Although Chinese GDP growth broadly held steady at the 6.5 -7% level in 2015, the real economy paints a much weaker picture as various indicators have pointed to increasing sluggishness. Despite this, China’s A-share market, fuelled by record margin lending and expectations of continued support by the Chinese government, saw an extraordinary run-up that began in Q4 2014 and culminated in a spectacular collapse in share prices halfway through 2015 as the unwinding of these margin trades sparked a heavy sell-off.
Back in May, we wrote about our concerns over unsustainable valuations in Chinese A-share markets and discussed our thoughts on navigating volatile markets amidst a slowing economy. We have always maintained the view that there continue to be long-term, bottom-up opportunities in China, as reflected in our investment strategy.
China’s two-speed economy
Although recent data for China have been soft, the services sector of the economy is generally in far better health but the pick-up is not sufficient to offset the slowdown in the manufacturing sector. Consumer demand has been hit hard by the anti-corruption campaign, across luxury and even consumer staple products, and for both local and multinational players. The pace of fixed-asset investments, which previously functioned as a counter-cyclical tool, has also shown signs of deceleration on the back of slower property starts and a lack of incentives for local governments to do fiscal stimulus.
Figure 1: China Industrial Output, Investment and Retail Sales – % YoY
Source: MSCI, IBES, Rimes, Morgan Stanley Research, October 2015
Perhaps one of the most relevant divergences, at least for investors, has been the differing fortunes of the private sector and state-owned enterprises (SOEs). The former have seen growing sales and net profits, with a notable example being some of the large players in the internet sector, while SOEs such as banks, industrial companies and oil companies have seen declining profits on the back of weak economies and commodity prices.
The private sector/SOE divide is set against the broader divergence between the manufacturing and services sector in China (i.e. the secondary and tertiary industries respectively, illustrated in figure 2). Continued weakness in manufacturing data for China has persisted but the consumer services sector maintains a healthy rate of growth, incrementally making up a larger share of GDP growth. This is part of a long-term transition that many feel is necessary for the Chinese economy to obtain sustainable growth.
Figure 2: China GDP composition – Tertiary Industry versus Secondary Industry
Source: NBS, JP Morgan, November 2015
Mixed record on reforms
Reform and restructuring have long been heralded as the key for the Chinese government to enhance corporate efficiency and optimise resource allocation. However, the reform initiatives have so far disappointed, especially amongst big SOEs. In contrast, some progress has been made amongst smaller SOEs given a higher level of flexibility to change and reform. Going into 2016, the government is likely to further encourage overseas mergers and acquisitions, especially in the much-needed technology sector. However, some of these deals may not enhance earnings and require close monitoring.
Continued liberalisation of financial markets
Where we have seen the greatest progress has been in financial market liberalisation. The renminbi’s (RMB) recent inclusion in the Special Drawing Rights (SDR) basket is a notable milestone for the RMB’s internationalisation.
Furthermore, the continued liberalisation of the stockmarkets, first through the Shanghai-Hong Kong Stock Connect and to be followed by a similar upcoming scheme for Shenzhen, should open up further opportunities in the investable China stock universe. In addition, index provider MSCI’s recent inclusion of the China-based ADRs (US-listed) companies to its MSCI China and MSCI Emerging Markets indices, due to be completed by May/June next year, should have a more profound impact on the development of China’s market. This rebalancing will also better reflect the reality of China’s ‘new economy’, where education, internet, e-commerce, travel and consumer names are all playing a larger part in growth.
Valuations see bad news priced in
Valuations in Chinese markets, as represented by the MSCI China index, are trading at levels seen in the past few crises, including the Global Financial Crisis in 2008, with the trailing price-to-book (PB) ratio close to 1.1x. We believe a lot of the bad news has already been reflected in share prices. Market liquidity should remain supportive as the deflationary environment allows for further monetary stimulus measures such as RRR/interest rate cuts.
Figure 3: MSCI China valuation in terms of P/B
Source: Datastream and Citi Research, September 2015
Potential risks for Greater China markets?
The potential risks for China include policy mistakes by the Chinese government, earnings risks for corporates on the back of weak top line growth in a deflationary environment and a further increase in non-performing loans (NPLs) in the banking system. Although restructuring may continue to exert pressure on the economy in the near term, we do not foresee a major systemic collapse in the financial system.
Another key risk for the China/Hong Kong market will be the US Federal Reserve’s timetable for interest rate hikes, while the unwinding of the US dollar carry trade will dampen investor risk appetite and put pressure on Asian markets.
As for Taiwan, the political headwinds of a presidential election scheduled for next year, where the opposition Democratic Progressive Party (DPP) is expected to win, could cause uncertainty to the cross-strait dialogues given the party’s less engaging relationship with Beijing. Currently, the market has probably priced in a relatively pragmatic approach of the DPP towards China.
Where do we see opportunities?
Against the market backdrop of sluggish economic growth and anaemic earnings, the importance of bottom-up stock selection becomes even more imperative. We remain focused on investing in companies that have sustainable business models and strong cash flows.
China – maintain overweight in consumption/service stocks
We continue to be overweight in the consumer/service sectors including internet, tourism and education on the back of our positive long-term outlook for consumption demand in China. We have also selectively invested in companies that can benefit from supportive government policies, including railway equipment, environmental protection and renewable/alternative energy stocks. On the other hand, we continue to remain cautious of the banking sector given the rising asset quality risk and declining net interest margins. Meanwhile, we are broadly underweight oil and commodities stocks.
Hong Kong – favour more traditional Hong Kong names
The sluggish Chinese economy and the continued drop in tourists from mainland China is having a knock-on impact on Hong Kong retail sales that has been a key driver for Hong Kong economic growth in the past few years. Despite the more subdued outlook for the local economy in the near term, we continue to see good value in more domestic names including commercial property investors, diversified regional and global conglomerates, regional insurers and selective manufacturing exporters, on a longer-term view. Balance sheets are typically very conservative, franchises robust, dividends supportive and management quality is well known to investors.
Taiwan –political headwinds and the technology product cycle
After a major earnings upgrade in 2014 led by Apple’s iPhone 6 new product cycle, we are struggling to see another visible catalyst to drive the re-rating of the technology sector, especially after the lukewarm reception to the iPhone 6S. Looking ahead, the prospects of old economy stocks (such as materials and banks) remain lacklustre where selective technology companies and telcos still offer investors with attractive valuations and decent dividend support.
China A-shares – slowly bottom fishing
China’s A-share market has witnessed a major short-term correction, as expected in Q3 2015. The market is expected to range-trade in the near term as liquidity remains buoyant and margin positions have declined to a more reasonable level. Although market upside is capped by the government stock overhang, some of the better quality names have become more attractive after the recent correction whilst valuations of many small/mid cap stocks remain excessive. Within our broad Greater China strategy, we took profit in most A-shares in Q2 and will selectively buy into this market on further weakness.
Past performance is not a guide to future performance.