If you want China to fail, that’s fine. We’re not going to try to persuade you otherwise. In fact, we will happily bet alongside über-bears, when either structural cracks expand of their own will, or the government seems determined to grind things to a halt. Since mid-2009 we have been more risk-averse than profit seeking in part because the Asian Asset Bubble story that so many believed in seemed to invite both a policy response as well as an unwinding of sloppy long risk exposures. Since then, both have happened.

In the meantime, a very popular theme among pundits and media monkeys has been China’s imminent collapse or, since this is easily proven wrong, headlines like “China to have big recession in the next 10 years”. But ten years is a long time even to a seasoned China investor and even two or three recessions in that span of time are not too difficult to envisage. So not only is this an easy prediction to make, but a useless one. Oddly enough, this is viewed as big news and media coverage has been extensive.

Things are never certain, but most of the evidence that we see now and that we expect to see for the rest of the year is consistent with a “not too hot and not too cold” view of China’s economy. Two successive hikes in reserve requirements have so far only sterilised ongoing liquidity inflows, but they are not without a signalling effect and combined with numerous measures targeting property speculation and bank lending, have already begun to cut expectations of an unchecked asset bubble down to size. This can be seen in declining property transactions and lower inflationary expectations, both in a general sense and for the property sector specifically. While exports may continue to recover, we expect sequential momentum to be slowing or moderating for the rest of the year. In addition, residential property investment and government infrastructure spending will clearly be slowing down by mid-year 2010 at the latest – though given the recent scrutiny that local governments’ off-balance sheet liabilities have seen, this could very well be showing up soon. So, in summary, China’s first round of tightening has already happened, and, it has already had a clear effect and this effect is not a flash in the pan.

China’s annual National Congress has been much anticipated for the clues it can give us about policy direction for the next two years. Going into the meeting, many feared something draconian as the end result, but given that the politburo put back statements about maintaining loose monetary policy just prior to the meeting, we have not subscribed to this view. With the meetings now done and dusted, we are beginning to feel vindicated. In line with our own views, the government does not consider inflation or an asset bubble to be an imminent threat at the moment and is not worried about general overheating. Lingering concerns about the strength and durability of global recovery and private domestic demand will take another six months before they can be set aside.

Key objectives for this year are to keep growth ticking along, continue to “rebalance” the economy along the well known rural/urban and consumption/investment axes and manage inflation expectations. Given previous concerns about a crackdown on an asset bubble, this seems like a pleasant surprise. The 7.5 trillion target for new lending came in as per original expectations (there had recently been some concern this might be revised down to 6.5tn to take account of the “latent” loan growth that was booked in 2009 but not disbursed).

We see China valuations as below mid-cycle norms with meaningful earnings upside. Very loose liquidity conditions remain. There are some inflationary pressures and these will likely intensify in the next few months, but so far they seem unlikely to bring about a big enough change in policy to derail either the recovery, or meaningfully crimp liquidity. This is especially the case now that a first wave of “earlier than expected” and “more aggressive than expected” tightening has already occurred.

All of this sounds pretty good for equity markets. That said, we still think China’s first hike in interest rates this cycle could come anytime between now and the end of the year and if pressed we would bet sooner rather than later. In addition, the aftershocks of the round of tightening that has just (in our view) concluded, could cause some of the über-bears to take a victory lap, so it will not be smooth sailing by any means. We’re looking forward to it.

On a sectoral level, many of the themes we have been highlighting and developing over the past few months remain in place. We still like banks, and by extension, property. In our last monthly, we explained how we were fundamentally comfortable with Chinese banks and how an opportunity might be coming. Some of the bottom-up ideas we have in the space are now beginning to find their way into the portfolio. By extension, Chinese property companies are also attractive. With many of the banks now having announced their capital-raising plans, investors might be able to look past this. Property does not suffer from this overhang at all. New issuance of paper has already happened some months ago and is completely digested. Valuation-wise, with many of the companies at 40-80% discounts to NAV, they also look attractive. China’s property sector has been held hostage to many of the same macro worries as banks – but here the concerns about solvency and business risk are very much out in the open and so while we think concerns on both sectors are equally overdone, the clarity in property is greater, while in banks the concerns have a lower than normal backing in reality.

Domestic consumption in China is a minefield of consensus trades, but if properly navigated, can reap big rewards. And as infrastructure investment slows at the same time as residential property investment shows signs of weakening, the commodity story could be called in for some serious questioning and a few die-hard commodity bulls might get taken to the cleaners, gold bugs among them.

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