Nearly everyone has worked out that China’s economy is just fine. Better than that, more than half of the investors who know anything about China think that we are just at the beginning of large liquidity and asset bubble that will drive the economy for at least several more quarters to come. Another large group of investors thinks the economy is in “Goldilocks” with a gentler and more extended bull market cycle ahead of us.

We too are positive on China’s economic growth for the coming few quarters – in fact to such an extent that we really have great difficulty seeing what could go wrong.

We’re not worried about exports. Exports’ contribution to China’s growth this year have been negative – even if they did not grow at all this year it would still represent a big uplift to 2010 growth over 2009 – and we expect more that merely zero growth next year. Nearly 40% of China’s exports are to emerging markets (far more than to America), and these continue to grow quite nicely, in aggregate.

We’re not worried about premature tightening. Circumstances are no longer “extreme” which means that Chinese policymakers are finding it difficult to achieve consensus on when and how much to tighten.

We’re not too worried about inflation or “overcapacity” either. We just don’t see a global economic surge that would be strong enough to overcome China’s natural tendency towards disinflation (high savings rate = plenty of capital to finance incremental productive capacity). At the same time, and perhaps paradoxically, we’re not worried about systemic overcapacity. Yes, its possible that China may have a few more aluminium smelters and steel mills than it needs at the moment, but we just don’t see economy-wide overcapacity. The recent surge in investment has focussed heavily on infrastructure, which is something China happens to need. At this point, consumers in a rapidly growing, continent-sized, heavily populated low-income country like China will find more convenient travel, better healthcare and housing as desirable now as more food, clothing, or colour TVs.

We’re not worried about the banking system. Putting aside the fact that the infrastructure projects which have absorbed the largest chunk of incremental new lending are essentially government guaranteed, it is simply too early to tell. Most projects are in the process of completion, and the vast majority will be completed. We don’t expect them to be huge money spinners, but we certainly don’t think they are “white elephants” either. While we have no doubt that banking sector NPLs will increase over the next few years (especially when and if China sees an economic slowdown), with current banking sector NPLs low, and bank leverage low as well, we find it difficult to understand the high level of investor concern directed here.

And we’re not worried about the sustainability of current stimulus policies. Of course high levels of new incremental bank lending will slow. Of course incremental government infrastructure investment will slow. But these will both continue at a high-enough level for China’s strong growth to continue in 2010 and prove many doubters wrong.

Our base case scenario is one where the growth comes through. While most professional investors looking at China will claim never to have doubted that China would “deliver the goods”, many of the residual doubts I have outlined above have continued to play some role in decision-making. We still find a fair contingent of investors who want China to fail on moral grounds (because, for instance, they don’t play fair on IP protection or human rights). There are others who are just checking to make sure they’re not doing the wrong thing by investing here – kind of like asking whether something is a good investment after having just mortgaged your house (or in Anthony Bolton’s case his career) to make an all-in bet on China.

In any event, we still think 2010 should be a year of China making good on its promises of growth and investors becoming increasingly comfortable that the China story will “work out in the end”. So we’re comfortable with China’s economy – at least for the coming year.

We are not as positive on equity markets, however. We have been looking at equity markets for too long to immediately equate economic strength with positive equity market momentum. For starters, while we are confident that China’s growth will come through, we expect some of its economic momentum to slow. There will be times when positive economic news loses its power to surprise and drive markets up.

Investors’ views are focussed on a very narrow range of outcomes for China, all of which seem to imply equity market strength. Anything that throws those outcomes into doubt (even if it is merely a rumour or based on a complete misunderstanding about how China works) could have a substantial impact on equity markets. While we too have a “Goldilocks” outcome as our base case, we know too well that investors’ views on China swing around far too rapidly – and based on far too shocking a lack of knowledge about what is actually going on for it all to be smooth sailing from here. This is further complicated by the fact that a consensus has been reached in China’s economic policymaking pantheon to focus on “structural adjustment” which, while different than all-out “tightening”, could still throw up unintended effects.

In the beginning, before China’s economic recovery had begun to take shape, a flood of liquidity came gushing out of the banks and with very few companies actually wishing to deploy it, much of this money was put right back on deposit with the banks. Some of it ended up in asset markets. We are now in an entirely different “phase” where money is being drawn down to fund investments in the real economy, at the same time as vigilance towards asset bubbles has increased on the part of policymakers. So we think investors are probably over-discounting the likelihood of a China asset bubble.

There are many other things that could plausibly go wrong. If, as we suspect, a large number of investors are already positioned for either a China/EM bubble or a positive growth outcome (and judging by the strong relative market performance ytd this seems to be the case) then one outcome which could throw a wrench into the works is if US growth begins to accelerate at the same time as Chinese growth begins to decelerate (although China’s growth rate will, of course, still be higher than that of the US) then we might very well see a modest “US Dollar carry trade unwind” effect and a temporary reversal of EM outperformance.

In the meantime, investors are positioned, if not for the greatest bull market of all time, at least for reasonable appreciation in Chinese asset prices. Certainly very few are betting that Chinese asset prices will deflate. Meanwhile, valuations have crept up, and we find a lot more of our long ideas these days fit the description of “misunderstood” as opposed to “stupidly cheap”.

One thing is clear – most Asian-focussed hedge funds have net exposures near their historical highs and long-only funds have cut their previously large cash levels back. We think the balance of risks, if not skewed to the downside, is at least balanced. And in that context, market declines will tend to be sharper than market rises. So, in the near term at least, a more conservative positioning seems appropriate.

So to sum it all up, we don’t think there’s going to be an asset bubble and while we think there’s a good chance of a “Goldilocks” scenario in China, we would probably ascribe only a 25-30% chance to the outcome, with the other 70-75% taken up by a multitude of different possible outcomes. We remain very positive on China’s medium term and long term outlook, but we think that as China “changes gears” asset price volatility is increasingly likely and we are working hard to find profits therein.

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