InvestmentsFeb 3 2016

Bullish on China

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Bullish on China

Chinese A-share markets started 2016 on a volatile note, dropping 7 per cent on the first trading day of the year and triggering a trading halt through a new circuit breaker.

Stocks have undergone a choppy month, with both the CSI 300 Index (which tracks A-shares) and MSCI China Index (which tracks H-shares) having declined by about 15 per cent year-to-date.

Further volatility over the short term may come as no surprise, but we think much of the negative news on China is overhyped. There is no denying that China is facing headwinds, but as medium to long-term investors, we are not unduly concerned. Here’s why:

1. Retail investors dominate Chinese A-shares, so market gyrations are to be expected.

The volatility in early January was fuelled partly by concerns that a six-month ban on share sales by significant shareholders, implemented in July 2015, would expire on 8 January this year. The People’s Bank of China’s move to lower the renminbi’s (RMB’s) mid-point rate on 7 January was also a key catalyst to China’s stock market plunge.

More importantly, Chinese A-shares are dominated by retail investors, accounting for more than 80 per cent of the trades, which tend to be short-term and speculative, with a “herd” mentality. There is a lack of participation from large institutional investors, who would usually start to bottom-fish for inexpensive stocks when markets fall.

A case in point: since 2005, there have been 86 trading days where the CSI 300 Index gains/losses were larger than 5 per cent. In contrast, there have only been 24 trading days during which the S&P 500 Index gains/losses were bigger than 5 per cent.

2. Chinese authorities are learning, and rapidly rewriting the rulebooks.

The Shanghai and Shenzhen Stock Exchanges scrapped the circuit breaker almost immediately after realising that the mechanism induced fear and panic rather than stability. China’s circuit breaker triggered 15-minute trading halts when stocks swung by 5 per cent, and a full-day halt after a 7 per cent fall, a narrow range, especially in a retail-oriented market. By comparison, in the US a 7 per cent/13 per cent swing effects a 15-minute halt, while a 20 per cent decline stops daily trading.

3. Chinese H-shares remain attractive versus A-shares.

The MSCI China Index currently trades at a 12-month forward price-to-earnings (P/E) ratio of 8.1x3 – back to levels seen before the 14 American Depositary Receipts (ADRs) were added to the index in end-November. In comparison, the CSI 300 Index is trading at a forward P/E of 10.6x.

4.The RMB’s devaluation may be a new normal, and should not cause too much concern.

To put things into context, the RMB’s depreciation in 2015 was less steep than that of major Asian currencies. With China’s ongoing capital account liberalisation and gradual shift towards a less managed exchange rate, further RMB devaluation looks likely.

In addition, Chinese regulators likely want to further depress the RMB because, first, a weaker currency helps exports, which may in turn boost a flagging economy. Second, they may be trying to avoid what Japan experienced in the 1990s, during which the yen appreciation hurt exports and led to gross domestic product (GDP) contraction and a massive stock market correction.

5.While much hype has surrounded China’s economic slowdown, it is not an entirely new event – and there are bright spots.

Weaker GDP, Purchasing Managers’ Indices, exports and Producer Price Indices are not entirely new phenomena, and continue to be an overhang on China’s economy. For instance, PPI has mostly trended downwards since September 2012, while the Consumer Price Index has been relatively flat over the period. Net exports, meanwhile, detracted from annual GDP growth between 2009 and 2011, and only contributed minimally in recent years.

Instead, we focus on the positive aspects of the economy. An example is China’s research and development (R&D) expenditure, which will rise as China continues to move up the innovation curve. Ambitious to resemble South Korea and Japan with regard to high-tech manufacturing, China is still way behind on its R&D spend as a percentage of GDP. Another positive example is the services sector, which is holding up well.

We believe structural reforms will continue to progress in 2016 and beyond. The government has set out to tackle overcapacity and promote manufacturing in China, and has made headway in reforming state-owned enterprises. Reforms may aid a recovery in cyclical stocks, which have underperformed defensives over the past few years. As China continues to loosen monetary, fiscal and property policies to help boost aggregate demand, it could see a cyclical recovery from stronger credit creation.

Finally, despite the talk of China having a sluggish economy, we would emphasise the fact that China’s “new economy” sectors are still enjoying strong growth. For instance, on China’s “Singles Day” (11 November 2015), Alibaba reported a 60 per cent year-on-year growth in total sales as it sold more than $14.3bn (£10bn) worth of goods on its e-commerce platforms – 1.7m deliverymen, 400,000 vehicles and 200 aeroplanes were needed to handle the orders. Unfortunately, these types of growth levels are not calculated in China’s overall GDP figures as most ‘new economy’ growth is not accurately reflected in official numbers.

Ken Wong is Asia equity portfolio specialist at Eastspring Investments

Key points

Chinese A-share markets started 2016 on a volatile note.

Much of the negative news on China is overhyped.

China’s ‘new economy’ sectors are still enjoying strong growth.