I recently wrote a series of columns on the Asian Infrastructure Investment Bank (AIIB) that -- along with the recent surge in Chinese equity prices -- have generated a number of emails from Real Money subscribers requesting that I write more about China. The gist of the emails was that the China stock market boom of the past year warrants taking long positions in Chinese equities. I've written a lot about China over the past several years, with the common theme being to avoid it. My position has not changed, but I want to update some of the reasons.
The Chinese economy is rapidly slowing. The countries first-quarter 2015 GDP report will be released this evening (tomorrow in China), and is expected to be announced as having been about 7% on an annualized basis. Although at that pace the rate of growth would be the slowest in about six years, the reality is that it is probably much slower.
In "Continue to Be Careful on China" I wrote that the country's demand for oil and electricity had declined on an annualized basis, up to that point, to 2.9% and 2.7%, respectively, even as the country was claiming an annualized GDP growth rate of 7.4%. For the past decade there's been an almost one-to-one ratio in China for energy consumption and GDP growth. In 2014 that ratio abruptly changed to about 0.5%, meaning that the annualized GDP growth rate would be roughly twice the rate of energy consumption. Some analysts believe this is warranted.
I find the claim of such a rapid change in the historical relationship between energy consumption and economic growth dubious, but even at that, the rate of energy consumption has fallen further in the past six months to an annualized rate of about 2.5%. Using the new metric, that would imply a GDP growth rate for the first quarter of 5%, not the 7% analysts are expecting the Chinese authorities to announce.
The simple takeaway is that economic activity is rapidly decelerating in China, and much faster than is being claimed. This naturally leads to the question of why Chinese equity prices have been surging for the past year with a roughly 100% increase in the Shanghai Composite stock exchange.
The two most common reasons offered by the financial media are that the liberalization of access to Chinese equity markets to foreigners has allowed for an increase in speculative flows into the country, and that the resulting increase in equity values has helped to stimulate demand for brokerage accounts by domestic Chinese citizens. The problem with this scenario is that foreign capital flows have been away from China this year, not into it. Foreign speculative capital has been selling into the surge in values with profits being withdrawn from the markets and the country. So, it is not foreign capital driving the markets up and drawing domestic investors and speculators in.
The most logical reason for the surge in values is that it is either state sanctioned and funded intervention specifically to drive values up irrespective of fundamentals, or it is quasi state-sanctioned intervention on the part of equities owners, which is concentrated in members of the politburo, including members of the People's Liberation Army (PLA).
The ongoing corruption purge within the Politburo may be motivating some high-ranking officials to extricate themselves from ownership of equities in order to distance themselves from inquiries concerning how they came to be in possession of them. In order to sell, buyers must be drawn in. The buyers are domestic, not foreign, and the market activity of the last several months looks to be closer to a "pump and dump" scheme than anything else. I don't know if this is the case, but I view it as the most logical narrative.
The most prudent course for investors is to stay away from the Chinese markets.
For speculators, my advice is not to follow this market run with long positions; instead, stake out positions that can capitalize on a reversal. The easiest way to do that for individual U.S.-based investors is with inverse exchange-traded funds, all of which are trading at record lows. The most conservative is the non-leveraged ProShares Short FTSE China 50 (YXI). For those who want to be a bit more aggressive, there's the 2x leveraged ProShares UltraShort FTSE China 50 (FXP) and the 3x leveraged Direxion Daily FTSE China Bear 3X ETF (YANG), which are at record lows.