By Bill Stone of PNC Wealth Management
"Notice that the stiffest tree is most easily cracked, while the bamboo or willow survives by bending with the wind."- Bruce Lee
Recently I traveled to China with a group of institutional investors and visited Beijing, Shanghai, Shenzhen and Hong Kong. Along the way we met with almost 20 Chinese companies, as well as government officials, entrepreneurs, venture capitalists, foreign business leaders in China, and the manager of our PNC office in Shanghai. This month's outlook reflects some of the major points gleaned from the meetings and our view of the implications for investors.
China is now the second-largest economy in the world at approximately 8% of global GDP. This trails only the United States, which accounts for about 25% of global GDP. China's GDP has grown at a low double-digit year-over-year rate in the first two quarters of 2010 and is certainly viewed as a key driver of the global economic recovery. For these reasons any concerns about the durability of the Chinese growth story typically result in ripples of fear through the financial markets.
While China has been an amazing growth story, it is worth considering and examining some of the possible risks in its system. A few risks that seem to be evident are:
residential real estate;
local government borrowing and the Chinese banking system; and
policy tail risk.
Our view is that despite some risks there remains a strong tailwind from the Chinese industrial revolution, so current conditions support continued economic growth. We believe Chinese economic growth will likely slow as the year progresses but still remain in the high single-digit range. In other words, we expect the Chinese economy to continue to support the global economic recovery. There remain risks -- policy error tail risks to combine them under one heading -- which we will continue to monitor. Alluding to our Bruce Lee quote, it remains to be seen over the long-term if the Chinese economy will become too rigid and crack under the accumulated weight of any errors or grow by bending and adapting to the challenges.
In addition to the previous macroeconomic thoughts, our research in China led us to two very specific implications for those interested in investment within China.
Many Chinese companies' earnings could be overstated due to government support.
Rapid Chinese GDP growth is no guarantee of rapid stock price appreciation.
There is little doubt that government support makes profits subject to arbitrary alteration of government policy and removing these subsidies would reduce profits. In addition many of these subsidies are opaque and make it difficult to estimate the true (excluding government subsidy) earnings of the companies.
Finally, it is worth discussing the assumption that underlies many investors' positive long-term view of Chinese stocks. There is a belief among many that the superior expected economic growth provides an automatic tailwind for equity investors. Unfortunately, this could prove to be a costly assumption.
Meanwhile back home in the U.S. markets...
Market views regarding the durability of the global economic recovery continue to dominate market action. Though the timing is unclear, we expect that this too shall pass and be supportive of stocks when the market begins to come to agree with our view of no double-dip but rather a half-speed economic recovery as the highest probability outcome. Bolstering our constructive view on stocks is that current valuations, if indeed there is not another descent into recession for the economy, are at a minimum very reasonable. While there are certainly numerous risks in the current investment environment, we believe current stock valuations provide a reasonable offset and an attractive risk vs. reward relative to other investment opportunities currently available.
Bill Stone is the Chief Investment Strategist for PNC Wealth Management and PNC Institutional Investments with over $100 billion in assets under management. He is a member of PNC's Investment Policy Committee and is responsible for defining the asset allocations and portfolio strategies used throughout the organization to advise individual and institutional investors. Stone is a cum laude and honor's program graduate of the University of Dayton with a bachelor's degree in finance. He earned a master's of business administration from the Katz Graduate School of Business at the University of Pittsburgh. In addition, he holds the Chartered Financial Analyst� designation and is a Chartered Market Technician. Stone has been quoted in many publications including The Wall Street Journal, Financial Times, Barron's, Fortune, Forbes and USA Today. He is regularly interviewed by Associated Press and Reuters. He is also regularly interviewed on CNBC and Fox Business for his market insights.