China in the Year of the Rabbit

Happy New Year 4708!

According to the Chinese calendar it’s the Year of the Rabbit. The leading Asian brokerage firm CLSA reports the Rabbit will “wrest the reins from the decidedly unpleasant and erratic Tiger that’s been tossing and turning the markets over the past 12 months.” We all could appreciate a respite from extreme volatility.

Chinese New Year is the longest and most important of the traditional Chinese holidays. It is celebrated around the world wherever there are significant Chinese populations. Customs vary widely but traditionally include an outpouring of gift giving, decorating, feasting, forgiveness and wishing for peace and happiness for everyone.

This is the fourth stage in the seasonally strong period for gold, which began back in August with Ramadan.

In the run-up to Chinese New Year, China’s gold imports are estimated to have more than doubled from a year ago, putting the country on track to overtake India as the world’s largest consumer of the precious metal. The growth in demand is being attributed, in part, to Chinese families giving each other gifts of gold instead of traditional red envelopes filled with cash.

Chinese markets are looking for a rebound in the Year of the Rabbit. In 2010, China’s A-shares market was the only Asian market with negative performance, as fears of inflation and an overheating economy cooled markets.

So far in 2011, China has outperformed the MSCI Emerging Markets Index. The Shanghai Composite Index has decreased only 0.28 percent versus the 1.54 percent drop for the MSCI Emerging Markets Index. By comparison, both Brazil (down 6.07 percent) and India (down 13.87 percent) have experienced declines this year, while Russia has jumped almost 9 percent.

Inflation continues to be the biggest threat to the Chinese economy and could be a headwind for the first half of the year. However, we expect the market to improve as the year progresses.

The Chinese government’s response to the threat of inflation is key. If inflation numbers moderate, then the government won’t be forced to hike interest rates or unleash additional tightening measures, which would be viewed positively by capital markets.

China’s economy is expected to grow about 9.5 percent in 2011, according to CLSA. Roughly 5.5 percent of that will come from investment and the rest from consumption.

One of China’s biggest strengths is that liquidity remains robust and that liquidity is likely to find its way into equity markets.

There is also opportunity through the restructuring of China’s economy with the government’s official policy of encouraging consumption. We believe government policies are precursors to change, so having the correct policies in place is the first ingredient of a consumption-based economy. Mix in rising incomes, only a dash of household debt, healthy consumer sentiment, and China has a recipe for robust consumption. CLSA estimates that consumption will account for 42 percent of GDP growth in 2011.

One sector with a strong upside is the information technology sector. First-rate technology is very important if China wants to move up in the manufacturing hierarchy. Low-cost manufacturing has brought China to where it is today, but advanced manufacturing capabilities are required in order for China to rise to the next level. Additionally, the government will not burden industries it is trying to promote with punitive policies, such as heavy taxes or undue regulatory constraints.

After a disappointing Year of the Tiger for equity markets, the Year of the Rabbit could usher in a change of government policy in the near future that could power markets higher. Or, as CLSA puts it, “hopportunities abound” in the Year of the Rabbit.

John Derrick, director of research, contributed to this commentary.

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