China: Despite Present Bubble, Financial Markets Remain Bullish over the Long Term

``The rise of China -- and of Asia -- will, over the next decades, bring about a substantial reordering of the international system. The center of gravity of world affairs is shifting from the Atlantic, where it was lodged for the past three centuries, to the Pacific. The most rapidly developing countries are in Asia, with a growing means to vindicate their perception of the national interest.”-Henry Kissinger, a former secretary of state, chairman of Kissinger Associates

LAST week we pointed out that aside from the overbought conditions seen in the US markets, which has been providing the leadership for global equities, one potential trigger for a correction was the continued spike in US Treasury yields.

A spike in yields could be interpreted as “tightening” of liquidity in the financial marketplace, which again does not bode well for the equities in general.

However, this comes in the face of persistent chitchat by domestic mainstream analysts of China’s market bubble as having a major influence on Asian markets, including that of the Phisix.

As we have argued last week or even in late February where the first “Shanghai Surprise” transpired, we believe that China’s market has manifested little signs of interdependence with Asian markets due to major fundamental reasons such as having a closed capital account, heavily regulated financial markets and extremely limited exposures by foreign investors as well as domestic investors.

Figure 1: stockcharts.com: Phisix-China: What correlation?

We noted that even as China’s markets fell apart, investors of the Phisix and most Asian markets went into a buying spree last week. And in contrast, this week as the tremors in the US markets were equally felt elsewhere, China’s markets took steps to recover from the recent shakeout, as shown in Figure 1.

The blue arrow tells us that Emerging markets (upper window), Asian markets ex-Japan (lower window) and the Phisix (center window) simultaneously in a corrective downdraft even as China’s Shanghai market appear to have convalesced. From which we ask: How germane the correlation of China’s Shanghai index and the Phisix?

Said differently, while we saw China as having initially been used as “scapegoat” for the much needed “profit-taking” from the overheated markets at the end of February (have we not been saying so as early as last quarter of 2006?), the global equity markets today appear to have discounted the relevance of Shanghai’s activities. So aside from fundamental reasons we initially broached, we can now see a stark price disconnect. Again, it seems that our views have once again been validated.

Yet local mainstream analysts find causality in presumed patterns that has never happened or has misinterpreted “coincidental” events as having cause and effect links. In behavioral finance/economics such is part of the “Cognitive bias” (human perception of reality) which is in particular is called as the Clustering Illusion or “seeing patterns where none existed”.

Yes, we think that China’s market today has exhibited signs of extreme froth or “bubble-like” conditions and envisages the risks of either having pronounced gyrations or of an implosion anytime. Yet, there is also a big chance that it could even go higher before its reckoning period, as discussed last week.

However over the long term (10+ years), we infer that since China has been cognizant of the importance of fostering a market-based economy for the nation’s wealth creation, it has acted gradually by rehabilitating its financial markets (enactment of property laws, expanding into more complex or sophisticated markets as the financial futures and gold market, has expanded supplies by amending the “non tradable shares”, gradual opening of its capital markets through the QDII and QFII programs) to reflect on allocation by price efficiency.

And those incremental steps to deregulate and adopt new market mechanisms are likely to provide a floor to any interim volatility. In other words, as China’s economy grows, the contribution of its financial markets in providing and intermediating capital becomes an imperative, as it veers away from its traditional form of financing, i.e. through banks, hence all these cumulative steps to amend the present system. These should support China’s asset prices over the long term.

Likewise we believe that as China’s markets opens, deepens and matures the likelihood is that our Phisix over the long term will increasingly cultivate deeper interrelations with them as well as with other major Asian financial markets (Singapore, Japan and Hong Kong).

This should be a lesson for us, since financing requires market based valuations and liquidity in channeling savings into investments. Finance without adequately functioning markets leads to the same inefficiencies of the past.