Geoff Cutmore - Morning Thoughts

Eyes East: It Is the Risk Trade for a Reason

Geoff Cutmore

I'm just back from China. We spent a week shooting interviews with the heads of some of the largest listed Chinese companies. All of this was against the backdrop of the World Economic Forum event in Dalian, the northeastern coastal resort city. A great chance to get among the business community and get a feel for the strength of underlying profit growth.

Two observations that make me slightly concerned:

1. There appears to be a strong and growing belief among both Chinese and Western business groups that China can soldier on almost untouched by a slowing U.S. economy. Market analysts describe this as decoupling and it is becoming consensus at a very quick clip.

2. And therefore, goes the argument, the Chinese economy has now achieved some advanced stage of maturity where growth is becoming self-generating and the landmines of soaring CPI, slowing FDI and domestic misallocation of capital will not blow the economy off its current growth course.

Frankly, I remain unconvinced. In conversation with the most dynamic CEOs that china has to offer I was beginning to suspect they were starting to believe the hype. But there are some niggling red flags.

Profitability at most very large companies remains behind its Western peers and, in fact, tends to be very small in relation to market cap. A bull market can do that to you, and companies focused on revenue growth don't always work too hard on containing costs, both arguments I accept, but strong domestic competition in most sectors is stifling revenue growth.

Look at the last retail data from china. The number was up, but on prices, not volume.

The optimists continue to point to the wealth being created in China and, as it happens, across Asia for support for the decoupling proposition. I don't believe there is a broad enough spread of wealth yet to replace the Western consumer.

Just a couple more thoughts. The major government-owned banks may have reclassified their NPL's and shifted them off the books, been streamlined for IPO and have Western banks as advisors, but the revelation of more that $11 billion worth of U.S. subprime exposure across China's top three tells me they still need to work on their lending practices.

Finally, if we're going to have a full-blown cleanout in Western credit markets, let's get on with it. We have deep rooted institutions, well established capital markets and central banks that can quickly adjust the credit conditions.

Can the same be confidently said for China or most Asian economies? The 1998 Asian crisis took years to bounce back from. Will we get a variation on a theme if Western export markets close?

The same analysts lauding decoupling were probably lauding the investment case for globalization in previous years. So if it's now a globalized economy, we are all much more integrated in the global economic system - -and as we know any system is only as strong as its weakest link.

By all means worry about the drip-drip of bad news from hedge funds and subprime lenders in the west, but keep a weathered eye eastwards. 

Top thought from last two guest hosts , Steen Jakobson and Nigel Bolton, has really been don't buy equity yet, it could still get cheaper.

Feedback welcome - here.