By Natsuko Waki
LONDON, Aug 14 (Reuters) - Investors are torn between hopes China will help to pull the world economy out of recession and worries about a major correction in its red-hot stocks, stirring volatility in a market during the holiday season.
Comments from various policymakers at Wednesday's Federal Reserve conference in Jackson Hole, Wyoming, will be crucial in highlighting divergent central bank responses to the improved global outlook, which gives trading opportunities.
While world stocks sped to a 10-month high on Friday, Chinese benchmark stocks slid 3 percent to a six-week low, posting their biggest weekly drop in five months. The fall follows a whopping 86 percent rally since January pushed valuations to their highest in more than a year.
"It's a bit alarming because it is going in the opposite direction of other markets. China was a lead indicator of the credit crunch when its shares came off in early 2008," said Nigel Rendell, strategist at Royal Bank of Canada.
"With China, so much of the good news has already been priced in. The government has already thrown massive amounts of money at the economy and there's not much left it can do to boost the economy other than wait for a demand pick-up in the rest of the world ... The risk is on the downside."
Thomson Reuters data shows that the price to earnings ratio on Shanghai stocks nearly doubled to 28 times since the start of the year. This compares with the P/E ratio of 15.7 times in the S&P 500 index.
According to Rathbones, return on equity -- a measure of a firm's profitability based on profits generated with the money shareholders have invested -- is about 5.6 percent in China.
This compares with 12 percent in the rest of the world and stems from the fact that Chinese companies typically produce high volume, low value-added products for export, the UK-based investment manager said.
BNP Paribas says the forward curve on Wall Street's fear gauge Volatility Index has recently steepened, suggesting that market participants are expecting volatility to rise.
The last time the VIX index developed a positive slope similar to now was back in August 2008, just before equities came under selling pressure.
FX ADJUSTMENT
Exchange rates in China may also be playing into an asset boom. According to Credit Suisse, the yuan currency is 44 percent undervalued on a purchasing power parity basis estimated by the International Monetary Fund.
"At some point the exchange rate will rise and that will benefit the consumer plays by helping consumers' purchasing power and hurt exporters," the Swiss bank said in a note to clients.
China's infrastructure spending and excess liquidity, measured by M1 money supply minus industrial production, are at all-time highs, it said. "There is clearly an extraordinary degree of fiscal and monetary boost in China ... Excess liquidity is likely to lead to speculative bubbles. This is especially the case in Hong Kong and China."
"In order to prevent an asset bubble from forming, we think the authorities would have to allow exchange rates to appreciate in real terms and, in particular, they would have to let the renminbi (yuan) break free from the U.S. dollar."
Non-Japan Asia is still one of Credit Suisise's top investment ideas and the bank does not believe China would tighten policy aggressively until inflation emerges.
DIVERGENT RESPONSES
Another focus next week is the Jackson Hole conference of central bankers. The Fed said earlier this week it would slowly phase out a programme of buying $300 billion in longer-term Treasuries, introduced in March, by the end of October.
Central banks, faced with different stages of economic and financial stabilisation, are not taking a uniform approach to exit strategies.
The Bank of England stunned markets last week by expanding its quantitative easing plan to 175 billion pounds while the Bank of Israel has become the first central bank to announce the end of unorthodox monetary easing by ending the bond and FX buying programme over the past few weeks.
"Central bank response functions will be varied. The global recession did not strike all economies the same way, and we expect this will become increasingly clear in the recovery phase," said Sophia Drossos, currency strategist at Morgan Stanley, in a note to clients.
Norway and Australia have already been hinting at raising interest rates, whereas New Zealand could still ease policy, she said. Drossos favours selling sterling following the recent BoE's expansion of its quantitative policy while she likes to buy the Norwegian crown. (Additional reporting by Sebastian Tong; editing by David Stamp)