MNI China Money Week: Cheap Equities Recall Japan In 2012

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By Stuart Allsopp

     LONDON (MNI) - While Chinese stocks and USDCNH are likely to remain closely

and positively correlated in the near term, we expect equities to outperform and

the yuan to underperform over the medium term. Chinese equities are trading

close to all-time lows in valuation terms relative to the EM basket, at the same

time as the yuan is once again testing all-time highs relative to the EM FX

index. This is in part driven by China's lower rates of inflation compared to

the EM universe, yet the divergence in valuations does not appear justified,

particularly as Chinese inflation pressures are rising, as today's PMI reading

shows.

     STOCKS NEAR RECORD LOWS VS EM

     Both the onshore Shanghai Composite and the Hong Kong-based Hang Seng China

Enterprises Index are trading at or near all-time lows relative to the MSCI EM

index on both asset-based and earnings-based valuation metrics. The

price-to-book ratio of the HSCEI is just 0.98x, compared to 1.50x for the MSCI

EM.

     YUAN TESTING RECORD HIGHS VS EM

     This huge valuation discount contrasts with the relative performance of the

yuan, which is testing all-time highs relative to the JP Morgan EM FX Index

following collapses in a number of more risky EM currencies. The outperformance

of the yuan is in part due to lower levels of inflation, but even in real

effective terms the yuan remains elevated relative to EM averages.

     With the government likely to increasingly turn to fiscal policy to

stimulate economic growth amid rising concerns around the export sector,

inflation pressures seem likely to rise. Today's CFLP manufacturing PMI data

showed producer prices rising to a YTD high of 54.3 and input prices hitting

58.7.

     ECHOES OF JAPAN 2012

     The combination of low inflation, a relatively strong currency and cheap

equity market is reminiscent of the situation in Japan in 2012 prior to the

surge in stocks and decline in the yen. While it was the BOJ's QQE policy that

ignited this reversal in asset market performance as investors begun to price in

a changing inflation picture, expectations of fiscal expansion in China could

provide a similar catalyst.

     This is not to say that we expect to see the current positive correlation

between USDCNH and Chinese stocks to break down any time soon, or that we expect

the yuan to resume its weakness in the dollar. However, we do see broad-based

yuan underperformance and Chinese equity outperformance as highly likely over

the medium term.

--MNI London Bureau; +44208-865-3829; email: Jason.Webb@marketnews.com

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