Chinese shares and the mandate of heaven

The arrest of Politburo member and the princeling Chongking Party boss Bo Xilai is a testament to a power struggle at the pinnacle of the world’s last surviving Marxist-Leninist superpower.

This is the last thing China needed as the President Hu Jintao and Premier Wen Jiabao era comes to an end. Chinese GDP growth has slowed down to eight per cent. China’s PMI has been on a downward spiral since November and Wall Street now clearly prices in a “hard landing”, the reason the People’s Bank of China (PBOC) has abandoned its anti-inflation tight money policies. China’s worst bear market since 2004-05 could well be in its last innings, to use a baseball metaphor that might well be apt for the performance of the Shanghai Composite Index.

Despite the slight uptick since October 2007, Chinese shares still trade at 64 per cent below their historic highs and at nine times forward valuation at a time when the PBOC is poised to further slash bank reserve ratios in a bid to stimulate the economy.

I am as bullish on Chinese shares as I am bearish on Indian and Brazil shares. Will China turn from ugly duckling to emerging market fairy tale princess overnight? No. Yet I doubt if there is more than 10-15 per cent downside in the Shanghai Comp from current levels while the upside could be as high as 30-35 per cent.

This means it is all too possible to make money by selling at the money put options on the Footsie Xinhua Index.

The trade is still vulnerable to a global risk aversion mood swing or more evidence of Chinese political/ financial risk.

The Chinese economy is extremely sensitive to bank lending and government investments. I believe the Politburo and State Council will do their best to revive the economy and the stock markets until the Party Congress in September anoints the new leadership duo of Vice-President Xi Jinping.

In any case, bank lending and industrial production have both surged since the PBOC rate cut. The boom-bust cycle in Chinese equities is almost perfectly correlated with shifts in PBOC monetary policy and bank lending quotas.

This is the message of Premier Wen’s promise to “fine tune” the economy in the twilight of his decade in power as a reformist successor of Deng Xiaoping.

So I expect the Chinese bank RRR to fall by at least three or four percent in the next six months. China is cheap and unloved. The Middle Kingdom, the world’s ultimate emerging market, trades at the lowest valuation since Zhu Rhongji’s sledgehammer gutted the banking system in the 1990s. The risk-return calculus, in my opinion, favours Chinese banks. The mandate of heaven smiles on ICBC, CCB and China CITIC.

I agree with Mark Mobius that there is no real risk of a hard landing in China. However, it is all too possible that GDP growth will fall to seven per cent as Chinese exports to the EU fall.

This means the central bank will do its best to be proactive and ease monetary policy. Chinese banks offer some of the cheapest bank valuations in Asia.

A sustainable rally on Shanghai necessiates a bottom in the Big Four Chinese banks.