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Europe keeps China stocks hostage

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Hong_Kong_2 December, 2011 (Chinavestor) For a pdf version, click here . What does it tell you about the uncertainty surrounding financial markets when European news move Chinese equities the most? Well, this was the case in November when news that Europe’s sovereign debt problem is far from over sent China stocks to new lows in the U.S.

As the chart below testifies the China ADR Index, compiled by Chinavestor, fell 1.5% in November and is off 11.3% so far for the year. The Hang Seng Index (INDEXHANGSENG:.HSI) tumbled 10.2% for the month and is down 26.1% YTD. Mainland Chinese investors were half that bearish in November, sending the Shanghai Composite Index (SHA:000001) 5.5% lower for the month. The index lost 18.2% of its value for the year despite news that Chinese policy makers have started a monetary easing later in November. The only positive development for the month came from the U.S. where the Dow Jones Industrial Average (INDEXDJX:.DJI) crawled back to positive territory for the year.

Key sstocks mentioned in this Newsletter include Sina Corp. (NASDAQ:SINA) and Sohu.com Inc. (NASDAQ:SOHU) as well as Youku.com (NYSE:YOKU), Baidu.com Inc. (NASDAQ:BIDU) and NetEase.com Inc. (NASDAQ:NTES). NYSE listed names of interest include China Eastern Airlines (NYSE:CEA) and China Southern Airlines (NYSE:ZNH).

 

NL_2011dec_1

But investors can’t get complacent in the U.S. either where all eyes are on Europe. The old continent is mired in a deep sovereign debt crisis where its central bank, the ECB, is not allowed to print money as a last resort. This makes the current crisis a lot more difficult to overcome since key member state Italy is now at the brink of entering the death spiral. The death spiral is a term used for countries that have to come up with ever larger cuts in spending to keep debt levels from exploding. With austerity packages choking growth in Greece and Italy, markets have required more premium on Italian and Greek debt, deepening the crisis.

Italy has borrowed at close to 7% in November, a wide margin compared to Germany’s 2.13%. But it’s not just Italy or Greece that’s under pressure as the chart to the right testifies. Borrowing costs have significantly increased in core European economies, including Germany.

NL_2011dec_2

Outlook in Europe is not all that bright either. We find it hard to agree on things in just one country here in the U.S. Now consider what it would take to do the same in Europe where 27 nations with different leaders, personalities and political agendas will have to find common ground.

When it comes to Chinese stocks, Europe’s problems present a real challenge. The European Union is the largest trading partner of China and any additional slowdown in Europe hits home in China, too. Investors have to consider that China’s quarterly GDP growth, while definitely slowing since 2010, is still above 9%. This proves that China’s economy is remarkably resilient to global slowdown and when the dust settles, Chinese companies are well positioned to take advantage of Europe’s diminishing economic clout. The real question is when the dust is going to settle.

NL_2011dec_3

We remain skeptical for the short term but Chinese equities may pick up momentum for the mid-term. Considering high volatility and uncertainty globally, investors may want to give ETFs a second look. While upside is limited for these financial vehicles, their downside risk is lower than individual stocks.

There are two key Chinese ETFs that investors in the U.S. should consider. One is the iShares FTSE/Xinhua China 25 Index (NYSE:FXI), the most liquid Chinese ETF. This is a sort of equivalent of the Dow Jones Industrial Average (INDEXDJX:.DJI) for this ETF is made up by 25 Chinese industry leaders. This ETF has tracked the performance of mainland Chinese stocks in Hong Kong historically. The index that tracks mainland Chinese companies in Hong Kong is the Hang Seng China Enterprises Index (INDEXHANGSENG:.HSCEI). Since Hong Kong is the home market for key components of this ETF, the FXI comes with some vulnerability to western financial woes going forward.

NL_2011dec_4

Another ETF to consider is the Morgan Stanley China A Share Fund (NYSE:CAF). This ETF is designed to track the performance of the broad Shanghai Composite Index (SHA:000001). Designers of the EF have done a great job in mimicking the Shanghai Composite Index (SHA:000001) as the second chart on this page testifies. The bad news is that the ETF did it very well in 2011 and it is down 19.85% YTD. But we’ve increasingly seen signs that the Chinese government may switch to monetary easing to keep GDP growth at a high rate. Investors took note at the end of the month when Chinese regulators lowered bank reserve ratio, e.g. cash banks have to set aside, for the first time in three years. Taking into account that investors on the mainland consider the government one of the most influential forces in driving stock prices, a surprise rally for the broad Shanghai Composite Index (SHA:000001) is a possibility. Should that happen, CAF investors have a chance to cash in a 20%-30% profit in the next three to six months.

When it comes to Chinese ETFs, investors should consider Chinese sector ETFs as well. Take a look at a wide array of Chinese sector ETFs presented by Guggenheim. Investors interested in technology stocks can use the Guggenheim China Technology ETF (NASDAQ:CQQQ) for example. But again, ETFs limit upside potential and might not be suitable for every investor. Those of you who like to invest in individual stocks, the following two charts hold the key going forward.

NL_2011dec_5

The first chart represents Chinese sector performance in the first four weeks of November. This is when the Dow Jones Industrial Average (INDEXDJX:.DJI) hit bottom for the month, down 999 points in the October 30– November 25 period. The second chart on this page measures the performance of Chinese sectors for the last three days of the month when the Dow Jones Industrial Average (INDEXDJX:.DJI) surged 813.9 points or 7.25%.

The reason why these two charts are that important is this: they give investors an idea what to expect when the market deteriorates on gloomy global outlook and also when the market is upbeat. Looking at these charts one thing is for sure: technology, basic materials, and transportation stocks were extremely volatile. Services, driven by sector heavy weight telecom stocks, provided a cushion when markets fell apart and advanced moderately when investor sentiment improved. But consumer cyclical stocks fell under both circumstances.

When it comes to technology stocks, Sina Corp. (NASDAQ:SINA) and Sohu.com Inc. (NASDAQ:SOHU) fell 28.6% and 30.1% earlier in November and failed to bounce back in the last three days. Most of the gain in the tech sector is attributed to Youku.com (NYSE:YOKU), Baidu.com Inc. (NASDAQ:BIDU) and NetEase.com Inc. (NASDAQ:NTES). Given sound earnings from Sina and Sohu, both stocks have a lot of upside potential left should market sentiment remain sound.

China Eastern Airlines (NYSE:CEA) and China Southern Airlines (NYSE:ZNH) moved transportation stocks in both directions. Similarly, Aluminum Corp. of China (NYSE:ACH) and Silvercorp Metals (NYSE:SVM) were responsible for the wide swings in basic materials. Investors looking for safety should consider China Mobile (NYSE:CHL) and China Unicom (NYSE:CHU) along with Huaneng Power International(NYSE:HNP), a stock that shines in Chinavestor’s Conservative portfolio.

Wish you successful investing,

Blaze Fabry.



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