China’s much maligned economy has managed to come out of a soft patch, during which a significant majority of economic indicators were weak across the board with electricity production and rail cargo volumes growth slumping and leading indicators showing contractions. The resulting weakness saw third quarter gross domestic product (GDP) growth for the world’s second largest economy moderating to “just”7.4% year-on-year, marking the seventh consecutive quarter of moderating growth and the slowest growth in three years.
Despite the above, markets seemed to react positively to the announcement, suggesting that previous concerns over the extent of China’s economic slowdown were overblown. With event risk in the shape of political uncertainty pertaining to the 18th CPC Party Congress removed, we highlight 3 reasons why the Middle Kingdom should take centre-stage consideration for investors looking to increase their equity exposure.
1. Economic Outlook Promising, Indicators Picking Up Steam
Recent quarters have been difficult for China’s economy, with the third quarter growth coming in at “just” 7.4%. That said, we certainly think that concerns over the extent of the slowdown have been overblown, leaving Chinese equity markets at unjustifiably depressed levels. In fact, this also led China to lag other markets such as Singapore, Hong Kong and the broader Asia ex Japan region in the performance charts with returns of just 3.4% year-to-date as of 16 November 2012. But despite a further slowdown last quarter, at the same time we saw that the Chinese economy has grown 7.7% in the first three quarters of the year; (then) Premier Wen had even assured markets that the 7.5% target for the whole year will be achieved. Moreover, other major economic indicators published for September seemed to paint a relatively optimistic picture for China, suggesting that it’s not all bad news in the nation and that the economy is starting to stabilise.
Referring to Chart 1, we can see that exports have rebounded from 2.7% in August to 9.9% in September and subsequently 11.5% in October, reflecting the fourth consecutive month of improvement as the global external environment continues to improve. Despite exports to the European Union continuing to weigh on the headline figure with year-on-year contractions, exports to US have managed to record a rebound in recent months whilst exports to other countries in Asia have remained stable. While we expect conditions in Europe to remain challenging (despite some gradual improvement, we will unlikely see a sudden turnaround in China’s exports to the region), improvements in exports to US and Asia are seen providing support to China’s overall trade activity.
Chart 1: China's Exports Growth
Looking at the other major drivers for economic growth in Chart 2, we also saw investments and retail sales growth pick up, putting a halt to its downwards trend. Fixed investments growth gained 20.7% year-on-year in October 2012, the highest rate since March 2012. Apart from investments, retail sales growth also continued to reaccelerate, rising 14.5% year-on-year and likewise reaching the highest rate of growth since March 2012. Last but not least, after slowing for four consecutive months, industrial production growth also showed improvements for the second month running, gaining 9.6% year-on-year in October.
Chart 2: Investments & Retail Sales Growth
Economic indicators in general have painted a more optimistic picture suggesting that the Chinese economy has stabilized and has begun to pick up speed yet again. Nonetheless, we also recognise that China will continue to face pressures to rebalance its economy and downside risks from external factors have not vanished completely.
Looking forward, consensus forecasts growth for China’s economy to accelerate, rising to 7.70% in 4Q 2012 while FY 2012 GDP growth is expected to be 7.70%. In 2013, markets are expecting the second largest economy in the world to post growth of 8.10% for the year, with growth accelerating to 8.1% year-on-year in 2Q 2013, while FY 2014’s estimates are expecting a 7.90% growth rate. With corporate profits usually tracking economic growth, Chinese corporates are set to enjoy healthy earnings growth in the coming few years.
Chart 3: GDP Growth In China
2. Accommodative Monetary Policy Likely To Continue
There are no definite answers as to why the PBoC has not cut interest rates or reserve requirement ratios (RRR) further since the beginning of July and May respectively, as its actions have often proved to be unanticipated. But we should note that the central bank has continued to fine-tune policy since the rate cuts, embarking on less aggressive measures. Its accommodative policies include conducting reverse repo operations to manage short term market liquidity. Apart from several ad hoc instances of liquidity injection in January and May, the central bank started to conduct reverse repo operations on a weekly basis starting in July, pumping into markets a total of RMB 2.24 trillion worth of liquidity from June to September. Plus, the central bank also injected a weekly record amount of RMB 365 billion during September, which effectively brought down the seven-day interbank repurchase rate from its 7-month high of 4.7% to 3.03% in just three days. However, we should note that this operation only has the effect of managing short-term liquidity as the repurchase agreements the central bank uses expires in a short span of time (with contracts lasting 7, 14 or 28 days), the measure thus cannot replace interest rate cuts.
A key consideration is that with the government’s ultimate priority being to control property prices, the resurgence of rising (albeit moderately) prices has perhaps temporarily delayed further aggressive easing. According to the National Bureau of Statistics, new residential real estate prices in 70 cities declined for eight consecutive months (month-on-month) before turning around in June 2012. Since June, the measure has continuously risen each month (until September 2012), gaining 0.02%, 0.14%, 0.05% and 0.01% in the months to September. The trend’s reversal reminds us that the risk of the property market overheating has not disappeared completely. Specific controls on the property market may still be intact, but cheaper credit will undoubtedly put upwards pressure on prices, reminding the central bank that it cannot loosen monetary policy too aggressively.
While we believe that the central bank will continue to loosen monetary policy moving forward, the risk of inflation and resurgent property prices could be factors that tie the hands of the PBoC from moving too fast or aggressively, although the central bank has recently deemed inflation as “currently stable” in its latest quarterly monetary policy report.
3. China's Valuations At Depressed Levels
Though the economy and market is not free from uncertainties, we think that the amount of pessimism reflected in the market’s depressed valuations is unjustified. According to market consensus, as of 19 November 2012, the estimated PE for the Hang Seng Mainland 100 (HSML100) index is at 9.8X and 9.0X for 2012 and 2013 respectively, while 2014’s PE is estimated at 7.9, a figure which is significantly discounted from its fair PE of 13X. With potential upside of over 44% by end 2013 and a whopping 64% by end 2014 as seen in chart 4 below, the discount on China is simply too huge for investors to ignore.
Chart 4: Potential Upside Too Huge To Ignore
Given that event risk in the shape of political uncertainty pertaining to the 18th CPC Party Congress has been removed coupled with an improving world economy where even Europe is expected to post positive economic growth in 2013, we believe the backdrop is positive for the one of the world’s economic growth engines to begin turning around the underperformance of its equities and realise its huge potential upside. We continue to maintain our 5.0 Star “Very Attractive” rating on the Chinese equity market.