China’s lending growth has been hugely above trend. Infrastructure spending has grown rapidly. And finally, a V-shaped recovery in every other part of China’s economy has taken shape. With loose policy, a fixed exchange rate, and high growth, upside risks to asset prices have been so clear that more than just a few investors have been willing to jettison their normal caution about greater fool’s theories and bet on the Chinese asset bubble that is “coming soon”. So far this has appeared right. After all, despite clear warning signs of an asset bubble in-the-making, a slow pickup exports, low inflation, and concerns about aftershocks from the global financial crisis have kept the authorities on hold.

Recently, however, CPI has turned positive, export numbers have picked up sharply, and some recent “aftershocks” such as Dubai and Greece were digested without too much difficulty. Chinese authorities recognize and care about the risks to stability that an asset bubble would bring, and by raising the reserve requirement ratio (RRR) a few months earlier than most expected, they have shown themselves willing to “lean against the wind” and attempt to manage liquidity actively, as we expected they would. While this will not make the “unchecked asset bubble” line of thinking go away, it calls it into question, and will allow investors to price in more realistic expectations for a tightening cycle. This may require a period of digestion, but should be viewed as a long-term positive for China, as the authorities win accolades from economists for “managing inflation expectations” and manage to extend the cycle a bit further. With this part of the equation in place, Chinese markets all of a sudden begin to look like an excellent place to position strategically for the next few years. China markets have actually underperformed many of their emerging market peers over the past 12 months, and the fundamentals and valuations are, in most cases, slightly better. Recent newspaper articles and dedicated short-sellers screaming publicly about China’s coming “collapse” only add to our conviction – especially when many of the arguments employed seem misguided at best (but we secretly harbour the view that most of these guys simply haven’t spent enough time looking at China without very strong preconceptions). At the same time as China proves itself willing to tighten (modestly), we expect investors’ views to congeal more convincingly around a “Goldilocks” scenario (see last month’s update) for the economy. Following this first round of “tightening”, further data supporting a goldilocks outcome is likely to bring a lot more money in to Chinese markets than out.

Investors’ views on stocks and sectors remain highly skewed, and represent a rich vein to mine for investments. There are few sectors in China were policy is not important, but property is clearly one of them. Policy announcements here have been a defining feature of the past few weeks and have included credit restrictions on speculative purchases, but also encouragement for low cost housing and development activities in general. China’s property sector has a love-hate relationship with Beijing. On the “love” side, not only do many government officials own several flats, but residential property construction is an important economic driver – even more so when fiscal infrastructure spending is nearing its peak and exports still appear sluggish. In addition, the sector provides one of China’s best conduits for bringing black-market-economy money into daylight – and given a relatively small number of savings and investment choices, property figures prominently. But the sector is highly troublesome – not only because it seems prone to boom and bust, but also because one of the most oft-cited criticisms of “the Chinese economic system” (and thus, by implication, the Communist Party itself) is that the average salaried urban worker finds most flats unaffordable – or in other words, that the divide between rich and poor in China continues to widen. When considered in this context, it is easy to understand most of the recent “tightening” measures and the message could not be clearer: speculative activities that drive prices up without meeting real needs will be strongly discouraged, but consumption-type housing demand for personal use will continue to be perfectly all right. We like the sector for a number of reasons. Not only is it notoriously volatile and subject to frequent sentiment swings, but a recent wave of new IPOs has created many more choices and new ways to express our ideas. In the past few months, we have not had much in the sector but maintained a small short skew. Going forward, expect to be increasing our exposures here – both long and short.

Another sector with obvious policy drivers is the banking sector, which has been so instrumental in providing the quick and easy contra-cyclical levers with which China engineered its recovery. Quantitative controls on lending (i.e. “moral suasion”) have long been a key tool in China’s policy toolbox, and the general direction here remains “less accommodative” – but not quite to the point where monetary policy could be construed as neutral, let alone tight. Even if investors understand that the recent hike in the RRR is unlikely to result in lower lending growth, and that its primary function is to mop up excess liquidity, they still view it as a form of policy tightening – if only because they understand that due to the “signalling effect” these moves requires sign-off from the state council. In this context, many investors have been deciding which of their two policy-driven sectors to sell first – banks, or property. Investors have not been extra-keen on property for some time now and so that’s been the first to go. Banks have been reduced at the margin, but not as aggressively, due to the view that even though quantitative controls on lending will cut back loan growth, interest margins are likely to surprise on the upside as policy rates remain low but effective lending rates can be hiked as loan demand increases while quantitative lending controls reduce supply. We think risks are roughly balanced for Chinese banks, but would, at this point, tend towards a slightly more positive view as we see the economy continuing to improve AND rebalance while policy is tightened only modestly.

We see the resources sector as modestly over-hyped, and have found a few shorts here. Domestic consumption names are perpetually preferred, and here we maintain a slight positive skew, largely because we are still able to find companies with strong positive change and low valuations in a sector that is mostly quite expensive.

In conclusion, we think that China’s first round of “tightening” has created a far more fertile ground for investment than has prevailed over the past four months, and we intend to take full advantage.

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