Chinese loan growth in June was faster than expected. Again. This not only brings the year-to-date figure to RMB7.33tn (or more than 20% of China’s expected GDP this year), but 30%+ yoy lending growth occurred in the face of repeated admonishments from China’s bank regulator (the CBRC) that loan growth over the past few months was quite fast enough already. In many parts of China property sales have long exceeded previous record highs set in 2007. Private sector construction activities have also seen a strong restart in recent weeks. Has China reflated the economy so much that it is time to watch out for signs of tightening in China?

Initially, warnings from the CBRC were the only signs in China that tightening might be considered, but they have since been joined by a chorus of mid-level officials questioning whether the torrid pace of China’s current fiscal stimulus might not lead to wasted investments like “bridges and roads to nowhere”. Most importantly, the PBOC has recently begun to step into the market to mop up liquidity, most recently by issuing 1-year PBOC bills for the first time since October 2008 in an amount theoretically equivalent to a 25bps hike in the reserve requirement ratio (at a time where China’s excess reserves are already much depleted).

Interestingly, this follows not long after an FOMC meeting where the US Fed came out incrementally more hawkish than “expected” – and only because they did not expand the scope of “quantitative easing” already in place. Is it possible that we now face a future where global policymakers will surprise markets with their hawkishness?

This may be the case, but not yet. In China particularly, we note that following increasing evidence that China’s no-holds-barred “shock and awe” monetary and fiscal stimulus is being “fine-tuned”, Premier Wen has clearly reiterated support for a proactive fiscal policy and a “relatively loose” monetary policy. In this context, it will continue to be difficult to control investment by local governments, who are always hungry for more projects and more investment.

Avid readers of our updates will know that we have been confident in China’s ability to reflate its own economy, pretty much regardless of how big of an external shock the economy faced from the developed-world financial crisis. This has now been “proven” with action and results. Many investors now understand that this was possible because China had the resources to do it: a strong fiscal position, strong corporate and consumer balance sheets and low bank leverage. And the will: a consensus at the top levels of China’s bureaucracy allowed these resources to be pushed through a relatively efficient command economy into a quick economic restart and subsequent recovery in confidence. Fewer investors, however, seem to realize that “loose” monetary and fiscal policy has had very little to do with China’s strong growth over the past ten years. In fact, credit to the private sector has generally been quite tight. It is only recently, and for the first time in many years, that China’s fiscal and monetary policy can truly be called “loose”.

Given that the broad direction of policy is unlikely to change for several months following Premier Wen’s reiteration of support for current policies, we think it is still safe to swim in these waters, to say the least.

Translating this into investment, though, is far from simple. H-shares have been a magnet for the crowd of money that struggled to add beta in a rising market and found it here. Emerging Markets funds are heavily overweight H-shares and they have increased this overweight in recent days. A sense of complacency has also crept in to a few key areas, such as Chinese property stocks, which have been among the best performers this year, and where we suspect that pent up demand has been a big driver which will fall off later in the year. In addition there have been initial signs of tightened lending to the residential property market in Shanghai and Hangzhou. Further, there has been a clear re-start to the HK IPO market, and also a wave of placements, many of which appear to be purely opportunistic.

The A-share market has been one of the strongest markets in Greater China year to date, and there is very little doubt in our minds that some of China’s loose monetary policy has helped. There is also increasing evidence that domestic retail investors in China are becoming increasingly active, which is making the risk/reward ratio here look less favourable. We are not at the moment forecasting an imminent reversal, as monetary policy hasn’t really changed, and there is room for retail investors to get more excited than they currently are, but this is not a market we would want to have a heavy commitment to at the moment.

In Taiwan, we remain somewhat more positive, but see signs for caution here as well. Institutional investors have not much increased their weightings, but retail investors are more hopeful. The changes we have seen so far argue for an end to Taiwan’s over 10 years of underperformance relative to the rest of Asia. Understandably, after a series of disappointments over the years, there is quite a lot of scepticism, and many seem to believe that the previous pattern of All talk and no meat will repeat itself once more. It is not just conjecture that things are different this time, though. Cross-straits flights are already in place, and the number of flights is being expanded. Meaningful numbers of Chinese tourists already criss-cross Taiwan and the numbers are growing. Most importantly, with a KMT administration in place, a consensus that the “Buy Taiwan” strategy is the right one has taken root in China. We think that a track record is being built that will eventually lead to a significant improvement in the Taiwan market’s performance relative to the rest of Asia. The only thing that makes us cautions, is that we have heard “blue sky” and “new paradigm” types of noises not only from one or two regional strategists at prominent investment banks, but also on the local talk show channels. In the short term, we will be treading cautiously here as well.

The opportunities for differentiated performance, however, remain enormous. We are not “thematic” investors in the sense that we blindly believe in macro themes with strong drivers (otherwise known as fairy tales) to drive a selection of core holdings (a recent very popular theme is healthcare in China), but we remain aware of the backgrounds and trends when thinking about how much markets have already reflected, and how much more room there is for further money to come our way. In this context, we are especially bearish on China’s heavy industrial SOE companies, which have been the beneficiaries of a sustained mis-allocation of capital, and where the evidence of overcapacity is clearest, and broadly more positive on consumer-focused private enterprises – particularly those not plagued by an excess of copycats and competitors.

We have recently found much to like about China’s internet sector, where companies such as Tencent, Baidu, Chinese Gamer, and Perfect World among others remain interesting, and we have begun to populate our portfolio with some of these. We have also recently added to our position in technology hardware, which has lagged the recovery in higher beta cyclical sectors, but where we feel the drivers are more sustainable. These include a strong corporate upgrade and replacement cycle, reduced cost pressures, a credible operating system from Microsoft (Win 7) and a possible new operating system from Google as well.

We have begun to cautiously and selectively add to short positions in China’s heavy cyclical and energy names, where we see a lot of investors who own a lot of these names, but whose logic for holding them appears unclear at best, and where the recent “fine tuning” in Chinese policy has the potential to shake them out of the trees.

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