The most frightening thing we saw this month had nothing to do with Greece. Rather, it was two major investment banks simultaneously upgrading GDP growth forecasts for China. And these were not small upgrades either – generally by over 100 basis points for the year – with both highlighting upside risks from exports. Considering that net exports subtracted nearly 4% from China’s GDP growth in 2009, if exports merely stood still they would to provide a big boost to China’s 2010 growth numbers. So, of course, the upgrades make sense, though one cannot help but wonder why this was not baked into the numbers much earlier. Of course near term economic activity has been very strong and probably provided some of the impetus. In January bank lending increased 29% yoy, auto sales were up 126%, housing prices up were up 9.5%, exports were up 21%, and imports were up 85.5%. Many of these figures were boosted by base effects, but were still very strong. So strong that policymakers, who were already on full alert for the elusive bubble in Asian assets that some investors still expect, stepped up their activities.

The good news, for those so inclined, is that this is already beginning to have an effect. So, while fiscal infrastructure investment is still showing strong growth, it has already seen its peak momentum, and given that new project approvals are much harder to come by these days, this is sure to tail off further over the rest of the year. A series of measures designed to reduce banks’ enthusiasm for lending in general and credit availability to the property sector in particular is beginning to bite, with buying intentions down sharply. It doesn’t seem that far fetched to think that by summer, some of the same investment banks will be revising their forecasts back down again – particularly if exports turn back down again.

Looking at the “big picture” we struggle to stay bullish on the world at large. The Euro project will be salvaged but when the German dentists wake up at some point in the next few years and realize they will need to foot the bill for more than just Greece, further strains seem likely. In the meantime, we are also faced with the increasing likelihood that by topping out and turning down, OECD leading indicators will confirm what the markets have already told us: the world is going to look a lot worse before it looks better. The near term outlook is further clouded by the fact that Southern European debt rollovers are concentrated between March and May. Fiscal problems in the West are likely to remain a big concern for some time to come.

Yet, over the past few weeks, we have been adding to our exposure instead of decreasing it. Why? Regular readers will know that we have argued vehemently against a sizeable asset bubble being allowed to take shape either in Asia or anywhere else, despite the very significant liquidity that has been pumped through the economy’s veins over the past 18 months. But we do believe in the next best thing: a liquidity put. Aftershocks from the global economic crisis like Greece mean that liquidity will be withdrawn more slowly than previously expected. We also continue to think that once the notion that China is experiencing an asset bubble has been dispelled, the next most likely magnet for investors’ views is the Goldilocks one. Given that a lot of money has recently been taken out of China and reallocated to other regions (e.g. Korea/India), the risk/reward for long exposure in China is not that bad. And as investors’ views on Asia transition from “runaway asset bubble” to “Goldilocks”, Chinese policymakers will relax. Near-term expectations for tightening are realistic and 100% if not 120% factored into the markets and this makes us comfortable on the near-term outlook, especially as liquidity remains abundant and not yet withdrawn from the system in any meaningful way.

In China’s listed companies, the banking sector remains key. Not only is it one of the largest sectors in the index, but given how key bank lending has been in driving and financing the current recovery, it looms large in investors minds and, along with the resources sector generally, can be viewed as a fair proxy for investors’ views on “China Inc.”. Of course there are a number of clear sector-specific overhangs. Among these have been concerns that last year’s tremendous loan growth will lead to big asset quality problems – and soon. All or most of the banks have been asked to raise capital, and more strictly enforced quantitative controls on lending also figure prominently in many investors’ nightmares. Valuations for the sector appear reasonable with price/book ratios of 1.4x to 2x at the high end and ROEs of 16%-23%. Given that much of last year’s surge in lending was extended to government-backed infrastructure projects, which, while they might not enjoy high IRRs, are unlikely to produce extensive asset quality problems. Another big chunk went to large state owned enterprises. Many of these didn’t really need to borrow, but, given that banks were under pressure to lend at the time, stepped up anyway and, in many cases, put the money right back on deposit with the banks. So while we expect NPLs to rise from their current levels of around 1.5%, we expect these increments to be in basis points, rather than percentage points. We are also, we feel, close to a point at which investors can begin to look beyond the capital-raising overhang. This has been a popular area of discussion for some time now but unlike their western counterparts, where capital raising plans were critical to plug huge holes on their balance sheets, this capital will be used to fund future growth. We have not owned a Chinese bank for over six months now and have from time to time been short of Chinese banks, but with absolute return investors largely out of the sector, and long-only funds neutral if not underweight, we think the time to own them is nigh. Do not be surprised to find at least one Chinese bank among our top holdings soon.

We are less positive on manufacturing. Here, the uplift from operating leverage is largely in the price and both raw material inputs and labour costs continue to see some upward pressure. We remain neutral on domestic consumption names, where the long term secular growth story is good, but where the valuation discrepancies are significant. We are, however, increasing our gross exposure in this area, with exciting ideas on both sides of the book.

Overall, we expect the year of the Tiger to be tumultuous but good hunting.

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