Chinese equities were among the top performers in the 10 months to 31 October 2017, with the MSCI China (offshore) index jumping by more than 48.9% and the MSCI China A (onshore) index returning over 21.9% (both in US dollar terms). Strong earnings upgrades and higher valuations in China were the main driver of this rally.
A stable macroeconomic outlook, improving results from supply-side discipline at Chinese companies, the government’s efforts on de-risking as well as the heightened expectation of a renewed push on reforms by the reshuffled leadership are all brightening the outlook for China over the long term.
Company performance supports Chinese equities
Chinese companies have done well so far this year. In particular, offshore-listed companies enjoyed earnings growth of about 10% year-on-year (YoY) in H1 2017. The energy, information technology, property and materials sectors saw their highest earnings growth since 2010.
Recovering earnings prospects in cyclical sectors could be more sustainable in this cycle due to fewer overcapacity concerns and amid industry consolidation. Improved earnings and cash flow conditions have eased investor concerns about asset quality and bad debt, which, in turn, underpins the earnings outlook for financials in H2 2017 (see Exhibit 1).
We expect global reflation and a domestic cyclical upswing to support further earnings gains.
Exhibit 1: Positive momentum for company earnings in ChinaNote: Earnings momentum = 6-month % change in 12-month forward EPS
Source: MSCI, Thomson Reuters, HSBC, as of 03/10/2017
Despite the rally, global investors seem to be wary of embracing Chinese equities because of concerns over the country’s increasing debt load, capital outflows and potential geopolitical risks. After such outperformance year-to-date, it would be natural to see Chinese equities taking a breather in coming months. However, we believe that Chinese equities are still well worth investors’ consideration as China is currently benefiting from positive structural and cyclical forces.
China’s economy has shown signs of stabilisation in recent years and data points to a more stable outlook. The GDP growth rate was steady at 6.9% YoY in Q2 2017. With the purchasing managers' index (PMI) comfortably above 50 in September, manufacturing activity continues to reflect the strength of China’s manufacturing-led recovery.
Industrial profits accelerated by a sharp 24% YoY in August after a 16.5% YoY spike in July, led by faster producer-price inflation and lower costs. Up by 6.9% YoY in September, producer prices continue to be supported mainly by rising materials prices, which have gaining on the back of solid demand and supply-side measures. Supply-side reforms were more actively initiated in early 2016, with the aim of reducing excess capacity and increasing efficient supply, primarily in the steel and coal sectors.
Supply-side measures appear to be working
A number of measures have helped prices rebound since H2 2016. As the world's largest steel producer, China closed more than 600 steel mills producing low-grade construction steel during H1 2017, cutting capacity by about 120 million tons. The government aims to cut 50 million tons of steel capacity in 2017 (not including low-grade steel capacity) and it had already met more than 80% of that target by mid-June.
The remaining output levels remain strong thanks to supportive demand. This has led to low steel inventories and higher prices compared with 2016. Meanwhile, industry consolidation continues to accelerate in the sector. Given the more aggressive capacity reduction, we are becoming more convinced that genuine reform has taken root.Exhibit 2: Progress in capacity utilisation in steel, led by supply-side reforms
Note: 2017E and 2018E are estimates
Source: BNPP AM, Mysteel, NBS, CEIC, Goldman Sachs, Gao Hua Securities Research, as of 14/07/2017
Progress has also been made on reforming state-owned enterprises (SOEs), such as the mixed ownership reform. Introduced in 2015, this aims at allowing private and strategic investment in China’s largest SOEs, with the goal of diversifying ownership and raising productivity. August saw two SOEs announcing plans to sell stakes to private investors. Telecommunications giant China Unicom unveiled plans to reduce its group stake from 62.7% to 36.7% and welcome strategic investors from both the state and private sectors.
Further progress on SOE debt reduction likelySuch developments reflect government efforts to ensure financial stability by reducing SOE debt, which remains one of the main sources of excessive credit creation.
Looking ahead, the latest leadership reshuffle should be positive for SOE debt reduction and continuity in the implementation of structural reforms. We believe the government is aiming for better quality, more efficient and more sustainable development.
Increased opportunities for foreign investors
The solid flows of the Stock Connect scheme are another positive. We expect additional liquidity from the scheme’s southbound flows, given that H-shares continue to trade at a discount to A-shares, with the generally undemanding valuations and relatively high-dividend yields of Hong Kong-listed (H) stocks.
Looking at the valuations of A-shares and H-shares, we believe they have returned to the historical 10-year average. Most importantly, both share classes continue to trade at below the valuations of developed equity markets. The MSCI China is trading at 12.8x the forward P/E and the MSCI China A is at 14.4x (2018 Bloomberg consensus estimates, as of 3 October 2017), representing a discount on Chinese equities versus the US, Europe and World indices.
Potential headwinds for Chinese equities
Domestic risks such as the tightening of China’s property market, capital outflows and the increasing debt load along with external risks including a fully blown trade war with the US and rising geopolitical tensions may pose headwinds.
S&P Global Ratings downgraded China’s long-term sovereign credit rating by one notch on 21 September to A+ from AA-. This was not a surprise as S&P’s concerns, citing in particular the increasing risks from the rising debt load, had been known to financial markets for a long time. S&P’s move followed a similar downgrade by Moody’s Investors Service in May. Therefore, it is unlikely to cause any major market reaction, in our view.
On the property sector concerns, we believe the acceleration of real-estate developer consolidation removes some of the tail risks of small developers going bust in a market slowdown. The rebound in private sector investment should also help offset any negative impact.
Infrastructure spending is a key GDP factor to consider, but what will be more essential to focus on is private capital expenditure. This better reflects confidence in the economy and sustainability and it is encouraging to see that capital expenditure has shifted from spending on expanding capacity (which is a more cyclical move) to upgrading and improving productivity. Companies are more disciplined on capacity expansion, which should help reduce overcapacity risk.
Opportunities in under-owned Chinese equities
We continue to discern strong potential opportunities in this under-owned asset class. After last year’s mixed results, macroeconomic data today continues to point to further momentum in activity across a number of sectors.
We are seeing impressive progress on supply-side reforms compared to previous years, which has helped boost corporate profitability.
Undemanding valuations and fading external risks with the US add to the positives for Chinese equities, in our view.
The leadership change would provide a further fillip for China’s long-term outlook should it lead to a further acceleration in reforms.
We believe the liberalisation of the financial system may also gradually increase opportunities for foreign investors to participate directly in China’s markets.
Written on 17/10/2017, performance figures updated as of 31/10/2017
Also read these articles on China on Investors' Corner:
- MSCI announces inclusion of China A-shares in emerging market indices
- After MSCI adds A-shares, China launches “Bond Connect”
- Grabbing the opportunity of China’s ‘Belt and Road Initiative’
- China’s foreign exchange policy and the outlook for the renminbi
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