Good News for China Stocks

Robert Hsu, March 01, 2008

It's the start of a new month, but the same old problems are plaguing the stock market. Here in the United States, the major indexes remain volatile. I believe we'll continue to see the choppy S&P 500 trade up and down in a narrow 10% range over the next few months.

But there's good news on the horizon for China Strategy investors. Recent developments in the U.S. and Hong Kong suggest that Chinese stocks will break out in the coming months. This month I want to take a look at these positive developments and how they're good for our portfolio.

As a result of these favorable economic events, there are a handful of high-quality Chinese stocks currently trading at attractive valuations. To capitalize on this situation, I have a new buy to add to our portfolio (at a discount!) that should run up as we get closer to the Beijing Olympics. You're probably already familiar with this high-profile company, but I believe that now is the perfect time to get in and ride shares higher.

We'll also talk about two major global economic trends that we need to watch carefully this year. These trends -- sovereign wealth funds and stagflation -- are important because they're rapidly changing the global economic landscape.

As always, I'll tell you my top buys for new money this month. I also have a very special person that I'd like to introduce to you. This skilled professional will help us stay up-to-date on what's happening in China.

So without further ado, let's get started by talking about the current economic picture in the United States and Hong Kong, and why it will help our China Strategy stocks.

Indicators Looking Bright for China Investors

As everyone knows, international stock markets -- and the United States in particular -- have been struggling with fallout from the subprime mortgage mess for months. It has been a tough road for investors around the globe, but here at China Strategy, there are only a few markets that directly affect our portfolio and that we must watch very closely. I'm talking about the U.S. market (where our ADRs trade in New York) and the Hong Kong market (where shares of many of our Chinese companies trade).

Let's examine where these two markets stand after the recent volatility. After climbing 4% in 2007, the S&P 500 Index dropped 6% in January alone, wiping out all of last year's gains and then some. The market in Hong Kong did better. Hong Kong's benchmark Hang Seng Index posted a 37% gain in 2007 and sold off only 16% in January, giving back less than half of last year's gains. Though investors in Hong Kong experienced quite a tumble in early 2008, they still ended up in positive territory with their holdings. This demonstrates that although Asian stock markets can be volatile, in the long run their gains tend to outpace their pullbacks.

If we extend the comparison between the U.S. and Hong Kong further, we can see more dramatic differences in the two economies. One big difference is corporate earnings. Because of poor results from the financial and housing sectors, fourth-quarter earnings for S&P 500 companies have plunged 20% from a year ago. But guidance from Mainland Chinese companies listed in Hong Kong has remained strong. In fact, top analysts are expecting a 20%–25% increase in earnings from these companies in 2008. Although Hong Kong-listed Chinese stocks corrected just like U.S. shares, solid earnings growth and fundamentals in China remain in place.

These differences in stock declines and corporate earnings occurred despite similar actions by the central banks of the U.S. and Hong Kong. The Federal Reserve aggressively cut the federal funds rate by 1.25% in January to help prevent the U.S. economy from slipping into a recession. As a result, the Hong Kong Monetary Authority (the region's de facto central bank) cut interest rates by the same amount. (Keep in mind that the Hong Kong dollar is pegged to the U.S. dollar, so Hong Kong must implement similar monetary policies to keep currency conversions the same.)

But unlike the United States, Hong Kong isn't suffering from a significant economic slowdown. Hong Kong's economy is actually quite hot, with projected growth of at least 5% in 2008 -- which is high by developed economy standards. The rate cuts in Hong Kong make the Chinese city's already-strong economy even hotter. The real interest rate in Hong Kong (which is the interest rate minus the inflation rate) is now about –1.0%. This means that cash sitting in a savings account is actually losing value even as it earns interest. As a result, people need to put their money in investments, not bank accounts, to earn real returns. This search for higher returns is exactly what keeps money flowing into Hong Kong's stock market and economy.

So, as you can see, after looking at these recent economic developments, it's clear that Hong Kong is emerging as a major global financial powerhouse and has what it takes to continue growth into the future -- even as the U.S. suffers from an economic slowdown. Here at China Strategy, this is why we'll continue to invest in Chinese companies that trade on Hong Kong's exchanges and do business across China, like China Mobile (NYSE: CHL), CNOOC (NYSE: CEO) and Yanzhou Coal Mining Co. (NYSE: YZC).

After a 30% market correction in the past three months and aggressive rate cuts from central banks in both the U.S. and Hong Kong, I'm starting to get excited about what's in store for the Chinese market over the next few months. At this point, I believe that one-third of Hong Kong-listed Chinese stocks have already bottomed, another one-third have yet to bottom, and a final third of poor-quality companies are in a long-term downtrend. In the coming weeks here at China Strategy, I'll focus mainly on the third that I believe have already bottomed and are starting to climb again. (One of these bargains is our new buy this month. Click ahead to the article called "Buy This Dominant Leader" for complete details.)

Going forward, Chinese stocks traded in Hong Kong should start outperforming U.S. stocks again, resuming a general pattern that has developed over the past five years. Given China's higher economic growth (projected to be 9.5% in 2008), strong currency (estimated 7%+ gain vs. the U.S. dollar in 2008), and favorable demographic structure (a younger workforce), it makes sense for top-quality Chinese stocks to resume their uptrend.

Speaking of trends, there are two new developments in the global economy that we should pay attention to this year. The first is the emergence of giant investment funds called sovereign wealth funds. Sovereign wealth funds are bailing out major Wall Street firms, helping the entire stock market. The second trend I want to examine is the spread of stagflation from low-growth social welfare European regions to other parts of the world. Stagflation can harm investors and entire economies, so we need to keep an eye on it.

To learn more about sovereign wealth funds and stagflation, please visit my China Strategy website.