Merrill Lynch - Increasing the overweight in China

[BlueDaze]

This strategy report was compiled by Mark Matthews, a strategist at Merrill Lynch - please note that this entry is extremely lengthy.

Increasing the overweight in China

We increase our overweight in China. As a closed market, it is insulated from global volatility more than open markets. Inflation is an issue but manageable. Meanwhile earnings are beating expectations and valuations in H-shares are not unreasonable. We believe that China will outperform over any time frame beyond the very short term, which we can't call.

Hong Kong: From neutral to overweight

This is Hong Kong’s time to shine. It has five solid themes:

1. strong corporate balance sheets,
2. increased liquidity from China,
3. asset reflation,
4. solid economic growth,
5. upward earnings revisions.

Rising borrowing costs have limited impact on Hong Kong companies. We are bullish big property developers.

Pakistan: Politics improving

Events are unfolding to plan. Benazir Bhutto says she plans to come back some time between September and year-end. It is increasingly likely President Muharraf will forgo his uniform in order to secure a second term. Were this to happen, his power with the army will remain strong, while a free press will keep a vigilant eye on the politicians. The cheapest market in Asia, and our favorite.

Chemical stocks: A perfect place amidst the market turmoil

A US economic slowdown will have almost no impact on chemicals. Demand from the US is mature, and demand growth in the US is driven by the Chinese economy anyway. Petrochemical share prices typically peak 9-12 months ahead of the peak in chemicals, which could be in 3Q08. Also, seasonal drivers have led to margin expansions over the past 4-5 weeks.

Calm continueth not long without a storm

… So spake the 16th Century parable.

Asian markets are not calm yet, but calmer. The key watch-points are:

1. China did not waver, and A-shares broke to new record-highs.
2. Hong Kong’s Hang Seng shook, but rapidly recovered and also broke to new highs on Monday. Australia is back within 4% of its all-time highs.
3. Singapore’s Straits Times which fell 14% is now down 8%, but the small cap SESDAQ index which fell 33% is still down 26%. It either means the index is too high, or small caps are too low.
4. Across rest of region, all other markets have staged recoveries.

It's all about risk appetite.

Either the recent recover is month-end window dressing, or (more likely), most of the redemptions have been initiated, and managers have discovered that investor desire to cash out is not as much as feared. That makes them slowly comfortable to redeploy, which means taking risks to generate returns.

You can sense that Asian stock markets “want” to go up – the domestic money that was just starting to take it into Phase Two of the great bull market is back.

In Korea for example, following the government’s efforts to foster a more developed investment management industry, there is an accelerated appetite from households to diversify assists and increase equity exposure. Although equity inflows have been growing around 100% for the past four years, currently just 4% of total household assets are in equities, and 78% in property. As compared to OECD countries, where the equities are 33% of household assets.

The Yen weakening again also helps, and Asian currencies offer the yield-hungry a pick-up. AFP wrote on August 27:

"Japan’s rock-bottom interest rates provide cheap credit but little incentive for savers to stash cash in a bank account, so more and more ordinary Japanese have been turning to currency trading to boost their savings. Japan’s wave of post-war baby boomers are also increasingly looking overseas for better returns on their savings, piling into “uridashi” foreign bonds.

Interest rates stand at 8.25% in New Zealand, 6.5% in Australia, 5.25% in the US and Britain and 4% in the eurozone — while the Bank of Japan last week left its key rate at just 0.5%. So the metaphorical Mrs Watanabe may be down, but she is unlikely to be putting all her money into a Japanese bank account just yet."

Now for the bad news

That’s the good news, and we think on the back of it, that September should stage a recovery of sorts for Asian stock markets.

There is however bad news. And that is, simply put, that there’s going to be more bad news.

The US credit market is where this sell-off started, and where Asian stock markets still look to for leadership. To recall the default rate in junk bonds at 1.5% is an historic low, down from 12% in 2002. Rising defaults rates will not make for pleasant headlines.

Merrill Lynch’s credit research department thinks at least 100bp off the Fed Funds rate is needed to re-activate the sub-prime mortgage market. Otherwise, investors will continue to prefer high-grade credits, of which there are many attractive ones to choose from.

Banks may also have other things to worry about than their holdings -- voluntary or involuntary -- of asset-backed commercial paper. Other things to think about might include negative equity home mortgages, or negative equity residential developments.

As is usually the case with unwinds, just when you think the bad news has been digested, more comes out. The Structured Investment Vehicles (SIV) are the latest case in point. They borrowed bonds, leveraged by buying commercial paper, and were sold to investors. Now they are being unwound, and liquidity is also being unwound. Here in Asia none have been reported so far. But DBS recently disclosed an additional SGD1.1bn in off balance sheet CDO exposure
via an asset backed commercial paper conduit.

And companies that do not appear immediately correlated to what is happening may slowly start to show that they in fact are. Already on Wednesday, Merrill Lynch Asian airlines analyst Paul Dewberry downgraded his rating on Cathay Pacific from buy to sell, in part because financial market volatility is bad for business class.

Hence no crisis per se, and no direct impact on most Asian economies as the credit market will be open to them. But enough concerns over credit markets and the financial industry, that we believe Asian stock markets will take another leg down at some point this year, as the risk appetite declines again.

Our own best guess is that October is when that leg down happens, and November is the bottom.

Next year should be good, but Phase Two of this bull market, led by Asian investors themselves, probably won't be until 2009.

Why 2008 should be good

We have written in the past that the performance of Asian stocks so far this decade is reminiscent of the performance of US small cap stocks in the 1970s. The S&P and the Dow peaked in 1972, and did not touch those levels again until 1980 and 1982 respectively.

If you were to just look at those two indices, you would think the 1970s were a lost decade for stocks. But it was a great time to be a fund manager if you were in small caps.

The reason small caps outperformed large caps was simply because the former had better growth. Today, with Reuters and Bloomberg, the Internet and email, information on Asian markets is much more available than in the telex days of the 1970s. And they are accessible now too, through managed investment funds, ETFs and GDRs. They are in a sense, what small caps were then.

The important thing for the small caps in the 1970s is that large caps remained horizontal. Had they fallen a lot, it would have been difficult for any stocks to rise. Had they risen a lot, it would have taken the wind out of the sails of the smaller stocks. The best case scenario for the small caps was a range-bound nifty fifty.

So too today, the best case scenario for Asia is a range-bound US stock market.

Now remember how bad the late 1970s were. Growth was the slowest that decade since the 1930s. Herb Stein was admonished for saying “recession”, so he used the word “banana” instead. Inflation which had been running at 2.5% throughout the century was 6% at the start of the decade and ended it at 13.3%. Interest rates were double-digit.

We live in uncertain times today, as our ancestors have done throughout humanity. Things were bad in the 1970s, yet the major indices just went sideways. If they do that this time, that is the best environment for Asia. As it stands now, Merrill Lynch Chief Investment Strategist Richard Bernstein’s target for the S&P is 1,560, while the index is currently at 1,463.

Between now and November

In this current uncertain environment, investors in Asian stock markets may come to rely a little less on valuations – PEs are only useful if we know where earnings and margins are in the cycle, which increasingly we will find we do not, given the uncertainties.

Behaviorism, a fascinating area of study in the way it relates to financial markets, is an influence when markets rise as well as when they fall. It may manifest itself more now on the downside in places deemed vulnerable.

Daniel Kahneman's pioneering work in this area shows that while economists assume investors are generally rational, in fact we are not.

We use shortcuts when making decisions, for example by doing what our friends do, or what we think other people are doing.

Vivid evidence also gets more proportional weight. When the market is rising, good news gets more airtime – witness China today. When it’s falling, bad news gets more airtime – witness the rest of the world.

Between now and the bottom, sector-wise, a good place to be is petrochemicals. That’s because a credit squeeze will curb competition in the short-term, while demand (India/China) is solid in the long-term. If the oil price falls as the US consumes less, that is also good for them. The US consumes 26mn bpd, while China and India are around 3mn and 7mn respectively.

Country-wise, what we can't see stopping is China, and that's where we'd be positioned now – through H-shares, which are the Chinese stocks listed in Hong Kong, which foreign investors can buy. That makes them more vulnerable to swings in the global stock markets, but over the longer term, their large discount to A-shares should be the primary determinant of their performance.

There is an obvious benefit to China being closed, when global markets are being shook up. As we wrote in the August 16 report Global Market Turmoil an the Outlook for Asia, the stock markets of Taiwan and Korea were unfazed by Black Monday – October 19 1987 – and ended that year up 125% and 93%. But the stock markets of Hong Kong and Singapore ended the year down 10% and 13%.

The economies of all four countries were registering equally impressive economic growth in 1987, in the 10-13% range. The only reason the first two stock markets kept rising after October 19, while the second two collapsed, is because the first two were closed markets to foreign investors at that time, whereas the second two were open.

Today, the big Asian stock market that is effectively closed to foreign investment is China. As was the case in Taiwan and Korea back then, foreign money can't get into A-shares other than in a severely limited fashion, and likewise domestic money can't freely flow out either. The currency is not fully convertible the exchange rate system is basically fixed.

As such, it is pure domestic asset inflation that moves the market. Its insulation – with foreigners owning less than 2% of stocks there – has allowed it to go on to make record-highs since the credit market scare began.

Even when volatility in global markets subsides and Asian stock markets bottom, we will still prefer China to its Asian stock market peers on a relative basis. That’s because when market bottom, growth should resume its out performance over value, as credit is made available again, and China has the growth. Simply put, when China is growing at 9-10% for the foreseeable future, Korea and Taiwan at 4-5%, and the US at 1-2% -- where will most people think to put their money?

The risks in China

We like China because we view the country as being at the beginning of a multi- generational expansion in household incomes similar to what happened in the US over the past fifty years.

As we wrote in our June 14 report China’s Golden Age, in 1950 US per capita GDP was USD17,000 in today’s dollars, and has since risen to USD43,500. China’s urban affluent today earn a per capita income of USD12,500 per year.

Yet when we speak with fund managers, we hear intelligent people who are wary of China. Shoddy products, underwriting Darfur, an "out-of-control" securities markets, rising inflation at the macro level – these are common observations.

Even those who like it say it's a good story, but it has outperformed everything else, and just can't keep on doing that.

The risks in China are that:

1. Inflation is rising,
2. Valuations are very expensive,
3. Companies may fail to deliver in earnings,
4. “Made in China” appears to be under attack.

Inflation is an issue, but not enough to de-rail the economy

July CPI at 5.6% YoY was the highest in a decade, and in excess of consensus, which was probably slightly above 5%. But Merrill Lynch economists had forecast 5.5%, and in doing so argued that such a number would not necessarily cause an acceleration in the authorities’ tightening program.

That is to say, we do expect two more rate hikes this year, but do not believe that the tightening agenda will be brought forward by these recent inflation numbers. The non-food price component was up only 0.9% YoY. Nevertheless, as Merrill Lynch economist Ting Lu wrote on August 27, concerns are picking up, and are likely to dominate macro policies through year-end. Yes there is inflation and while worth watching, it’s not going to de-rail the economy.

Valuations are high, but not as high as the consensus thinks

Admittedly A-shares on 50x are expensive. While in most Western countries, people can buy bonds, or stocks outside their own country, in China citizens can’t really invest in anything beyond domestic property and stocks.

Higher value-added money market products don't exist because there is no corporate bond market, and with what’s happened in the US recently it is likely the attitude from Chinese authorities will be to say “look at what happens with a complicated financial system”.

In the absence of more alternatives, it’s Taiwan all over again. To recall, twenty years ago Taiwan made the things for the rest of the world that China does today. Its export earnings were so large it had the second-highest foreign reserves in the world (after Japan) by 1989. The stock market rose 12.5x between 1985 and 1990. At its peak it was on 100x.

Of course we are not advocating investors buy shares on 50x, in the hope that massive unsterilized liquidity will take them to 100x. But not all of China is expensive.

Look at Petrochina on 12x, or Sinopec 9.5x, CNOOC is 13x. These are big index stocks, and they are not expensive, in our view. H-shares are also not expensive, and the gap between them and A-shares should narrow as Chinese citizens are allowed to buy stocks in Hong Kong.

China will deliver the goods, and then some

We can use Southeast Asia in the early 1990s as an example of where expectations were failed by reality. The author lived in Thailand in the 1990s, and witnessed the bull market (1992-1993), bear market (1994-1996), and ultimately the crisis (1997-1998). Going through some old boxes of books recently, he found a magazine titled Thailand Business Digest, dated January 1994. The tone of the magazine is optimistic. An article “Bullish on stocks for ‘94” writes:

"The bullish trading in the local stock exchange, driven by a downtrend in interest rates. Relatively moderate inflationary levels, and high liquidity, is likely to buoy local stocks, said local fund manager."

Another article titled “Thailand poised for new upturn” writes:

"Thailand’s economy will grow 8.2 percent next year said the National Economic and Social Development Boar (NESDB). Although the Bank of Thailand’s prediction is more conservative. the general consensus is still that there’s no other way for the country but be bullish."

Yet January 1994 was the month the SET index peaked, at 1,753. Adjusted for the depreciation in the currency, the stock market is still 65% lower now than it was then.

Thailand was not a cheap market in January 1994, on 26.7x PE. But it was still a lot less than the 50x that China purportedly trades on today.

The problem in Thailand was simply that peoples’ expectations overshot reality. There was a lot of hype associated with the bull market, which ultimately was not delivered on.

While there is hype in China today, it would be wrong to say that expectations are not being met. If anything they are being exceeded. Take for example 1H in the A-share market. At the end of last year, the consensus was looking for 35% EPS growth for 2007, and 16.5% for 2008. Now it expects 57.4% for 2007, and 22.1% for 2008.

But Merrill Lynch China strategist Andy Zhao notes that net profits for the 1,298 A-share companies that have comparable 1H06 data rose 75.3% YoY in 1H07. Although non-operating profits (including investment income) rose 230% YoY, they accounted for just 10ppt of the growth. So core earnings are in the order of 65%.

Hence we can say with a fair degree of certainty that the 50x PE, as frequently asserted by the media and quote vendor systems, is incorrect. Annualizing 1H EPS, the PE would be 39.8x.

The quality issue

A last issue in execution can be broadly termed “quality”, be it management, the way it treats the environment, and the products it makes.

Most companies in China are state-owned, and not up to international standards in terms of corporate governance. There is a strong desire to change that on the part of the government, and listing the SOEs is one way it hopes to do so. But we will not say that management is a strong point in China.

The New York Times wrote in an August 26 article As China Roars, Pollution Reaches Deadly Extremes:

"No country in history has emerged as a major industrial power without creating a legacy of environmental damage that can take decades and big dollops of public wealth to undo. But just as the speed and scale of China's rise as an economic power have no clear parallel in history, so its pollution problem has shattered all precedents.

Environmental degradation is now so severe, with such stark domestic and international
repercussions, that pollution poses not only a major long-term burden on the Chinese public but also an acute political challenge to the ruling Communist Party. And it is not clear that China can rein in its own economic juggernaut."

This article is just one of hundreds which have been written criticizing Chinese industrial production. Which is no bad thing. Upton Sinclair's "The Jungle" exposed the wretched conditions of Chicago slaughterhouses at the turn of the last century, and moved President Roosevelt to push through the Food and Drug Act. The muckraking of similar problems in China will boost quality of Chinese products, and reduce environmental degradation.

Stocks we like in China

We believe that China will outperform over any time frame beyond the very short term, which we can't call. A basket of Chinese stocks that we like would include:

* China Construction Bank (939 HK).
* Sinopec (386 HK).
* GOME (493 HK).

Hong Kong’s time to shine

In each negative is hidden a positive. In our August 24 report Credit crunch...sorry we have cash, we detailed why the current environment is one that benefits Hong Kong. It has been underwritten by the two most powerful forces in the business world:

1. The Fed, as Hong Kong's dollar is tied to the USD,
2. The Chinese government, which will increasingly allow its citizens to buy stocks in Hong Kong

Four times over the past fifteen years, HSBC’s dividend yield touched 5%. In each ensuing period, the Hang Seng index rallied 32-64%. At 4.7% today, HSBC’s dividend yield is almost there again. To be sure, the bank’s weighting is down from 27% in 1992 to 17% today, and will be 15% after full free-float adjustment on September 7. Nevertheless, we believe it a useful indicator.

Hong Kong’s five forceful features

While Merrill Lynch’s global team forecasts a lengthy period of leverage unwind in the US leverage, Hong Kong’s shines on five counts:

1. A virtuous combination of USD weakness, rising local inflation, and potential interest rates cuts spells Hong Kong asset reflation.
2. More liquidity from China.
3. Strong Chinese economic growth.
4. Cash-rich domestic balance sheets,
5. Earnings growth prone to upward revisions.

Big balance sheets withstand credit tightening

It is very logical to infer from the freeze in the credit markets that borrowing costs in general will rise, and Asian bond spreads in aggregate have increased 86 bps since June 7.

But the average spread in Hutchison bonds, a Hong Kong bellwether, has only widened 63 bps over the same period. The impact of credit widening for Hong Kong Inc. is less pronounced, because Hong Kong companies have traditionally preferred to raise capital via equity as opposed to debt. Last year, Hong Kong companies raised USD64bn on the equity market, but just USD8.3bn in debt securities. Year-to-date, Hong Kong companies have raised USD29bn on the equity market, and USD5bn through debt securities.

Most Hong Kong companies can access capitals from banks if necessary. Hong Kong banks have a lot of it - total deposits in the banking system are at a record high of USD683bn, and loan growth remains sluggish. The loan-to-deposit ratio around 0.5x is at record lows. As the chart below-right shows, free cash flow for Hong Kong companies has reached a record high, while the net debt-equity ratio will reach 11.4% next year, a low for the decade.

Liquidity from China

The Chinese government is making use of several channels to divert excessive liquidity from its A-shares, the largest and most obvious one being Hong Kong. Recently a pilot program was announced which allows Chinese retail investors to invest in Hong Kong’s stock market directly, through personal accounts at Bank of China’s Tianjin branch and BOCI Securities. Unlike QDII, there is no quota limit.

It is most likely this program, once demonstrated successful, will expand to other Chinese cities. While Merrill Lynch’s China head of research David Cui believes the impact on Hong Kong more psychological for the time being, this new policy should eventually add millions of new retail investors to the Hong Kong stock market. David Cui identified four ways to benefit from this new policy in his August 20 report Millions of mainland investors coming to HK.

Bullish big property developers, bearish office sector

The USD has dropped around 30% from the peak in Feb 2002, and in an August 17 report, Merrill Lynch’s global currency strategy team gave three reasons why they believe it will remain on a downward trend:

1. Appetite for USD-denominated risky credit will be less than before,
2. US growth is lower than that of other regions and,
3. America needs capital inflows to balance its current account deficit, but in the absence of these flows, a weaker dollar is another means to adjust the balance.

Rising inflation in Hong Kong and China, USD weakness, potential lower US interest rates and rising household income are positive for the Hong Kong property sector. Hong Kong’s property index has underperformed Singapore’s (in USD terms) since 2005, but this trend has started to change.

What we don't like is office space. Keith Yeung, Merrill Lynch property analyst, expects Hong Kong’s office sector to enter into a two to three year down-cycle, starting in the middle of next year.

Keith Yeung’s premise, as he wrote in his August 21 report See You in Kowloon, is that the peninsula’s massive ICC office tower will become an alternative location for investment banks, giving investment banks and fund managers bargaining power to reduce high rental rates in Central. We expect Central office rentals to drop 15% in 2008, and a further 10% in 2009.

Stocks we like

Hong Kong’s equities yield is still higher than the domestic bond yield. The earnings yield gap is also above its ten year average. Trading at 16.3x 07 PE and expecting 17.7% and 3.2% earnings growth for 2007 and 2008, the market is not expensive on a historical basis.

Based on our five forceful features, our most preferred Hong Kong stocks are Henderson Land, Sun Hung Kai, Hang Seng Bank, Citic Int’l Financial, Hopewell, Li & Fung, Li Ning and Pacific Basin Shipping. Least preferred are Hong Kong Land, Hysan, China Gas, COSCO Pacific, Foxconn and Johnson Electric.

Overweight China and Hong Kong

Given our more positive stance on China and Hong Kong, we increase our overweight in China from 14% to 24.5%, and change Hong Kong from a market weight to an overweight, or from 9% to 14%.

North Asia is generally seen as being closest to the US not only geographically but in terms of direct economic exposure. Korea has done very well, and is now no longer at as much of a discount to the region as it was at the beginning of the year. We move to underweight, or from 17.8% to 8%.

We also move Taiwan to a further underweight from 10.5% to 5%. Investors like it because it’s cheap and defensive, but how can you dislike the US and like Taiwan? The TWSE is up 10% year-to-date, a lesson that value without a catalyst can be a trap. Investors looking for value would do better in Pakistan, which is the best value in Asia.

Pakistan: Politics improving

Readers may find our interest in Pakistan repetitive – we think you are about to see a big bull market there, so we wish to remind investors of our commitment to it. It is also strangely somewhat of a hiding place, with the lowest correlation to the S&P of any Asian stock market. After having risen 42% intra-year, Pakistan is now up 22%, and bouncing off its 200-day moving average.

The politics deserve to be addressed; as it is an unfortunate reality that General Pervez Musharraf's power and control are being diluted as the two former prime mininsters look to come back.

Two days ago, former Prime Minister and Chairperson of the Pakistan People’s Party Benazir Bhutto disclosed while speaking to a television channel that she plans to return to Pakistan between September to December, and that Musharraf had agreed to step down as army chief before the upcoming presidential election. This was seconded by the MQM Party, a Musharraf ally. Benazir also claimed 80% of the issues between the two have been settled.

This is a positive, as this ends the deadlock on the political front. Uncertainty on how this deadlock would end had been haunting the market for the last month.

The other former Prime Minister, Nawaz Sharif (1990-1993, 1997-1999) could be arrested as soon as he landed if he came back now, as he has made no deal with Musharraf as Benazir has done. His relationship with Musharraf is likely more acrimonious as it was his administration that was toppled when Musharraf came in.

Sharif left Pakistan in 2000 under a deal brokered by Arab countries, which are now trying to stop him from going back. He is not really a force, but there is a lot of hype associated with his potential return, and some of the ministers of the incumbent PML-Q party are said to have been talking to him, which is not surprising as their power stands to be diluted if Benazir comes back. A mass defection to his PML-N party would be bad, but also very unlikely.

An issue remains of what policy will be like with Benazir as Prime Minister. This is crucial, as when she was last Prime Minister, from 1988 to 1990, and from 1993 to 1996, the big issue was corruption through her husband. And Pakistan’s open market policies under Musharraf (it is the only country in Asia where foreigners can own 100% of any asset in any sector) are what have made it the third-fastest growing economy in Asia after China and India. Foreign direct investment into Pakistan, from banks to telecoms, tobacco to dairy, has been huge.

But Benazir has voiced no disapproval of the free market economic policies, and it is hard to believe she would want to go out of her way to fix something that isn’t broken. Also, a big difference between her previous terms as Prime Minister and now, is that the media is free.

It boomed after Musharraf became president, when between 2000 and 2001 he issued many private television channel licenses. Even those which were being aired from Dubai to remain unbiased or avoid government pressure have gradually shifted to Pakistan. Now fifteen channels actively report on politics and the economy. There would be a severe backlash if Benazir tried to shut any of these private channels down. Even Musharraf himself tried to curb them, but couldn't.

As for the army, the vice chief of staff Ahsan Saleem Hayat operationally commands it. His term expires in October, and a new crop of generals will be coming in, who are junior to Musharraf in age by about 7 to 10 years, and like him for his moderate views. Indeed he has been able to extract extremists from influential positions, and made sure the people coming up are good.

That's a negative in the short-term, because he's been holding everything together. But from long-term perspective, what's important is that the transition to democracy is smooth. There are too many powerful backers of Benazir in the West for this not to happen eventually, even if for the economy the status quo is far preferable.

Ms. Nasim Zehra, a fellow of Harvard University Asia Center, Adjunct professor at SAIS Johns Hopkins University, and an expert on Pakistan politics, wrote recently in the Khallej Times:

"Washington's current high profile 'engagement field' is Pakistan. The US lame duck administration is deeply engaged in guiding the present Pakistani regime in how to tailor Pakistan's future political and security framework."

Generally we agree with the tone of this article. Precedents can be found in the Philippines and Chile. When Aquino, under US backing, became president of the Philippines in 1986, it was under US pressure, but Marcos did not leave willingly, the economy was in a shambles with negative growth, and remained moribund until Fidel Ramos came in six years later.

On the other hand in Chile, General Pinochet recognized it was his time to go after a plebiscite rejected him in 1988, and while he handed over the reigns to politicians in 1990, his army kept a watchful eye on things. He told Dan Quayle such was necessary as “Chile is a violent country”. Reform was even deepened under the politicians, and economy went on to grow in the 8% range during the 1990s.

We see the Chilean precedent as being the more likely course of events for Pakistan.

Meanwhile, its stock market is on 10.5x for 12.5% growth this year and next, and a 5.1% and 5.6% dividend yield.

US demand for commodity chemicals

Merrill Lynch chemicals analyst Sonia Song wrote in her On August 28 report Why buy chemicals now? that a slowdown in the US has almost no impact on chemicals globally, for three reasons:

1. Demand for commodity chemicals from the US is mature, and has a low correlation with GDP fluctuations,
2. The US is an exporter of commodity chemicals, and its overall demand growth in recent years has in fact been driven by the rapid growth of Chinese economy. US demand for the five major commodity chemicals – PE, PP, PS, PVC and PTA – was flat at 34-35mn tons over 1999-2003, then rose to 37-38mn tons in 2004, when China started to grow at a breakneck pace.

Interest rate increase is net positive

Asian petrochemical companies will benefit from a tighter credit environment, especially those that do not have project commitments. That’s because:

1. Higher rates push up capital costs of new projects and so could further delay supply growth,
2. For companies under our coverage, interest rate risk to earnings has been reduced as a result of massive de-leveraging, a higher portion of fixed-rate debts, and discipline in large-scale investment projects.

Of the 11 Asian petrochemical companies we cover, two are debt-free (Honam and LGPC), and nine have net debt-to-equity ratios of 8-60%, with fixed-rate debts making up 60-70% of total. Based on our sensitivity analysis, a 1ppt increase in interest rate should lower our 2008 net profit forecasts for Asian petrochemical companies by 0.4%.

2008E peak utilization cut to 93%

Merrill Lynch’s Global Economics team has lowered its 2008 US GDP forecast from 2.3% to 1.8%, and global GDP was lowered as a result from 5.0% to 4.8%. Reflecting these new forecasts in projections for demand while keeping supply expectations intact, we lower our global petrochemicals utilization rate forecast for next year from 93.3% to 93.0%. That’s still higher than the 92.1% we expect this year, and almost matching the previous peak of 92.9% in 2004.

A modest decline to 91.4% is anticipated in 2009, and to 89.6% in 2010. On the supply side, Iran’s new projects are unlikely to materialize, and a significant portion of other Middle Eastern petrochemical projects may be delayed due to rising capital costs, lack of skilled E&C labor, and feedstock shortages.

Why buy now?

Share prices of petrochemical companies typically reach their peak 9-12 months ahead of the sector’s cyclical peak. Based on our global utilization estimates, we believe 3Q08 should be the peak of this extended cycle, thus suggesting share prices should peak by end-2007 or early 2008. In light of this, the recent equity market correction offers an attractive investment opportunity.

Additionally, petrochemical margins have risen sharply in the past 4-5 weeks, recovering 1Q strength. We believe the upward momentum will continue until February next year, driven by the following five factors:

1. No new supply addition in 2H07-1H08 – Iran’s failure to commission #9 and #10 crackers by end-2007,
2. Further supply loss due to a high rate of maintenance shutdown until October,
3. Entering peak demand season, which is August to early November,
4. Inventory drawdown in April-May,
5. Naphtha feedstock cost decline on increasing exports from India.

Sonia Song’s top picks are Honam and LG Petrochemical in Korea, which have net cash positions and no investment commitments. She also likes Formosa Petrochemical in Taiwan for its timely capacity expansion in 2Q, and PTT Chemical in Thailand in expectation of a 2H earnings recovery after a near three-month shutdown in 1H.

Ebbs and Flows

The market is still focus on possible lower US interest rates and investors increased their favour to Asia this week. The MSCI Asia Pac ex Japan index gained +3.4% this week outperformed the MSCI World index by +2.8%pts.

The MSCI China index is still the best performing market in the region this week, supported by strong corporate earnings. China Life reported stellar 1H07 net profit growth of 160% to Rmb 23bn. Bank of China HK’s core earnings also up by 30%YoY in 1H07. The bank had HK$12.8bn worth of US sub-prime ABS (all AAA rated) in its books at the end of June.

Hong Kong’s market turnover is impressive. The market is very optimistic after the Chinese government announced it would allow individual investors in Tianjin to invest in Hong Kong’s stock market although the authorization is still pending.

In Taiwan, Acer announced to acquire US-based Gateway with cash of US$710mn. Chung Hwa Telecom announced 250mn shares buyback for next 2 months and the company plans to better utilize its idle properties starting next year.

In Singapore, the government proposed increasing oversight for sales of existing apartment blocks. Public tenders will be required for all collective or en-bloc sales, where apartment owners jointly sell all of their building’s units. DBS finally admitted they had addition S$1.4bn CDO exposure.

The amount of foreign net selling has decreased this week. Total foreign net selling across Asia’s emerging markets slowed to -USD908mn this week vs –US5804mn last week.

Foreign net outflows in Taiwan slowed down to -USD109mn, markedly down from -USD844mn previously.

India attracted large foreign net buying this week – foreigners were net buyers to the tune of USD236mn vs –USD1,708mn net selling last week.

Thailand also had USD82mn net buying vs -USD359mn net selling last week.

Korea - Underweight. Better times are ahead as the economy recovers, politics improve and local funds return to the market after a year of solid selling.

Rotation into energy names is likely to be the new theme in Pakistan. Credit growth in the banks still robust at 18%-20% and market is both cheap with high yield. Overweight.

Positive policy changes and corporate restructuring are now taking place in Malaysia, while the MYR is amongst the most under-valued regional currency. Overweight.

Mining in the Philippines could be the next fillip for the Filipino economy. Overweight.

China is an Overweight while Vietnam is 0% on valuation grounds. We believe the Chinese market can move higher due to strong liquidity and see parallels with Taiwan in the late 1980s.

India is an Underweight. Market multiple is under pressure as cost pressures begin to bite.

[BlueDaze]

Chinese PER & Earnings Growth
Posted by Salvatore_Dali

"At the end of August, 852 Shanghai-listed companies and 487 Shenzhen-listed firms reported their earnings for the first half of this year. The aggregate net profit of the Shanghai companies was 290.3 billion yuan (US$38 billion), up 69.2 percent year on year, while their aggregate income was 2.69 trillion yuan, up 24.9 percent. Shenzhen-listed firms reported a combined 99.23 percent increase in aggregate net profits at 47.52 billion yuan, while aggregate income was up 28 percent at 754.52 billion yuan.

Blue-chip companies reported the best performance, with their aggregate net profits accounting for 77.4 percent of the total in Shanghai. The aggregate net profit of the top 30 Shenzhen firms jumped 77.23 percent to 27.47 billion yuan, 57.8 percent of the total for all listed firms. Companies in the financial, non-ferrous metals, excavation and real estate sectors performed well. Seventeen Shanghai-listed companies in the financial sector enjoyed a combined net profit growth of 74.1 percent.

That's the often uttered fundamental factor in explaining high PERs accorded to China firms. Its the sustainability and quality of growth which are needed to be examined further. Now, a simple analysis would show a disparity in Revenue & Net Profit growth patterns. Herein lies the pandora's box.

Revenue Growth / Net Profit Growth

Shanghai 24.9% / 69.2%
Shenzhen 28% / 99%

You cannot have such disproportionate jumps - but you can I guess, if the employees all agree to have their salaries reduced by 40% every year; or you can manufacture a product 30% cheaper with every progressive year. Some disproportionate jumps can be explained via "extraordinary gains" such as asset sales, disposal of subsidiaries at a profit or even "revaluation gains" of land and buildings - all of which are one-off and non-operating, hence non-important (sic).

The magic elixir is investment income contributed most to profit jumps. The total investment income was 10.4 billion yuan on the Shenzhen exchange, 15.33 percent of the total. I believe the proportion for Shanghai listed firms could even be higher, closer to 25% of total. That may not sound like sizable but this is the actual percentage following a 70%-99% jump in base value. In other words, the investment income in 2007 as a % of 2006 total net profit should be in the region of 35%-45%!!!

Sure, the operating performance is still solid after you strip out investment income from their net profits, but it goes a long way to challenge the sustainability of earnings growth and the quality as well. Investment income is NOT recurring income, it could be huge losses (really big ones) in one of two financial years ahead though.
To be fair, what we have in China corporate profits is part earnings driven and part investment income driven. When investment income make up a sizable portion of net profits, many silly decisions get made:

a) Over reliance on trading and investments

b) Misallocation of capital towards trading and investment at the expense of funding organic growth, necessary capital investments and R&D expenditure

c) Over-reliance on local investments will cause many to stay domestic, and not consider to go global to expand their reach

d) The exponential domino knock-on effects of a 30%-40% correction will be very severe, and could cause many companies to kill off otherwise healthy businesses

Just a reminder, just a reminder... till then, China bull is alive and well... still. But don't paint the bull up more than what it deserves to be, just a bull, who will die someday."

[rffrydr]

The universal Shanghai bubble call here in the west has, like all universals, proven quite contrary. Nonetheless we ourselves have now proven how the universally despised finally becomes despicable.