US 10-year yield is approaching inflection; significant risk-off events looming in 2H: The US 10-year yield is of

singular importance for global markets. Indeed, the ebbs and flows of the 10-year yield have been a chronicle of global

crises and recoveries. It is hardly surprising – the Fed remains the central bank of the world and the lender of last resort

during crises. A surge in 10-year yield shows a drain in global liquidity, and serves as the finest risk-off signal. Indeed, the ’87

Black Monday, ’94 Mexican Crisis, ’97 Asian Crisis, ’00 TMT bubble and ’08 Great Recession were all concurrent with a

dramatic surge in the 10-year yield (Focus Chart 1). Recently, the surge in 10-year yield is once again in focus.

We believe the surge in 10-year yield is nearing inflection, even though the market is still besieged by concerns about Fed’s

tapering. But leading indicators are rolling over and inflation is tamed, and yields should fall, if history is a guide. The other

time the Fed’s balance sheet was at ~20% of GDP was in the early 40s, and the World War II helped normalize it. Once it is

clear that the Fed cannot immediately quit, yields will fall together with the dashed hopes for a strong recovery. And the

rally underpinned by the chimera of growth will soon falter, with the aftermath rippling through the global markets (Focus

Chart 2). If we were wrong and yield continued to surge, the advent of a crisis similar to 1997 or 2011 would simply be

sooner rather later.

China’s liquidity inflow reversing; rate cut won’t help: The inflow of speculative capital disguised under export trades has

plunged. The crackdown on suspicious trades, as well as a change in expectation of RMB appreciation must have disrupted

some carry trades. After all, the most important element of carry trade is the stability in basis difference, but it is vanishing.

And overseas risk-off events can exacerbate funds outflow and drain system liquidity when it is most needed. In the past

few days, China’s interbank market has been under the worst strain since the China bubble burst in October 2007, and

stocks have plunged, offering a glimpse of what is to come.

With deflationary risk looming, the PBoC could opt to cut interest rates. But excess capacity and significant leverage in

private sectors make the economy insensitive to the level of interest rates, and worry about the level of debt instead. And

the fact that 9 trillion yuan of total financing YTD has done little to spur growth evidences that even rate cuts won’t help.

That said, lower rates can alleviate the debt service burden. At this juncture, deficit spending may work, yet the public

sector’s leverage also makes this a difficult choice. It is an impasse that China is facing.

Stocks will struggle amid slowing growth and inflation; a capitulation can see 20% downside; stay put: The Chinese and

the US economies are a symbiosis, as shown by their highly correlated interest rates (Focus Chart 3). If the US stumbles,

China will, too. And vice versa. The drag from slowing investments on China’s economic growth is now evident. Many have

been advocating a structural reform, but are not prepared for the interim pain. As such, market sentiment remains elevated

despite a series of economic setbacks (Focus Chart 4).

In a highly leveraged economy, companies should be valued by their capacity to service debt, rather than their earnings

growth potential. After all, companies could succumb to heavy debt load before their potentials are even realized. Even

estimates of replacement value such as P/B will not serve as a reliable benchmark, as there will be no market to render a

fair price during liquidation. We would use the P/EBITDA ratio instead, as it measures debt servicing capacity. This ratio is

still ~20% above its 2005 and 2008 lows, hinting at further market dislocations ahead. As global risk-off events are looming

large, investors should stay put for now, and resist the temptation of oversold rebounds. Don’t fret about an impending

capitulation. It will be a sale that one wouldn’t want to miss.

(This is a preview of our second half outlook to be published on June 26, 2013.)


10 June 2013 China Market Strategy

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Focus Chart 1: US 10-year yield is a chronicle of global crises and recoveries.

Source: Federal Reserve, Bank of Communications (Int’l)

Focus Chart 2: The surge in 10-year yield is about to turn; EM and China will face looming headwinds.

Source: Federal Reserve, MSCI, HKSE, Bank of Communications (Int’l)

'13 QE3

'93

'81 Oil Cris is

'86

'98

'03

'08 QE1

'10 US Relapse

'11 EU Cris is

'07 Subprime

'97 Asian Crisis

'00 TMT Bubble

'94 Mexico Crisis

'89 S&L Crisis

'87 Black Monday

'73-'74 Severe Bear Market

'70 Recession

'71 Bretton Woods

-

2

4

6

8

10

12

14

16

18

1-62 1-67 1-72 1-77 1-82 1-87 1-92 1-97 1-02 1-07 1-12

0

2

4

6

8

10

12

14

16

18

5yrs

5yrs

5yrs

5yrs

(3)

(2)

(1)

-

1

2

3

6-93 6-94 6-95 6-96 6-97 6-98 6-99 6-00 6-01 6-02 6-03 6-04 6-05 6-06 6-07 6-08 6-09 6-10 6-11 6-12 6-13

-100

-50

0

50

100

150

10yr Yield (Y/Y Chg, LS) HSI (Y/Y%) MSCI EM (Y/Y%)

?



3

Focus Chart 3: The US and China’s interest rates are closely correlated.

Source: Federal Reserve, PBoC, Bank of Communications (Int’l)

Focus Chart 4: Our proprietary Chinese Market Sentiment Index is elevated, suggesting China has not yet bottomed.

Source: Bank of Communications (Int’l)

-2.5

-2.0

-1.5

-1.0

-0.5

-

0.5

1.0

1.5

2.0

Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0US 10-yr Yield (Y/Y Chg, LS)

China 10-yr IRS (Y/Y Change)

Feb-8-13

Ja n-6-12

Oct-31-08

May-4-12

Sep-30-11

Apr-15-11

Jul -2-10

Jul -31-09

7.4

7.5

7.6

7.7

7.8

7.9

8.0

8.1

8.2

10-08 1-09 4-09 7-09 10-09 1-10 4-10 7-10 10-10 1-11 4-11 7-11 10-11 1-12 4-12 7-12 10-12 1-13 4-13 7-13

7.4

7.5

7.6

7.7

7.8

7.9

8.0

8.1

8.2SHCOMP (Log Scale)

Feb-8-13

Aug-31-12

Ma y-4-12Apr-15-11

Jul -31-09

Jul -2-10 Sep-30-11Oct-31-08

Jan-6-12

(8)

(7)

(6)

(5)

(4)

(3)

(2)

(1)

-

1

2

3

4

5

6

7

8

10-08 1-09 4-09 7-09 10-09 1-10 4-10 7-10 10-10 1-11 4-11 7-11 10-11 1-12 4-12 7-12 10-12 1-13 4-13 7-13

7.2

7.4

7.6

7.8

8.0

8.2

8.4SH Sentiment

SHCOMP(Log Scal e, RS)



4

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5

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LT Buy: Expect more than 20% upside but longer than 12 months Market perform (“MP”): Expect low volatility

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Research Team

Head of Research @bocomgroup.com @bocomgroup.com

Raymond CHENG, CFA, CPA, CA (852) 2977 9393 raymond.cheng

Strategy Economics

Hao HONG, CFA (852) 2977 9384 hao.hong Miaoxian LI (86) 10 8800 9788 - 8043 miaoxian.li

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Summer WANG (852) 2977 9221 summer.wang Toni HO, CFA, FRM (852) 2977 9220 toni.ho

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Kevin WANG (852) 2977 9386 kevin.wang

Insurance Telecom & Small/ Mid-Caps

Jerry LI (86) 10 8800 9788 - 8053 liwenbing Zhiwu LI (852) 2977 9209 lizhiwu

Internet Technology

Yuan MA (86) 10 8800 9788 - 8039 yuan.ma Miles XIE (852) 2977 9216 miles.xie

Connie GU, CPA (86) 10 8800 9788 - 8045 conniegu

Transportation & Industrial/ Automobile

Geoffrey CHENG, CFA (852) 2977 9380 geoffrey.cheng

Wei YAO (86) 21 6065 3675 wei.yao

Ian FENG (852) 2977 9381 Yinan.feng



6

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Strategy Bocom June 2013

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