Bursting the China Bubble, Not so Easy

by Joshua Enomoto, Founder of ContangoDown.com and CrushTheStreet.com Contributor

For several years now, we have been warned about the greatest real estate bubble in modern history brewing within the vast borders of China: it was in May of 2005 when Bloomberg BusinessWeek posted an article regarding the rocketing prices of the housing market in Shanghai, the most populous city in the world. Of course, much of the warning signs were pushed aside back then when America itself was undergoing its own housing bonanza.

Fast forward to the Great Recession, shortly following the bursting of the American real estate and stock market bubbles, and we began to see a far more pessimistic tone towards Chinese real estate, and for that matter, their overall economy. Nowadays, it’s not uncommon to see financial headlines such as this one offered from Business Insider (Jan 13, 2010) : “Why Shanghai Real Estate is the Most Obvious Bubble Ever.” The article is an interesting one, which covers the suspected bubble from multiple perspectives, including income disparity, investor psychology, demographic trends and an emphasis of quantity over quality, to name but a few.

However, despite the impending bearishness that many analysts are warning about, the simple reality is that the notorious bubble hast yet to burst and some are beginning to question why that is. One factor that is unique to China’s economy as compared to its Western counterparts is the existence of a “gray market” in salaries: when one looks at the official income statistics, it is unrealistically low across the board, considering the enormous growth that China has seen over the last several years. The disparity, according to Professor Wang Xiaolu of the China Reform Foundation, can be attributed to unreported earnings, of which the professor claims a total amount of $1.5 trillion dollars worth.

Gray income (07172013) A

Such a revelation, if true, certainly paints a different context of the so-called China bubble. Another element that is often left out is that Chinese property owners do not have to pay annual property taxes, thus freeing up more capital. The average consumer in the Asian giant is likely more robust than was previously given credit to.  
However, we also don’t want to get too carried away: using Professor Xiaolu’s adjustment for unreported income, he discovered that the income disparity between the rich and poor widened to nearly 200% as opposed to using the official reported income statistics. Further, there is no guarantee that China introducing new tax laws to grab more of the income-pie will be successful. If anything, the lack of transparency in even the most basic information is a cause for serious concern.  
What do the technicals tell us about the state of investing for China? For this, I would like to review the 3-year weekly chart for the iShares FTSE China Index Fund:

FXI (07172013) B

Often considered the jewel of the emerging markets, China suffered heavily a few months ago in conjunction with their fellow developing nations, such as Brazil. Coincidentally, this downleg occurred after the technicals charted a bearish head-and-shoulders formation. Since the beginning of this year, momentum began to reverse, another clue that volatility was in store. While the current price action is beginning to show signs of a recovery, and could very well move even higher from here, FXI will meet strong resistance at $40. This is where a declining level of resistance has formed and the fund will have its work cut out for it.
Why this is has to do with the state of the American economy: as investors surely know by now, the bond market has been in free-fall, with interest rates rising over 30% year-to-date. With the S&P futures also rising, the market has turned in favor of cyclical names, such as consumer goods and services. This is indicative of rising consumer sentiment, which is confirmed by the Consumer Board, which studies the metrics of purchasing behaviors of Americans. Logically, this is also another clue that the economy is improving and while rates may be getting ahead of itself, the long-term trajectory of both the interest and the dollar is up.
The return of the American consumer will allow more economic activity to be centered back towards the United States: for several years, emerging markets such as China have engaged in a zero-sum game of deliberate currency manipulation (any cursory look at the Yuan index can tell you that), which resulted in a net positive for China and a net negative for the U.S. This manipulation was likely not called out more aggressively for political reasons: the Federal Reserve needed to do its own “adjustments,” thus ensuring a sort-of mutually assured destruction scenario. However, with the final days of quantitative easing ahead of us, the U.S. is positioned in the most advantageous manner (relatively speaking) and its robust infrastructure will be a source of high investment demand, both domestically and internationally. Therefore, both leverage and stability favors American equities, and the long-term trend is likely bearish for China exposure.