When the world was still in full financial crisis mode, the system was arguably too fragile to cope with policies designed to reduce leverage and systemic financial risks. Now that everyone agrees we are on the road to recovery, such policies may start to be introduced.

Chinese policymakers have reiterated three or four times that they are maintaining a ‘moderately loose’ economic policy but actions speak louder than words. The PBOC has recently stepped up open market operations to mop up liquidity, and increased the duration of its bills to the one year maximum in order to increase their effectiveness. The CBRC has proposed a ban on the cross holding of sub-debt by Chinese banks – a move clearly aimed at reducing systemic risks. Given that current sub-debt is around 50% of the total in the system, this is more than just increased regulation or red tape. It is a policy that removes liquidity from the system, and makes it more difficult to extend liquidity in the future. Whether you call these moves a real change in policy or merely “fine tuning”, they nonetheless represent a change in behaviour and rhetoric that will lead to further changes in expectations which markets will not ignore.

In the meantime, analysts have recently been scrambling to upgrade their earnings estimates, target prices, and recommendations – in some cases for reasons that we can only read as “because markets are going higher”. Investor sentiment has also taken a noticeable turn for the better in both China and Taiwan. In our view, the room for upside surprise in fundamentals is now somewhat less than before, but this could still come. For instance, we acknowledge that the majority of loans extended by China’s banking system during 1H09 have not yet made their way into the real economy, let alone created much of a multiplier effect. We are also in agreement that even if loan growth slows dramatically for the rest of the year (as we have already begun to see in July), the stock of loans extended in 1H09 will be sufficient to see through an acceleration of growth for the rest of the year.

We (and a growing number of other investors) recognise China’s structural tendency to overheat. Apart from the natural entrepreneurial tendencies in Chinese culture, which have only been unleashed in the past 20 years, the structure of local government incentives plays a significant role. If local governments are told to invest, they will do so with gusto, if they are told to stop, they will do so reluctantly, at best. Many investors have recently begun to draw the conclusion that, given this natural tendency, China is always doomed to tighten policy far too late. They have also trundled out the argument that China will not tighten ahead of the 60th anniversary of the Chinese Communist Party in October this year.

We think this view is a systemic underestimation of Chinese financial policy makers, who, in our view, not only recognize China’s “structural growth bias”, but also are meaningfully more competent and rational than most market participants give them credit for. Chinese bureaucrats may yet surprise. That said, we aren’t panicked about any imminent over-tightening. There is still enough of an output gap to prevent inflation from accelerating frighteningly in the near-term, but this is not the only trigger for monetary policy tightening. The rise of asset markets, including the A-share and property market has been steep, and memories of the last bubble are still fresh enough that the current pace is unlikely to continue un-checked. It may be that policymakers scratch their long-standing itch to remove leverage from the system and generally bring down and “better manage” systemic financial risks. Or it may be that investors find this increasingly plausible after a steep run up, and allow markets to become more “self-correcting” in a “two steps forward and one step back” type of pattern. Since “scary” inflation is still many months away, the likely trigger for any tightening or heightened speculation about tightening should, in the near term, come from asset markets. If asset markets rise quickly, then speculation about imminent tightening will resurface. Thus “two steps forward and one step back” has now become our base case scenario.

While there no longer exists a potential flood of short term money with trigger fingers at the ready, waiting for a dip to buy, we still believe in the “money on the sidelines” argument in a medium-term sense. That said, we think that the biggest delta in money reallocation to equities is now past, and that likely means that the very steep rally we have recently seen in equities is unlikely to be repeated in the near future.

We have been treading carefully for most of the past two months, and we are still not comfortable with a beta-intensive quasi-buy-and-hold strategy. Fortunately, dispersion among sectors and stocks has increased – both in their fundamental changes, and also in the near term over or under-shooting of expectations.

We see Chinese commodity stocks as slightly overextended. In part this is a rational reflection of improved economic prospects going forward. But it is also the result of investors chasing beta. On top of this, a further contingent of investors thinking ahead to possible hyperinflation (one long-tail outcome among many) has emerged from a knee-jerk reaction to unconventional monetary policies in the West. So we are beginning to look for shorts here.

On the other hand many investors are underweight Chinese financials, on the view that slower lending growth is not a positive. We think that margin improvement will more than offset this and we are looking for opportunities here. Among China Banks, we prefer China Citic Bank, which, due to its higher 77% loan/deposit ratio (though high capital adequacy ratio) should be a more sensitive beneficiary as liability re-pricing improves margins.

In Taiwan, optimism clearly reached its near-term peak by the end of July. Given significant rapprochement with China with respect to a financial memorandum of understanding, we remain generally positive, but are expecting the ride to be bumpier than others believe given that the current tone of negotiations does not support the naïve thesis that Beijing will just concede to Taiwan’s every whim. We have sold most of our Taiwan financial exposure, which included Polaris Securities (Taiwan’s most interesting sizeable brokerage industry M&A candidate) and have added new short positions in several financials including Chinatrust, which is still suffering from asset writedown issues, and looks increasingly likely to put in an ill-advised bid for Nan Shan Insurance – AIG’s former Taiwan subsidiary. Moreover, with stable financial markets and an economy that is now acknowledged to be “in recovery”, the urgency of looking to China for economic help at any cost has faded. Taiwan can now afford to remember some of the political considerations that have been known to make these negotiations difficult in the past. Medium term however, we expect Taiwan to continue to outperform in the context of Greater China, and we will be back soon.

On the “pure Hong Kong” side of things we have recently added New World Development – a much-maligned HK property developer whose Chairman has a partially deserved reputation for not giving minority shareholders’ interests due care and attention. We believe this is changing with the heir apparent who now runs its two main subsidiary corporations, and their upcoming project launch in HK’s luxury segment seems increasingly likely to surprise on the upside.

In summary, it is likely that markets have moved back into a kind of “normality” where volatility is lower, and dispersion is higher. In this environment, the prospects for long/short equity investment in China have never looked better.

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