We anticipate that a number of factors will act as catalyst for a positive performance of Chinese equities in 2015.
Potential catalysts include: attractive valuations, accelerated reforms, lower commodity prices, pro-growth PBOC policy, and a supportive global backdrop. All would be positive for Chinese equities.
In our view, positive momentum in Chinese equities will come in part from onshore investors reallocating to stocks, reinforced by increased participation from international investors joining Shanghai-Hong Kong (& Shenzhen-Hong Kong) Stock Connect.
2015 presents ongoing challenges for China, but also opportunities for investors. Below are five themes that in our view support the case for strong positive momentum in Chinese equities this year.
1. Attractive valuations and strong relative growth (versus global peers)
China H-shares ended 2014 at a 9.3x P/E and 1.3x P/B multiple. Exhibit 1 below shows the 12 month forward P/E ratios and five-year historic average and suggests to us that Chinese stocks are attractively valued relative to Asian and global peers. After a +52% rally in 2014, Chinese A-shares ended 2014 at a five-year historic average P/E multiple of 13.6x (but it should be remembered that A-shares have been in a multi-year bear market until 2014).
Exhibit 1: Valuations of Chinese A-shares and H-shares and a selection of other Asian equity markets.
The “new normal” growth rate for China is now widely accepted. However, even with an official GDP growth rate of 7.4% in 2014 (the IMF forecasts growth of 6.8% for China in 2015) China is still the fastest growing economy in Asia Pacific (excluding frontier markets). China’s economic growth rate remains the envy of slow-growing developed economies in the west.
2. A supportive global backdrop
A benign external backdrop should provide further support for Chinese equities in 2015.
a. Reaping the benefit of low commodity/energy prices: China is a net importer of oil and commodities. Lower energy and commodity prices tend to strengthen demand from both domestic and global consumers (by leaving more cash in their pockets). They also lower input costs for Chinese industry.
b. Accomodative central bank policy: The world’s main central banks have official rates either on hold or are biased towards easing. This provides a positive backdrop for global equities.
c. The US rate hike cycle: The Federal Reserve is currently not expected to pursue an aggressive policy with regard to possible rate hikes later this year.
d. A sustained economic recovery in the US: The US market accounts for around 25% of China’s exports. A sustained recovery should provide support for manufacturing and trade in China.
3. More accommodative policy from the People’s Bank of China (PBOC)
The surprise rate cut announcement in November 2014 signalled a shift by the PBOC towards a pro-growth policy. As inflation pressures are muted, the PBOC has plenty of room to pursue a more accommodative monetary policy. This view was confirmed on February 4 2015 when the PBOC made a system-wide cut to bank reserve requirements, the first in over two years, to provide a fresh flood of liquidity. The announcement cut reserve requirements (the amount of cash banks must hold back from lending) to 19.5 percent, a reduction of 50 basis points from across the board that should free up 600 billion yuan (around USD 96 billion) or more held in reserve at Chinese banks. This could then inject 2-3 trillion yuan into the economy after accounting for the multiplying effect of loans.
Easing funding costs will benefit high-geared companies and alleviate the high financing costs for small/medium-sized companies. As the unwinding of excessive property development remains a significant concern for China, further easing measures to reduce the cost of financing for developers and home buyers will have positive implications for the wider economy.
4. Strong promotion of new growth areas
Heavy promotion and implementation of growth-supportive measures by the government is expected to accelerate in 2015, with a focus on developing infrastructure links with its trading partners.
a. Domestic infrastructure investment: Further development of the Beijing-Tianjin-Hebei region. The State Council has approved RMB10 trillion for 400 infrastructure projects (Source: Bloomberg, January 2015).
b. Outward direct investment: An expanded agenda to promote outward direct investments and the export of China’s infrastructure industries.
• The “One Belt One Road” with an initial USD 40 bn Silk Road Fund already earmarked.
• BRICS Development Bank and Asian Infrastructure Investment Bank (AIIB) to provide funding for infrastructure projects with an initial USD 150 bn commitment in funding.
• 12 Free Trade Agreements signed with trade partners globally.
c. Promotion of “new economy” industries: Fostering growth in, for example, technology and services is another priority for China’s escalation up the value-chain and increased independence regarding manufacturing.
5. Comprehensive and deepening reforms
The implementation of reforms that began last year will continue, 2015 should be a crucial year for comprehensive and deeper reforms.
a. Fiscal improvements:
• Central government budget management: establish a transparent budget scheme with full coverage of government revenue and expenditure at all levels.
• Local government budget management: provide a means for local governments to raise funds, but tighten controls to regulate borrowing activities.
• Promotion of the Public-Private-Partnerships (PPP) model should allow private capital to become an effective funding source.
• Improving the tax system to achieve a higher collection of revenues.
b. Restructuring of State-Owned Enterprises (SOE): While significant focus in restructuring some of the larger SOEs started in 2014, we expect an acceleration of reform activities in 2015.
• Allowing some SOEs in competitive sectors to fail;
• Revamping of SOE pay structure;
• Promote mixed-ownership structures; and
• Reduce control on asset pricing to allow the market to set pricing.
c. Social / environmental reforms:
• Public service reforms: expand pension programs; improve the healthcare and education systems.
• Promoting consumption and services: promote new growth drivers especially in the services and technology sectors; urbanisation (hukou) reform to drive consumption.
• Prioritising environmental protection: i) stricter policy and enforcement; ii) promote clean energy and clean transportation projects; iii) reform pricing for utilities to align with preservation goals; and iv) promote sustainable agriculture.
Exhibit 2: Environmental projects are a priority for China.
• Government reform: Reforms at the government level include eliminating excessive red-tape and removing corruption in the private and government sectors.
Financial reforms: 2014 saw a wave of financial reform measures including:
– policy changes to widen the daily trading band of the USD-CNY exchange rate
– introduction of the Shanghai-Hong Kong Stock Connect programme
– announcement of the deposit insurance scheme. and the expansion of new renminbi clearing centres and RQFII quotas. Reform priorities in 2015 will include further measures to liberalise interest rates, renminbi, and capital markets as well as the expansion of free trade zones.
Exhibit 3: Further reforms will be made to China’s financial system in 2015
We see a number of catalysts that will provide positive impetus for Chinese equities in 2015. In addition the A-share market is likely to see more mainland retail investors returning to the stock market. H-shares will, in our view, be supported by the international community as global portfolios are underweight China.
The Shanghai-Stock Connect programme will facilitate the process of owning Chinese equities for international investors. Preparations to extend the programme are underway and Shenzhen-Hong Kong Stock Connect may be online in the second quarter of 2015. Inclusion of Shenzhen would complete the creation of a “single China” market, offering an additional USD 4 trn of incremental market cap to the investible universe. Given the general underweight of Chinese equities in most global portfolios a decision from the MSCI and/or FTSE Group to add A-shares to their global indices would provide a big boost for Chinese equities.