China rallying for all wrong reasons to top-rated analyst


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Customers look at an electronic stock board at a securities firm in Shanghai, China. Customers look at an electronic stock board at a securities firm in Shanghai, China.
The more China does to boost economic growth, the more bearish David Cui gets on the nation’s stock market.
The Bank of America Corp. (BAC) strategist, ranked No. 1 by Institutional Investor magazine, says the state spending and monetary stimulus that drove a 14 percent rally in the Hang Seng China Enterprises Index (HSCEI) from this year’s low in March are only making equities less appealing as leverage rises and free cash flow dwindles. He predicts the gauge will drop to 9,600 by year-end, or 8.4 percent below yesterday’s close.
Cui’s pessimistic outlook for the largest emerging market puts him at odds with bulls at some of the biggest banks and money-management firms, including Goldman Sachs Group Inc. and BlackRock Inc. He says policy makers’ unwillingness to endure the “short-term pain” of slower growth, needed to cut debt and shift the economy toward a consumption-based model, will prevent a sustainable rally.
“Given that growth is still being driven by the usual factors, it means the core issue is getting worse as people are building up debt,” Cui said in a phone interview on July 14. “The issue is whether this growth is good quality and sustainable. My belief is that it’s not.”
Cui is part of a dwindling camp of China bears that includes Deutsche Bank AG (DBK)’s John-Paul Smith, who reiterated this month his forecast that emerging-market stocks will drop about 10 percent this year in part because rising debt levels pose a risk to China’s economic stability. Goldman Sachs, Morgan Stanley (MS), Citigroup Inc. (C) and HSBC Holdings Plc are all either predicting gains in the nation’s stocks or have overweight ratings.
Economic expansion
The Hang Seng China gauge slipped less than 0.1 percent at 9:40 a.m. in Hong Kong, while the Shanghai Composite Index (SHCOMP) lost 0.3 percent. The MSCI Asia Pacific Index (MXAP) rose 0.3 percent.

David Cui, China strategist at Bank of America Corp.'s Merrill Lynch unit.
Data yesterday showed China’s economic growth accelerated for the first time in three quarters in the April-June period. Premier Li Keqiang’s government has brought forward railway spending, cut some banks’ reserve requirements and reduced taxes to protect an annual growth goal of about 7.5 percent that’s under threat from a weakening real estate market. The country’s broadest measure of new credit last month was the highest for June since the lending spree of 2009, when policy makers acted to shield the economy from the global crisis.
Cash flow
While the measures have helped shore up the economy, they also swelled corporate debt, hurt earnings quality and led to an increase in overdue loans, Cui said. The market capitalization-weighted average debt-to-equity ratio for non-financial companies in the Hang Seng China index has increased to 61 percent, the highest level since the third quarter of 2009, less than two months before the end of a 176 percent rally in the stock gauge from its financial crisis lows.
The companies’ combined free cash flow, a measure of how much cash they generate after investing to sustain their businesses, dwindled to minus $21 billion, the lowest since the final quarter of 2011, according to data compiled by Bloomberg. PetroChina Co., the nation’s biggest state-owned energy company, reported a negative free cash flow of about $9.85 billion in the first quarter, the data show.
Bulls point to Chinese stocks’ tendency to rise in the second half as the government supports economic growth. The Hang Seng China gauge, known as the H-share index, has climbed from July through December during all but two of the last 10 years, including an average gain of 18 percent in the past two years.
Defensive bets
The measure is valued at 1.2 times its companies’ net assets, a 25 percent discount versus the MSCI Emerging Markets Index. That compares with an average premium of 6 percent during the past decade, according to data compiled by Bloomberg. The H-share index is still down about 26 percent from its November 2010 high.
Cui, who has been mostly bearish on Chinese stocks since May 2010, says he’ll turn more positive if policy makers take further steps to reduce debt levels, cut overcapacity and foster consumption.
For money managers who need to stay invested in stocks, he recommends utilities and telecommunication companies, which offer relatively high dividend yields and tend to outperform in falling markets. He also favors shares of some state-owned companies that stand to benefit from government efforts to introduce more private investment in the oil and gas industry, declining to name any specific stocks.
No end
A gauge of utilities in China’s large-capitalization CSI 300 Index has risen 5.3 percent this year, the best performance among 10 industry groups, and its 3.5 percent dividend yield is almost one percentage point higher than that of the CSI 300.
We can take the short-term pain, write off debt and re-capitalize the financial system and move on, or we can drag on like what Japan did, where every growth slowdown led to some spending here or there" -- David Cui
Cui, who has worked for the Merrill Lynch unit of Charlotte-based Bank of America since 1999, says the broader Chinese stock market is showing some parallels with Japan’s during that nation’s so-called lost decade, when the Nikkei 225 Stock Average (NKY) lost as much as 80 percent from its 1989 peak.
Chinese policy makers should avoid following Japan’s strategy of stimulating growth after every slowdown, and instead allow companies to reduce debt while letting banks write off bad loans, he said.
“We can take the short-term pain, write off debt and re-capitalize the financial system and move on, or we can drag on like what Japan did, where every growth slowdown led to some spending here or there,” Cui said. “That’s why this downturn has lasted for four years and there is no end in sight.”

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