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GUEST ARTICLE: Why China Equities Look Attractive Again - Standard Chartered Private Bank

Clive McDonnell

15 March 2017

The following article is by Clive McDonnell, head of equity strategy at Standard Chartered Private Bank. He writes about the state of the Chinese economy and the performance of Chinese equities. The editors of this news service are pleased to share these views with readers; they do not necessarily endorse all views of guest contributors and invite readers to respond. They can email

China’s equity markets have been on a wild ride in recent years. After peaking in 2015 at its highest level since 2007, the Shanghai Composite Index plunged almost 50 per cent by January 2016. Since then, the index has returned more than 20 per cent. The Hang Seng China Enterprises index on Hong Kong-listed China stocks has recovered more than 30 per cent since the 2016 lows.

We believe the China bull market can continue.

First, China’s economy has stabilised after a couple of years of fiscal, monetary and credit easing. Although growth has been on a secular downtrend since 2010, the National People’s Congress has set a healthy 6.5 per cent growth target for 2017.

The stabilisation in economic activity - which is confirmed by the so-called "Li Keqiang" index which tracks underlying economic indicators such as bank lending, rail freight movement and electricity consumption - has helped calmed nerves, slowing down capital outflows in recent months. A resilient economy, combined with a broadly range-bound dollar and official measures to restrict fund outflows, has helped stabilise the renminbi. Economic conditions are likely to remain stable as China’s policymakers head into the once-in-five-years Communist Party Congress in autumn this year to pick its next batch of leaders.

Second, Beijing’s efforts to tighten capital controls have resulted in increased domestic liquidity. As capital can no longer flow as freely overseas, it is finding its way into domestic asset markets, including equity and real estate markets. Although increased supply of real estate and administrative controls has slowed the pace of property price appreciation in recent months, policies remain supportive, especially in the middle-to-smaller tier cities.

This, combined with the "trapped liquidity" from the capital control measures, has helped lift the housing market. The so-called "sell-through rate" - percentage of housing units sold at project launch - has risen in recent months as buyers return to the market. This has led to the outperformance of the real estate equity sector against the broader China stock market.

Third, the improvement in the underlying economic activity is showing through in rising corporate earnings expectations. Consensus estimates now forecast a 16 per cent earnings growth for the MSCI China index for 2017, up from a contraction of 8 per cent in 2016. This pace of growth is similar to the 15 per cent earnings growth in 2017 estimated for Asia ex-Japan as a whole.

While the main drivers of the earnings recovery centre on the telecom and consumer staples sectors, the "new economy" sectors such as technology, consumer discretionary and healthcare are the clear favourites. This is backed by strong consensus earnings estimates - the "new economy" sector earnings are expected to grow 21 per cent this year, compared with 7 per cent growth in the "old economy" sectors dominated by energy, industrials and materials. Moreover, the technology sector dominates China’s equity markets, accounting for 32 per cent share of the MSCI China index, making it a key driver of the overall market.

Fourth, China’s equity market remains inexpensive relative to peers. At 12 times 12-month forward estimated earnings, the market is valued in line with its long-term average, but is cheaper than major market indices such as the S&P 500 index which trades at 19 times 12-month forward estimated earnings or Asia ex-Japan which is trading at 13 times 12-month forward estimated earnings.

Moreover, the 16 per cent earnings growth expected in China implies the equity market can post significant gains without seeing a further rise in its valuation multiple. Alternatively, any setback in earnings growth forecasts may not result in a sharp drop in the index, given that the valuations are not elevated.

Part of the reason for China equity market’s moderate valuation is the depressed value of China’s banks, which institutional investors are underweight amid concerns about the non-performing loans. Excluding the banks, China’s equity market valuations are elevated at around 15 times estimated 12-month forward earnings. However, this can be justified by the faster growth in the "non-bank" sectors, especially sectors related to the new economy, which are driven by strong domestic consumption.

Finally, a stabilising dollar should help attract foreign fund flows back to Asia, which is likely to benefit China, the largest market in the region. China’s policymakers, in turn, are likely to limit renminbi depreciation and tighten controls to limit capital outflows, at least until the Communist Party Congress in the fourth quarter. This may contribute to continued excess liquidity in the domestic economy, buoying asset markets including equities.
For sure, investors in China’s equity markets have had a rocky ride in recent years. Some of the risks have not gone away, including elevated debt levels at companies, the possibility of a stronger dollar and weaker renminbi as the US Federal Reserve starts to tighten policy at a faster rate, or the US under President Donald Trump enacting punitive trade policies against major exporters such as China. Any of these factors could raise the risk of a sharp deterioration in China’s economic growth, leading to a "hard landing".

However, there is a low probability of such an outcome. For now, the combination of China’s policy-led stabilisation in economic growth ahead of its crucial Party Congress, strong earnings growth driven by the consumption-driven new economy sectors, attractive valuations and trapped liquidity as a result of tighter capital controls give us confidence that the equity bull market has longer to run.