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Why Do We Still Favour The H-Share Market?
May 28, 2015

Our research team will explain the reasons behind China's latest rate cut and explore how the policy benefits H shares.


Author : iFAST Research



 Why Do We Still Favour The H-Share Market?

The People’s Bank of China (PBOC) recently announced for the third time since November 2014 to cut its benchmark interest rate by 25 bps, which already became effective on 11 May 2015. In this article, we will discuss the reasons behind and our view on this rate cut, and explain our outlook on Chinese investment.

The cut brought the official one-year lending rate to 5.10%; deposit rate was also decreased to 2.25%. Other deposit and lending rates as well as the individual housing provident fund deposit and lending rates were cut accordingly. In addition, the PBOC also decided to lift the ceiling of the floating range of interest rates on deposits for financial institutions from 1.3 times to 1.5 times of the benchmark interest rate in order to facilitate the interest rate liberalisation reform.

Table 1: Adjustment of Benchmark Deposit and Lending Rates,Effective on 11 May 2015
After Adjustment(%) Before Adjustment(%) Change(percentage point)
Deposit
Demand Deposit 0.35 0.35 0.00
3-month 1.85 2.1 -0.25
6-month 2.05 2.3 -0.25
1-year 2.25 2.5 -0.25
2-year 2.85 3.1 -0.25
3-year 3.5 3.75 -0.25
Lending
Within 1 year
(including 1 year)
5.1 5.35 -0.25
1 to 5 years
(including 5-year)
5.5 5.35 -0.25
Over 5 years 5.65 5.90 -0.25
Individual Housing Provident Fund Lending Rate
Under 5 years
(including 5-year)
3.25 3.5 -0.25
Over 5 years 3.75 4.0 -0.25
Source: PBOC and iFAST compilations

WHY? ECONOMIC TRANSFORMATION & LIBERALISATION OF INTEREST RATE

1. To support economic growth amid economic transition

Almost all of the economic indicators in April came off surprisingly weak. For example, industrial production only recorded a 5.6% year-on-year growth, the lowest since February 2002. Amidst the current economic transformation, small and medium industrial companies inevitably suffer the most with contracting PMI activities in the past few months. The weaker demand of the “old economy” sectors such as cement, ethylene and coal has kept dragging industrial production.

Manufacturing PMI in April was 50.1, the lowest since March 2009. Inflation remained at 1.5% year-on-year, far lower than the targeted 3.0% and was the lowest since 2010. Retail sales only gained 10.2%, which was also insufficient to fuel the Chinese economy solely.

The overall April data indicated a weakening domestic demand that may hamper’s the central government’s goal to reach 7% growth target in 2015. As the three main growth drivers of the Chinese economy (consumption, investment and exports) all show signs of deceleration, it is widely expected that the country’s quarterly GDP growth will take more time to bottom out. Thus, we believe the rate cut is not unanticipated and is also proof that the government is determined to boost economic growth.

2. Liberalisation of interest rate

PBOC also lifted the ceiling of the floating range of interest rates on deposits for financial institutions from 1.3 times to 1.5 times of the benchmark interest rate in order to facilitate interest rate liberalisation, whereas lending did not enjoy such freedom. Therefore, it can be regarded as an asymmetric rate cut. Compared with a symmetric rate cut that is more able to maintain banks’ profitability, an asymmetric rate cut is a significant step towards interest rate liberalisation, and banks’ net interest margin would be narrowed. As the floating range of interest rate expanded, financial institutions in China have a greater autonomy to set depository rate, which marks a symbolised move of giving the Chinese financial institutions more pricing power over its rate products.

WHAT’S AHEAD FOR THE ECONOMY?

A surprise interest rate cut is not always good news. Given the still prevailing deflationary risks, the rate cut was evidently implemented in order to ease mounting economic stress and is a sign that the economic conditions are worse-than-expected. The timing of the interest rate cut is also interesting as it was done just a couple of days before a range of critical data was released for May, including industrial production and trade figures for the weekend, and new loans for the following week. Once again, we witness the PBOC’s policy fine-tuning in action as it implements more drastic measures to preemptively offset the upcoming weak data releases.

Recent publications of weak economic data have demonstrated high levels of uncertainty surrounding China’s economic outlook in the short term. We expect further policy moves to come, which will involve both further RRR and interest rate cuts. At the same time, the timing of these policies will be difficult to predict, and highly dependent on and sensitive to the upcoming economic trends. It is also worth noting that although it appears as though the government has shifted its focus away from inflation towards growth considerations, we believe the headline CPI figure will remain a determinant factor for monetary policies.

WHY DOES THE MARKET SURGE WHEN THE ECONOMY WORSENS?

In the past ten years, China has gone through two interest rate cut cycles: one in 2008 and one in 2012. The market reacted negatively as economic fundamentals became weak. As seen in Figure 1 and Figure 2, both A shares and H shares dropped with the rate cuts. However, since last November when PBOC started cutting rates, A shares, represented by CSI 300, delivered stunning performance and yielded a return of 80.3% since the day of announcement till 18 May 2015. Why did the market surge this time? We believe it is mainly because of favourable factors like the transformation of the economy, the opening up of the Chinese market and the reformations of state-owned enterprises (SOEs) that support the surge.

Figure 1: Rate cut and the Chinese A shares’ movements (from Jan 2002 till May 2015)

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Figure 2: Rate cut and the Chinese H shares’ movements (from Jan 2002 till May 2015)

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EARNINGS FORECASTS REMAIN STRONG IN ECONOMIC TRANSFORMATION

In the beginning of this year, Premier Li had warned that China must overcome problems like low economic efficiency, overcapacity and difficulties private companies face, paving the way for China to embrace the “New Normal” as the government is now steered to encouraging the development of private companies and new economy sectors from the traditional, government-directed infrastructure investment, heavy industrials and low valued-add industries. It has also begun to carry out industry reforms by introducing concepts like “one belt one road”, “internet plus” and “internet financing”, which all have helped improve market sentiment.

Corporations supported by such policies have since enjoyed earnings expansion, especially sectors like alternative energy, internet, electronics and healthcare. Only the “old economy” sectors like coal, oil and gas and the mining industry have their earnings estimates for 2015 in the negative territory. This proves that certain industries such as high technology-related sectors are able to benefit from the policies in terms of earnings. Different from the economic slowdowns in the past, corporates’ earnings remain positive despite a decelerating economy this year.

Figure 3: 2015 Earnings forecasts

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EQUITY MARKETS “GO OVERSEAS”

With the launch of “Shanghai-Hong Kong Stock Connect” back in August last year, the Chinese government is now probing the feasibility of “Shenzhen-Hong Kong Stock Connect” in the second half of 2015. At the moment, the deviation of the stock preference of the two markets’ investors is still great. As the major market participants in A shares and H shares are different, the preference of shares are also vastly different and hence the difference in valuations across different sectors. From the market participants’ perspective, Hong Kong market is mainly compose of local and overseas institutional investors, accounting for over 61.2% of daily total trade volume. On the other hand, 85% of the investors in the A-share market have an investment amount of less than RMB 100,000. Risk appetite for individual and professional investors is different too. Domestic A shares are mainly sentiment-driven, while Hong Kong institutional investors are driven by valuation. Rational investors are beneficial to the stock market’s long-term development. On the other hand, the possibility of including China’s A shares in one of the highly popular MSCI indices mean that the overseas investors would require greater corporate governance, transparency, liquidity and a sound regulatory framework.

TO SUPPORT SOE REFORMS IN 2015

With favourable interest rate environment, reforms for China’s SOEs can be played out nicely. As the Chinese A-share market moves towards the international stage, a better corporate governance and transparency would be required to develop a more mature financial market in order to attract global investors. The first step would be introducing institutional investors to the domestic equity market, and hence better corporate governance, regulatory framework and accounting reporting of international standard must be developed.

To achieve such goals, SOEs must lead the reformation. As the central government pointed out earlier this year, “the restructuring of China's state-owned enterprises will proceed rapidly in 2015 as the government is set to unveil 10 policies for SOE reform”. Local SOEs that performed worse than their central counterparts would be the first to undergo a restructuring. In the meanwhile, large SOEs have also seen reformation in production efficiency and better corporate governance; one example is the merger of two large SOE railway corporations—China CNR Corporation Limited and China CSR Corporation Limited. With the SOEs’ reformation on the agenda, a lower interest rate environment would definitely be beneficial to the reformation.

Another factor for consideration is that more corporates would want to raise funds through equity financing when market sentiment improves. From Figure 4, corporates tend to raise more funds through equity financing during a bull market, which also presents an opportunity for SOEs with weaker fundamentals and need to pay for the cost of raising funds through fixed income financing, which is more expensive than equity financing.

Figure 4: Funds raised through equity financing by Chinese non-financial institutions versus CSI 300 (from December 2002 to May 2015)

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WHAT SHOULD INVESTORS DO?

China’s economy has turned out to be worse-than-expected and it may only bottom out towards the end of the year. However, in line with our expectations, the PBOC continues to remain sensitive to economic trends and fine-tune policies accordingly. The rate cut is evident of the central bank’s commitment to defend economic growth, and thus we maintain a positive outlook on Chinese equities.

Despite the recent surge in the A-share market, investors should keep close track of fundamentals in the long run. We have also observed that the valuations of H shares continue to show significant discount against the fair PE when compared with the A-share counterpart. As of 26 May 2015, CSI 300 and Shanghai Stock Exchange A Share Index, both representing A shares, see an estimated PE of 19.1X and 16.7X—a premium to its 15X fair PE (Figure 6). In terms of H shares (Figure 5), Hang Seng Mainland 100, which measures Hong Kong-listed Chinese corporates including H shares, sees an estimated PE of 12.1X against 13X fair PE, which translates into an upside potential of an annualised return of 26% until end-2016 (data as at 26 May 2015).

Figure 5: China H Market Valuation

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Figure 6: China A Market Valuation

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Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website.



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