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China Mapping the Recovery in 2009-10 Japan High Cash, Low Leverage: A Macro/Quant/Micro Approach View GEF Archive

		The Global Economics Team

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Recent data indicate improvement, or ‘less-bad’ developments, in the underlying economic situation, raising hopes that China’s economy may have begun to recover. Many wonder what the potential recovery path in China will look like over 2009-10. In this context, the recent strong rally of China’s onshore A-share market has been interpreted by some market observers as leading signs that an economic recovery is underway.

V-Shaped and W-Shaped Recovery in 2009

Our assessment of China’s economic outlook remains unchanged, with GDP growth forecast at 5.5% for 2009 (see China Economics: 2009 Outlook Downgrade: Getting Much Worse Before Getting Better, January 18, 2009). Moreover, we expect the economy to get worse before getting better, with a V-shaped recovery over the course of 2009: after the sharp deceleration in 3Q-4Q08, the headline year-on-year GDP growth rate is expected to drop further and stay low in 1Q and 2Q before staging a rebound in 2H09.

However, in terms of sequential quarter-on-quarter growth, we think the economy will likely demonstrate a W-shaped recovery during 2009. GDP growth started to decline in 3Q08 and bottomed in 4Q after a hard-landing of the industrial sectors. We expect the economy to register rather strong positive growth in 1Q09, as de-stocking runs its course and trade finance normalizes to some extent. However, sequential growth should moderate again in 2Q09 after the technical rebound in 1Q, as the headwinds facing the economy likely remain strong. We envisage growth to accelerate in 3Q and 4Q09, as the effect of policy stimulus kicks in and G3 economic growth bottoms in 3Q and makes a tepid recovery in 4Q.

At least two fundamental factors lead us to attach a high probability to the economy picking up in 2H09. First, we expect the effect of the aggressive policy stimulus to start showing up as an improvement in indicators of real economic activity by mid-year. Bank lending – a key gauge of the strength of policy responses, be they fiscal or monetary – accelerated sharply in November 2008 to January 2009, after the administrative bank lending quota was abolished and the authorities called on the banks to support the government’s effort to revive the economy. It is highly likely that strong loan growth may be continuing in February 2009.

While we do not expect the rapid loan growth of as high as over 20%Y to be sustainable throughout the year, it is quite possible that loan growth will remain very strong, in the range of 15-17%, through year-end (see China Economics: Recent Rapid Bank Credit Expansion Not Sustainable, February 1, 2009 and China Data Releases: Loan Explosion in January Unlikely to Sustain, February 11, 2009). Past experience indicates that bank lending tends to lead investment by five to seven months, suggesting that it takes time for easy credit conditions to translate into an improvement in real economic activity.

Second, our global economics team expects the growth rate of G3 economies to bottom in 3Q09 and show a tepid recovery in 4Q09. Stabilization and improvement in the external environment would help to boost confidence and bode well for a potential recovery in China’s export growth in 2H09. At the current juncture, a clear sense of where the bottom is in the G3 economies is critical in restoring confidence, helping to revive private investment, and even emboldening the policymakers to take stronger policy action, if warranted, to address near-term weakness.

Recovery in 2010 and Beyond

We think that the aggressive policy response by the Chinese authorities will bring about a meaningful rebound in activity by mid-year; however, the strength and sustainability of this rebound will hinge on a potential recovery in the G3 economies. If recovery in the G3 economies were to fail to materialize, China’s growth rebound would likely be unsustainable through 2010, without substantial augmentation of the existing policy stimulus package.

Entering 2010, we expect growth momentum to moderate, as the impact of policy stimulus will likely diminish in 1H10. The subsequent growth in 2H10 will primarily be underpinned by improved external demand, as the G3 economies recover toward their trendline growth rates. We forecast 8% GDP growth in 2010. Specifically, we expect the year-on-year GDP growth rate to start to moderate – after peaking in 4Q09 – over the course of 2010 towards the 6-7%Y range by end-2010. We see this as likely being the sustainable growth rate for China over the next decade, after the global economy in 2010 pulls itself out of what is potentially the deepest recession since WWII. The deceleration in growth rates over the course of 2010 should reflect the recovery in exports and private investment being partly offset by a smaller fiscal policy stimulus.

We remain structurally positive on the Chinese economy over the long run. We believe that the four key secular themes – urbanization, industrialization, globalization and market-oriented economic liberalization – should continue to underpin relatively strong growth compared with the rest of the world in the long run. And the relative strength of the balance sheet of the economy (e.g., government, banking system, households) should help to cushion the impact of the financial turmoil in the short run (see China Economics: Unscathed from Crisis; Not Immune to Downturn, October 6, 2008).

However, at the current juncture, there is tremendous uncertainty about the outlook for 2010 for the global economy in general and the Chinese economy in particular.

Downside Risks: Short-Run Capacity Retrenchment and Long-Run Structurally Lower Growth

A prolonged global economic recession due to aggressive deleveraging by consumers in major industrialized economies could fundamentally jeopardize China’s investment- and export-led growth model, entailing capacity retrenchment and perpetuating a private capex shortfall.

First, it is still uncertain whether the G3 economies can successfully stage a decent recovery toward their trendline growth in 2010, as envisaged under our baseline scenario for the global economy. Richard Berner, our US Chief Economist, highlighted this risk recently by noting that, under an ‘ugly’ scenario, if the US fiscal policy response were to fail to get traction and negate the headwinds of recession, US GDP may well register no growth in 2010 (see US Economics: Policy Traction: The Key to Recovery, February 17, 2009).

Second, in the event that the G3 economies were to fail to recover in 2010, this would require an even stronger fiscal policy response from China, if the objective were to deliver 7-8% growth per annum. For instance, if the fiscal deficit in 2009 were to be 3% of GDP, the size of the fiscal stimulus would also need to be 3% of GDP, given a nearly balanced budget position in 2008. However, if the same size of fiscal stimulus were to be delivered in 2010, this would entail a fiscal deficit of about 6% of GDP, in our view. At some point, the authorities would have to weigh the benefits of propping up growth through public spending against the attendant fiscal and efficiency costs.

The authorities have in fact already started to take action in anticipation of the persistent weakness in external demand that is bound to exacerbate the overcapacity problem in domestic production. They announced in recent weeks ‘rejuvenation plans’ for ten industries. We believe that the key purpose of these industrial ‘rejuvenation plans’ is to achieve a government-directed production capacity retrenchment with a view to facilitating a speedy exit of smaller and inefficient enterprises and consolidate the position of industrial leaders.

Beyond the near term and to the extent that China is able to successfully rebalance its economy by transforming its growth model from investment- and export-led to consumption-led, which entails structural reforms that can help lower households’ saving ratio (e.g., a well-established social safety net), the sustainable growth rate will likely be structurally lower, as suggested by cross-country development experience. This is in part because the supply-side structure of a consumption-driven economy is unlikely to be able to generate productivity growth as fast as that of an export- and investment-driven economy in the long run, in our view.

Upside Risk: A Goldilocks Recovery Scenario?

The recent surge in bank lending growth and the strong rally of the onshore A-share market have made many market observers wonder whether the Chinese authorities are not taking a rather unorthodox approach in managing the economic downturn – boosting the real economy through reflating the stock market first. Indeed, some pundits have been calling on the Chinese government to take this route, as they argue that the lack of confidence has been the key reason for the sharp slowdown in the Chinese economy and boosting the stock market should be an easy way to shore up confidence and improve sentiment, providing a quick fix for potential social discontent amid a serious economic downturn. Similar arguments have been made for more aggressive policy efforts to support the property market.

In this context, a Goldilocks recovery scenario that is being contemplated by some market observers would feature a series of positive catalysts, such as: 1) a technical rebound in growth as de-stocking runs its course and trade finance normalizes somewhat in 1Q09; 2) on the back of a policy-induced, liquidity-driven stock market rally (despite weakening fundamentals), the confidence of consumers and private investors is boosted despite job losses and slower sales/income growth, thus preventing too rapid a slowdown in consumption and private investment in late 1Q and 2Q09; 3) the effect of fiscal stimulus starts to show in a major pick-up in public investment growth in late 2Q or early 3Q09; and 4) the G3 economies bottom and stage a tepid recovery in 4Q09, improving external demand and further boosting confidence.

While we attach a low probability to this ‘everything-goes-exactly-right’ scenario, we cannot dismiss it entirely. This is possible, if the authorities, who still have powerful and pervasive influence over the business community (including in particular the banking sector), decide to leverage the strong ‘balance sheet’ of the economy for temporary gains in the ‘income statement’, regardless of the potentially high costs to the economy in the longer run. If this scenario were to materialize, the ‘getting-worse’ leg under our baseline recovery scenario would not be as deep as we envisage, and thus the average GDP growth rate in 2009 could be higher than 5.5%.

Implications: China to Be Among First to Recover

Aggressive policy stimulus is expected to bring about a GDP growth recovery in 2H09, likely making China among the first to emerge from the global downturn. While the policy stimulus can help to bring about a rebound in headline GDP growth and may even prevent a sharp rise in the unemployment rate, it will not be able to deliver corporate earnings growth nearly as strong as when the same level of headline GDP growth is fueled by buoyant private sector spending. This would be a relatively ‘job-rich’ but ‘profit-deficient’ macro environment, with sectors/companies exposed to government-supported capex programs most likely being able to outperform.

Japan
High Cash, Low Leverage: A Macro/Quant/Micro Approach
February 25, 2009

By Robert Alan Feldman, Ph.D. | Tokyo

Introduction

Macro prospects are bleak (see Takehiro Sato’s Capex Recession: Deep V, but Not Extended L, January 13, 2009; Takeshi Yamaguchi’s Lowering Base-Case Outlook to the 1998 Post-War Nadir, December 10, 2008; and Japan in 2013: Winners and Potential Winners by Robert Feldman, Naoki Kamiyama and Takehiro Sato, September 26, 2008). Policy visibility is near-zero (see Politics and Policy in 2009: Caught in the CRIC, January 7, 2009). Risk-aversion is intense. Under these circumstances, investors are naturally searching for investment ideas that are less vulnerable to a serious recession.

This paper proposes a method for screening 3,367 listed companies for those that are less vulnerable, and uses macro profit forecasts to stress-test which companies may remain less vulnerable. Depending on the screening criteria, the number of firms in the resulting list can be as high as 79. An overlay of analyst ratings results in a final list of 22 companies.

The Method

The method for identifying less-vulnerable firms is simple: companies can be categorized on the basis of their combination of leverage and cash levels. The reason for using leverage is straightforward: the lower liabilities are relative to equity, the less likely firms are to fall prey to credit cut-off from lenders.

For the cash ratio, however, the simple ratio of cash to assets is not so relevant. Under current circumstances, with sales dropping quickly, the question is how much cash firms have relative to sales. In the most extreme interpretation, the cash/sales ratio shows how long the firm can survive (at a given level of costs) if sales were to dry up. For example, a cash/sales ratio of 20% means that a firm has 20% of annual sales, or about 73 days of sales, in cash on the balance sheet.

Some classifications of companies by these criteria are given in the full report. The standards for drawing lines are necessarily arbitrary, but nevertheless defensible. We use three standards, a ‘harsh’ set, a ‘strict’ set, and a ‘MoF Average’ set. In addition, to ensure sufficient liquidity of selected companies, we imposed a criterion of market capitalization exceeding JPY100 billion.

The ‘harsh’ criteria are i) a cash/sales ratio of 20% or more, and ii) a leverage ratio of 0.5x or less. As of results for fiscal years ending in 2008, there were 42 large-cap firms that meet both criteria. The ‘strict’ criteria are i) a cash/sales ratio of 15% or more, and ii) a leverage ratio of 1x or less. In the sample, there are 79 large-cap firms. The ‘MoF Average’ criteria are i) a cash/sales ratio of 9.8% or more, and ii) a leverage ratio of 1.8x or less. These levels came from the averages of firms included in the Ministry of Finance Corporate Statistics. In the sample, there are 151 such large-cap firms.

Are Less-Vulnerable Firms Outperformers?

The next question is whether selected firms actually outperform the market. Stress-testing this concept during earlier times of financial system stress suggests that the answer is mostly yes, with a few qualifications.

We illustrate that portfolios based on all three sets of criteria would have outperformed TOPIX in two periods of credit crunch, 1997-98 and 2008-09. During the collapse of the tech bubble, however, which also had credit crunch aspects, two of the three would have slightly underperformed, while the strict criteria portfolio would have been virtually identical with the market.

Another question is whether some types of less-vulnerable portfolios outperformed other types of less-vulnerable portfolios. Our finding suggests that there is no clear evidence that the harsh criteria portfolios outperformed either the strict or the MoF Average criteria portfolios on a consistent basis. Thus, restricting the sample to the most harsh criteria may not be the best screening technique, even though some screening appears to help in credit crunch periods. This result warns us to define ‘less-vulnerable’ by more than just cash-sales and leverage ratios.

Today’s Less-Vulnerable Portfolio

The less-vulnerable portfolios of today are not the same as those of yesterday, and those of tomorrow may not be the same as those of today. Hence, to see which firms are likely to remain less vulnerable, we have taken the Morgan Stanley macro profit forecasts of -60% for both F3/09 and F3/10, and mechanically reduced the cash ratios of all 3,367 firms in the sample by corresponding amounts.

To do this, we reduced sales across the board by about 3.5% and 1.4%, respectively, and deducted these amounts for each firm from recurring profits, cumulatively in 2009 and 2010. We then deducted identical amounts from cash balances, and recalculated the cash ratios, using the mechanically projected sales figures in the denominators. We also presumed that the leverage ratios were unchanged – i.e., that the firms funded shortfalls entirely out of cash, and that the shrinkage of the balance sheet was offset by realizing gains on undervalued assets elsewhere on the balance sheet.

With these calculations done, it is possible to create a set of less-vulnerable firms based on projected cash/sales ratios and leverage for 2010. There are 33 large-cap firms that meet the harsh criteria, based on the projected values for 2010. So far in the equity price collapse since July 2008, this group has outperformed the market, by 5.8%. There are 56 firms that meet the strict criteria in 2010, and this group has outperformed the market by about 6.0%. Results are a touch better for the 79 MoF Average firms, which outperformed by 6.8%.

For a list of the firms included in these screens at each level of criteria, see Appendix Table 1 in the full report.

Piecewise Sector Selection of Less Vulnerables

A final exercise is to look at a sector-balanced selection of less-vulnerable stocks. After all, sectors with high volatility of sales or high development costs (e.g., video game makers, pharmaceutical producers) naturally have higher cash ratios than sectors with stable sales or low development costs (e.g., food retailers).

To investigate whether sector-balanced selection of less vulnerables yields a better result, we adapted the cash ratio criterion to each sector. ‘Sector’ is defined here by using the two-digit Nikkei sector classifications, yielding 32 non-financial sectors. Focusing on the ‘strict’ criteria, instead of using a uniform sales/cash ratio of 15%, we used 0.5 standard deviations above the sector average cash/sales ratio, with a 1% sample trim to exclude outliers.

Results show that the sector-balanced portfolio of 38 large-cap firms outperformed TOPIX by 10.43% during the June 2008 to January 2009 period. Thus, there may be extra value in a sector-balanced approach to high-cash, low-leverage screening.

The firms selected by the sector-balanced screen are presented in Appendix Table 2 in the full report.

Bottom-Up versus Top-Down

Of course, a portfolio based on mechanical screening criteria must be checked by investors for the many other factors that determine stock prices. Indeed, on the two portfolio lists in Appendix Tables 1 and 2 in the full report, there are several stocks that are rated Underweight by Morgan Stanley analysts. Our analysis gives a list of the 22 firms that are i) in the high-cash, low-leverage porfolios (either uniform-criteria using MoF Averages or sector-balanced criteria using strict criteria), and ii) rated either Overweight or Equal-weight by Morgan Stanley analysts.

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