Chinese Stocks Look Ready to Rally

Chinese stock valuations have tumbled to a record low compared with those in Hong Kong, a sign to investors that mainland equities are poised to rally even as the government cracks down on inflation. The MSCI China Index began its retreat on Nov. 8, after the country's policymakers stepped up efforts to reduce inflation by raising interest rates on Oct. 19. Its ensuing 9.4 percent slump leaves the index trading at 11.6 times estimated profit for 2011, data compiled by Bloomberg show. The MSCI Hong Kong Index, meanwhile, rallied 26 percent between July and December, beating China shares by the most in nine years and pushing its valuation to 17.5 times earnings, the highest ever compared with shares on the mainland.

Prudential Financial (PRU) and USAA Investment Management say the gap will close because China's economic growth may average 9.6 percent over the next two years, double the International Monetary Fund's forecasted average global growth of 4.4 percent for 2010 and 4.5 percent for 2011. Premium valuations in Hong Kong stocks, which are the route into China for most investors, signal that seven government-ordered increases in bank reserves and two interest rate boosts since the start of 2010 won't derail growth, they say. "Things will be all right even as China takes steps to tighten," says John Praveen, the Newark (N.J.)-based chief investment strategist at Prudential International Investments Advisers. "Chinese growth will still be good."

While the pace of China's growth will slow in the next five years, its economy need not contract, says Aaron Gurwitz, chief investment officer at Barclays Wealth and a bull on Asian stocks. The global recovery is boosting demand for Chinese goods even as the nation takes steps to cool expansion in what likely became the world's second-largest economy last year. China's exports to the U.S. totaled $283.3 billion in 2010, according to customs bureau figures released on Jan. 10. Gross domestic product in the U.S. grew at a 3.2 percent annual rate in the fourth quarter, up from 2.6 percent during the previous three months, the Commerce Dept. said on Jan. 28.

The last time Chinese stocks were this cheap relative to Hong Kong's, in June 2004, the MSCI China Index was almost two months into a 3 1/2-year bull market. Index valuations increased fivefold, and the earnings multiple climbed to 31 from 12.5, data compiled by Bloomberg show. At the time, the U.S. Federal Reserve was preparing to raise interest rates from 1 percent, a record low until policymakers cut their target for overnight loans between banks to near zero at the end of 2008.

Despite that history, many investors are wary. Global investors are bracing for a financial crisis in China, with 45 percent saying they expect one within five years and another 40 percent anticipating a meltdown after 2016, according to a quarterly Bloomberg Global Poll of 1,000 Bloomberg customers who are investors, traders, or analysts. "Chinese stocks look very cheap," says Terrace Chum, the Hong Kong-based managing director of greater China equities for Manulife Asset Management, which oversees $118 billion. "But no one wants to be the first to get in."

Chum won't jump in without a better feel for inflation in China. China's statistics bureau reported consumer prices rose 5.1 percent in November, the fastest pace in 28 months. "The test Chinese policymakers face is probably a little tough," says Madelynn Matlock, who helps oversee $13.8 billion at Huntington Asset Advisers in Cincinnati. "They have to find a way to keep the economy growing without overheating. The good news is they've done a good job so far."

The bottom line: China stocks are at a record low vs. Hong Kong's. Concerns over a Chinese financial crisis are keeping investors on the sidelines.

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