China Strategy: Initial and fragile signs of stability; policy complacency is a risk, in our view

* While there are signs of stability in the Chinese economy—and the A-shares’ gains and outperformance YTD appear to be consistent with those signs—we still see risks that could disrupt stability and recovery. Re-stocking may not automatically happen or last, even if we are close to the end of the de-stocking process.

* Risk #1: deflation: Given deflation risk, and China’s real GDP growth of only 1.5% in 4Q08 (Q/Q annualized), real interest rates still look too high. We believe interest rates need to be cut substantially and urgently. Risk #2: the recovery in property transaction volume since Nov-08 could stall, without further timely stimuli. Residential property inventory (about two years) is too high, in our view. Prices are still under pressure and transaction volumes need to be further stimulated to allow faster digestion of unsold inventory. More importantly, without a transaction volume recovery in the property market, the government needs to further stimulate consumption, in our view. Risk #3: as the global recession broadens and deepens, we believe the worst for Chinese exporters is yet to come, although exports were resilient in 4Q08, relative to other exporters in the region and the world. We see the need for more timely measures to boost domestic consumption. It has been our long-held view that for the second stimulus round, boosting consumption and the country’s consumption rate—at 38%, the lowest among the major economies in the world—over the medium-to-long term should be the policy focus.

* Despite our near-term cautious stance since mid-Dec-08, we believe investors should stay positive on China for the medium-to-long term. China’s problems seem mostly cyclical and P&L-related; China does not have a balance sheet problem and there is no domestic financial crisis, in our view, so all the stimuli and printed money can go into the economy right away, unlike in many other economies where they have to go to repair the balance sheet first. We believe the chances of the stimuli working in China are high. The key point, in our view, is that the Chinese government still needs to do more, and urgently.

* We expect more government policies to support consumption (especially discretionary consumption) and lower interest rates, with key measures focusing on property and consumption.

* In our model portfolio, we recently increased exposure to consumer discretionary (see Views from the Bund, published on January 23, 2009) and IPP names. Signs that de-stocking is close to an end and tentative signs of re-stocking mean power demand in China should improve. We also like mid-cap property names (R&F, Hopson) and large caps (CR Land). We see the IPP and property sectors as being most sensitive to lower interest rates.

For detailed analysis, please find the attached PDF report.