It was good while it lasted, but Goldilocks never lasts for very long. China’s combination of accelerating economic momentum and policymakers’ focus on decreasing leverage has led investors to abandon their previous views of China as either a coming asset bubble or imminent hard landing candidate. The next logical step was to believe in the “not too hot and not too cold” view of China that we had expected investors to move to for some time. This has now happened. At the same time an increasing number of people across the globe have started to believe in a “real recovery” where previously the best they dared hope for among the developed economies was anaemic growth, if not a “double dip”. Recently we have heard more than one investor describing expectations of higher than expected growth in the near term. If global investors had not begun this process then China might possibly have stayed in a “Goldilocks bubble” for longer.

But while investors have been busy changing their views, the reality on the ground has been changing too. China is now well past Goldilocks. From the top to the bottom of Chinese society, we have never seen restaurants so full. Department stores are buzzing. High end watches and wines are selling well. We were told by a local lawyer that there are sometimes 10 different private equity funds fighting over any good deal. Several manufacturing companies we speak to are planning to triple capacity. Inflation is obviously running well ahead of headline statistics. Not only are property prices up sharply, but raw material prices, vegetables, and the cost of preparing your kids for high school and college exams have all rocketed higher.

Amongst all these, China’s property market looms large. Not only does it lie at the heart of the Chinese economy, but it is highly topical and political as well. For the record, we still do not think the property market is a bubble. Yes, the average resident of Shanghai or Beijing cannot afford city centre property. But this is also the case in London, New York, Paris and most other major capital cities worldwide. This is because prices for these cities are not set by the “average city resident” but rather by the aggregate purchasing power of wealthy individuals across the nation and indeed the world. However, this unfortunate reality is somewhat new to China and residents are having a hard time adjusting. There are of course many other reasons why property prices have recently surged across China, such as a high savings rate, loose monetary policy and greater confidence in the economy. In addition there are few other avenues for investment. But even if all of these factors were reversed, it is still unlikely that city centre property will become easily affordable for the average Beijing or Shanghai resident. This is creating serious pressure on the political establishment to “do something” – especially since previously enacted measures do not seem to have done much to change a now entrenched bullish mentality among China’s companies and citizens. While Chinese leadership is far from likely to do anything rash, it clearly wants to do something. We are regularly asked by Chinese policymakers how property taxes are implemented in the US and the UK. And in line with a continuing focus in policymaking circles on mitigating systemic risk, downpayment ratios continue to be increased – most recently to 50% for second home mortgages. We think that eventually, first home mortgage downpayment ratios could go as high as 60%, depending on what direction monetary policy takes. Policy seems to have now turned the corner – and the direction is tighter. With markets at the moment fairly gung ho, this is enough for us to dial down the risk temporarily.

What concerns us further, is the high level of excitement displayed by some retail investors in the US, who are willing to invest in small OTC-BB US-listed Chinese companies doing backdoor listings and illiquid placements (PIPEs) without much knowledge of the underlying business. While not all of these companies are bad (and some of them are actually worthwhile investments), there appears to be a bit of froth. There also appears to be a bit more “tactical bullishness” in the long/short community. And the private equity investors who have been sitting on their hands for a year now appear to be increasingly willing to look at marginal deals.

We think China has some near term (and long term structural) issues – such as excess liquidity, and local government finances. Policy will tighten. The structural issues will stop China from taking over the world, but not from growing decently and creating plenty of opportunities. We are cautious for now, but the key to the outlook for China over the next few years is “muddle through and rise again” (repeated perhaps ten times in the next ten years). This may not be as exciting as “take over the world” or “collapse” but, based on our assessment, “muddle through and then grow” is far likelier.

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