StevenThompson38's Investment Weekly - PMI mystery

Equity investors have been very alert recently to the readings of surveys of purchasing managers around the world. This has been a curious change in emphasis away from the usual economic indicators such as unemployment, inflation and retail sales. As far as I’m aware, business surveys in the past were given very little credence by the markets either in bull or bear markets. So why has there been this sudden change in focus? Part of the reason can be put down to an underlying conflict. Traditional economic indicators are ineffective at providing clues about the future intentions of businesses/consumers because economic data are a lagging indicator. This contradicts the function of the stock market as a leading indicator. Some could also argue that investors have lost faith in economists because they failed to adequately warn of the problems that manifested themselves in the great bear market of 2008. However the greatest reason is that equity investors want to hang on to something different because of the failures of the past. Purchasing Manager Indices currently fit the bill because they are relatively timely, they have an element of future expectations and they involve a certain degree of human interaction. However, there is a major flaw with the PMI data from China (which was the first survey of a major economy to show signs of moderating and rising). According to acquaintances I know that work for or own manufacturing businesses in Guangdong, the 700 questionnaires that are sent out each month are skewed towards the electronics industries (which have benefitted the most from re-stocking by their overseas customers). There is also a degree of skepticism about responses from companies that are state-owned or are influenced by the state (which is effectively everyone). Quite often the responses reflect state policy rather than business conditions. Take, for instance, China’s stated policy of stock piling basic raw materials. It has been well known for a while that China has been buying basic metals on spot markets (particularly copper) in recent months as a hedge against future higher prices as the global economy recovers. How much of this stockpiling is reflected in the China PMI survey is unknown. The correlation between <?xml:namespace prefix = st1 />China’s PMI and the Hang Seng Index is quite tight at 0.54, but it gets closer (0.63) if there is a one month lag. This fits with the general view that the PMI offers some sort of lead for Hong Kong equities and that the HS Index is heading for a couple of months of consolidation. A leading indicator for the financial health of a bank is any decision to sell off core parts of its business. Bank of East Asia has always highlighted the strength of its overseas Chinese businesses, particularly those on the west coast of North America. So it came as a real surprise that the bank has decided to sell a majority stake in its Canadian business to state-owned ICBC for US$72 million. This is not a non-core business. BEA set up its Canadian business in 1992 to tap the mass immigration of middle-class Hong Kongers to Vancouver and Toronto ahead of the 1997 changeover. These migrants have firmly settled in Canada and have formed a large pool of banking assets that BEA has gleefully tapped. Why has BEA sold this little gem? It may because of the attitudes of two external agencies. The HKMA, like all regulators, has been getting tough on local banks, urging them to increase their capital ratios. BEA’s Canadian subsidiary had paid up capital of C$58 million and grew its balance sheet 10% in 2008 (compared with a 9% decline in its Hong Kong business). Rating agency, Moody’s, downgraded the outlook for BEA to negative in early March and it downgraded ICBC (Asia)’s outlook to negative due to its relatively low CAR last week, so the pressure is on to avoid a credit rating downgrade at heavily-indebted BEA (the bank has debt of HK$18 billion against equity of HK$58 billion). Selling a majority stake in the Canadian business does two things: it frees capital and brings cash back to its balance sheet. Good news for BEA, but why would ICBC buy this asset? It is almost certain that BEA’s customers (whose mind-set is suspicious towards the Mainland (why would they have immigrated if it wasn’t)) are likely to leave in their droves at the prospect of their money being held at a Mainland controlled bank. There is likely to be massive destruction in the value of the franchise, and the size of the business is so comparatively small, that ICBC would not benefit financially in the short, medium or long term. The only explanation is that BEA needed the money. Countering this is BEA’s decision to buy-out ICBC’s 75% share of local investment bank, ICEA, for US$48 million. However, this business absorbs a lot less capital than an overseas commercial banking subsidiary, so the argument still stands. Investment advice in cases like this is problematic because, although it appears there is an issue, it could be glossed over in a rising market. It is unlikely that BEA’s share price will deviate significantly from the overall market, but I would expect the share price to underperform and would suggest switching out of the stock.