Investment Review №327. The soft power of the Federal Reserve

During the height of the trade war, I often discussed the repercussions for the U.S. economy and stock market, while the Chinese market received very little attention. However, in the July-August period, Chinese stocks experienced gains alongside rising Treasury yields, driven by a more conciliatory U.S.-China tariff discourse and governmental measures to curb excessive price dumping. Over recent years, there has been an increasing trend of households opting for time deposits. Yet, with interest rate cuts, including a target of approximately 1.25% for 3-year deposits in the first half of 2025, there is potential for a shift from redeemable deposits to the stock market. This shift could bolster China’s stock market and help address the valuation discount that Chinese stocks have faced over the past decade. Despite a recovery over the past 18 months, stocks remain below their 10-year average valuations. High-frequency data for July and August seem stable, and a low base effect is improving year-over-year performance. For example, containerized shipments suggest stable exports, supporting economic growth. Government debt issuance and the status of interbank liquidity confirm the softness in fiscal and monetary policies, while persistent weaknesses in the real estate sector and high youth unemployment (nearly 18%, presenting a significant social issue) create an asymmetric risk profile.

Given this context, it is logical for investors to form their exposure to Chinese assets, focusing on leading companies in the internet and AI ecosystems alongside EV manufacturers that are poised to benefit from stabilizing long-term interest rates and available liquidity. We recommend Alibaba (BABA) for its platform scale and cloud services offering operational leverage amidst normalizing competitive pricing; PDD Holdings (PDD) for its high efficiency and international expansion in Europe and other countries, bolstering growth; Baidu (BIDU) where AI and cloud infrastructure increase “duration” and sensitivity to discount rate cuts; NIO (NIO) with its refreshed model lineup and focus on unit economics aiming to support gross margins; XPeng (XPEV), with advancements in autonomous functions and partnerships adding revenue streams beyond vehicle sales. This mix strikes a balance between consumer and technological drivers, focuses on scalable models and free cash flow, and remains selectively sensitive to interest rates. This approach is not ideal, and it carries inherent risks related to regulatory pricing policies, lending pace, geopolitical issues, and the RMB exchange rate. Nonetheless, for investors seeking opportunities outside the U.S. and aiming to participate in the growth of major technology companies on a global scale, China presents a compelling risk-return proposition.