Breakable China

S&P: Global markets may wobble when China corrects -- but they won't fall down

The 248% gain in the Shanghai Composite index since January, 2006 is stunning, but it has created what we think are unsustainably high valuations for Chinese equities.

The index is currently trading at 37 times 2007 consensus earnings vs. only 16.2 times for the S&P 500 and 14.8 times for the MSCI EAFE index, the leading developed international equity benchmark. While Chinese growth prospects are undeniably stronger than those in the United States or other developed international markets, we believe this is more than reflected in the current yawning valuation gap.

The index fell 6.5% on May 30 in response to the government's tripling of the tax on stock transactions. Global investors are growing concerned about whether a Chinese equity bubble burst would lead to a negative effect on equities around the globe. With the global economy increasingly dependent on Chinese growth, investors are afraid a sharp downturn in the Chinese stock market will knock that critical economy flat on its back. This, in turn, would hurt United States, European, and Asian multinational companies, which are increasingly dependent on Chinese sales for growth.

While the current Chinese sell-off will likely spark some healthy short-term profit taking in global markets, we doubt the ramifications will be more severe. Standard & Poor's expects the Chinese economy, which grew 11.1% in the first quarter, to remain strong as momentum builds leading up to the 2008 Summer Olympics.

In addition, with an average annual income of only $1,500 for the typical person, consumption is not the primary catalyst for Chinese economic growth. Rather, growth is driven by export manufacturing, lessening the economy's vulnerability to a stock market downturn. Lastly, reflecting the infancy of China's capital market infrastructure, the vast majority of Chinese wealth is invested in banks and real estate, not the stock market.

S&P expects strong exports and ongoing domestic infrastructure expansion to lead to Chinese GDP growth of 10.2% to 10.6% in 2007. As long as China's real economy remains robust, we believe the Chinese sales of global multinationals will remain solid, allowing investors to largely ignore short-term volatility in local, and illiquid, Chinese stock markets. Until the economic data out of Beijing softens, S&P believes China will remain a bullish global equity indicator.

S&P continues to favor equities over fixed income and cash over the coming 12 months. As such, our recommended global asset allocation is 65% stocks, 25% bonds, and 10% cash. More specifically, our 65% equity allocation is made up of 40% domestic and 25% foreign stocks.

Our U.S. allocation includes 34% in large caps (SPY), 4% in mid-caps (MDY), and 2% in small-caps (IJR).

The international allocation includes a 17% weighting in the MSCI EAFE index, comprised of developed overseas markets like Europe, Australia, and Hong Kong (EFA), a 5% emerging market weighting (EEM), and a 3% allocation to Japan (EWJ), reflecting the diversification benefits of its low 0.29 correlation with the S&P 500.

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