· GDP in the second quarter merely grew 6.7% year-on-year, which marks the slowest growth since 2009.
· The contribution of tertiary sector increased while the growth of primary and secondary sectors muted.
· Retails sales remained resilient while household disposal income continued to grow. Sectors related to domestic consumption is expected to take up a larger size of the economy in the coming years.
· The leading indicators in the Li Keqiang Index, such as electricity consumption and freight cargos, suggested that the industrial sector would struggle continuously, however, the overall economy has actually stood up better. This shows a fall in relevance between the old indicators and real economy. Thus a new economic index shall be used.
· The stagnant performance in 1H2016 might reflect the pessimism towards Chinese corporations. The market has overlooked some positive sides of Chinese economy, leading to the low valuation indicated by the HSML100 Index. However, the China’s H-share market still remains to be our top rated single-country equity market with a 5.0 star (very attractive) rating in a three-year investment horizon.
The Chinese economy grew by 6.7% year-on-year in the second quarter, slightly beating market expectations of a 6.6% growth. However, looking at China’s GDP in the second quarter, the quarterly growth rates have decelerated to the slowest since March 2009. The market remains skeptical about the growth rates announced officially, and it is also pessimistic towards the recovery of Chinese economy from the economic transformation. Nonetheless, headline figure shows that the economy might end its struggle soon after the rebalancing. In the following article, we will discuss the real economic situation in China and explain the accuracy of the new economic proxies over the old ones. Lastly, we will provide investors the forecasts of Chinese economy.
CHINESE ECONOMY IS ACTUALLY DOING WELL
CHINA IS UNDERGOING A REBALANCING
Although the year-on-year economic performance of China in the second quarter is comparatively feeble, it does not mean that all the sectors are performing woefully. We can see that China is gradually changing her economic structure from the secondary sector to the tertiary sector as shown in Table 1. The contribution of the secondary industry to the overall economy has declined from 41% in 2015 to 39% in 2016, prompting a 2.3% drop in its year-on-year growth under the supply-side reform. Meanwhile, the contribution of the tertiary sector to the overall economy rose from 52% to 54% a year earlier. Emerging sectors, such as service sectors, expanded 10.87% on a year-on-year basis in the first half of this year. Therefore, we can observe that China is entering an economy driven by the tertiary sector. (See Table 1)
Table 1: GDP BY EXPENDITURE
DEFERRED RATE CUT MIGHT IMPLY STABLE ECONOMIC CONDITIONS
Apart from the economic rebalancing mentioned above, the deferred rate cut also implies that the Chinese economy is actually doing far better than the market expectation. The People’s Bank of China had started going for rate cut since Q42014. Particularly in 2015, it had cut its benchmark interest rates 6 times to 4.35%. Cutting interest rates dropped a hint to the market that the economic growth would keep slowing down. After the rate cut frenzy, the Chinese property in tier 1 and 2 cities rallied significantly, meaning that the economy is being stable and outperforming the market expectation. As an alternative to support the economy, PBOC also lowered required reserve ratio of major banks in order to increase liquidity in the banking system.
CHART 1: LOWERING OF RRR AND INTEREST RATE OF PBOC
EVALUATION ON OLD ECONOMIC INDICATORS
The economic indicators suggested by the current Chinese Primer, Li Keqiang, in 2013 include electricity consumption (40%), rail cargo volume (20%) and bank loans (40%). They are the leading indicators to represent Chinese economy. According to Bloomberg, “electricity production” and “electricity consumption” can be used interchangeably. Since the former is more common in use, the term “electricity production” will be addressed in this article.
Since the tertiary sector are expected to take a larger proportion in the overall economy, the old proxies might no longer be the best indicators to portray the situation of Chinese economy. However, bank loans are still regarded as an appropriate economic proxy. Explanations will be provided in the following sections.
CHART 2: ELECTRICITY PRODUCTION (3MA) GROWTH IN PAST 10 YEARS
THE PERFORMANCE OF ELECTRICITY PRODUCTION COULD NOT REFLECT THE ACTUAL ECONOMY
Since 2013, the growth pattern of electricity production and Chinese economy have been going their separate ways. As shown in chart 2, the electricity production (3MA) dwindled steadily throughout 2013 and hit a bottom in 3Q2014 (note that PBOC decided to roll out its first rate cut in November 2014). However, China's economy did not followed a similar trend as the electricity production.
China is transforming from an economy driven by manufacturing industries to high value-added industries. Demand for electricity has thus reduced as service industries do not rely much on electricity as the manufacturing industries do. Therefore, the data of electricity production may not be able to reflect the actual situation of Chinese economy.
THE PERFORMANCE OF RAIL CARGO VOLUME COULD NOT PICTURE THE ECONOMIC CONDITIONS
The growth trend of the freight cargo volume and electricity production is similar. Both of the factors might be insufficient to reflect the overall situation of Chinese economy. From Graph 3, the country's freight cargo volume rebounded and recorded a year-on-year drop of 5.4% in June 2016. Although the freight cargo volume dropped significantly, the impact on the overall economy was minimal. As a result, the freight cargo volume is not an essential indicator for measuring the Chinese economy.
There are numerous reasons triggering the decline in freight cargo volume. The Authority believes that the economic slowdown is not the core reason contributing to this situation. The rise of new and renewable energy, such as water, wind, nuclear and natural gasses, is a crucial part of the story. Meanwhile, shifting the electricity generation from coal to clear energy caused a slump in freight cargo volume. As shown in chart 3, the ups and downs of freight cargo volume does not closely intertwine with the GDP.
CHART 3: RAIL CARGO VOLUME (3MA) GROWTH IN THE PAST 10 YEARS
With reference to the above data, the current business environment of manufacturing industries is poor under the supply-side reform. This situation can be observed from the disappointing performance of electricity production. Going forward, we expect the stagnant growth of manufacturing industries will lessen the impact on Chinese economy. The importance of tertiary sector to the economy will increase steadily.
TOTAL SOCIAL FINANCING IS STILL AN APPROPRIATE ECONOMIC PROXY
Although the figures of electricity production and rail cargo volume are ringing alarm bells, China’s total social financing has shown an increase on a year-on-year basis (see Chart 4). Both bank loans in Li Keqiang Index and total social financing we are using in this article represent the lending offered to non-financial sectors. Since more statistics from the past are available for the comprehensive analysis of “total social financing”, it will be used as the new indicator for measuring the Chinese economy in this article.
The National Bureau of Statistics of China claimed that total social financing is undergoing a structural transformation. We believe the majority of the bank loans has been flooded to infrastructural projects and new enterprises in emerging sectors. In fact, the total social financing in industries with overcapacity and real estate sees a slower increase. However, the total outstanding bank loans in June rose by 12.3% year-on-year. According to Mr. Sheng Songcheng, the head of the Statistics Department of People's Bank of China, overcapacity and steel sectors have recorded a 0.5% and 6.7% year-on-year decline respectively. The growth of outstanding loans in real estate sector fell to 10.1% in June, which is lower than the 13.5% growth in the same period of last year. Meanwhile, the high-technology manufacturing and service sectors have been expanding rapidly in response to the supply-side reform. The medium- to long-term loan balance of the former has climbed 13.5%, outpacing the 4.3% growth at the end of last year while the latter has jumped to 12.4%. Emerging sectors, such as high-technology manufacturing and services industries, have replaced industries with overcapacity and real estate to take centre stage in China’s total social financing.
CHART 4: CHINA’S TOTAL SOCIAL FINANCING IN CNY (YOY)
HOW NEW INDICATORS SUBSTITUTE THE OLD INDICATORS
In view of the structural reform in Chinese economy, the old set of indicators, including electricity production, rail cargo volume and outstanding bank loans, might no longer be the chief gauges of the economic conditions in China. As China is gradually transforming to a consumption-driven economy, the existing total social financing (bank loans) can be utilized along with retail sales and disposal income per capita to interpret the Chinese economy.
A CLOSER RELATIONSHIP BETWEEN RETAIL SALES AND ECONOMIC GROWTH
CHART 5: RETAIL SALES GROWTH VS CHINA’S ECONOMIC GROWTH
The spending power of consumers is overwhelmingly important to a consumption-driven economy. As observed in Chart 6, spending power of Chinese consumer, which is measured by China’s disposable income per capita, and retail sales are highly correlated. Wholesale and retail sales grew 10.6% in the first half of the year and beat estimates of 9.9%. It is worth noting that the online retail sales of goods and services had skyrocketed 28.2% on a year-on-year basis. Moreover, the online retail sales of physical goods accounted for 11.6% of the total retail sales. In contrast to the old indicators, retail sales have performed a similar trend with China’s overall GDP. The data also meets our expectation that China will transform to a consumption-driven economy in the future.
CHART 6: CHINA DISPOSABLE INCOME PER CAPITA BY QUARTER
NEW ECONOMIC INDEX IS A MORE RELIABLE PROXY
The new China’s Real Activity Index from Bloomberg Intelligence comprises the weighted-average consumption of medicine, exports of vehicles, clean energy electricity production, communication equipment and computers production as well as output of private enterprises. Meanwhile, the old China’s Real Activity Index mainly consists of the weighted-average real estate investment, exports of textile yarn and fabrics, thermal electricity production, ferrous metal ores production and output of SOEs.
It is obvious that the new economic index is evaluating sectors that engage proactively in the recent Chinese economy. It can thus better mirror the accurate market performance. In reference to chart 7, the new index has outperformed the old index lately, unfolding the fact that the economy is not as pessimistic as how the GDP shows
CHART 7: A COMPARISON BETWEEN THE NEW CHINA’S REAL ACTIVITY INDEX AND THE OLD ONE
CHART 8: A COMPARISON BETWEEN LI KEQIANG INDEX AND THE NEW CHINA REAL ACTIVITY INDEX
As mentioned above, the slowdown of Chinese economy has bottomed out in recent months and the new economic sectors are showing strong resiliency.
Previously, China relied too much on government policies to boost its growth rates, which would generate risks and economic unsustainability. Therefore, the country is pursuing a sustainable economic model, possibly triggering a slower economic growth. In our view, it is necessary for China to transform its economy into a consumption-driven one in the long run.
THE MARKET VALUATION LOOKS ATTRACTIVE
It is not surprising that the market will suffer from sluggish economic growth in the long run, which is partially reflected in the low valuation of the market.
TABLE 2: CONSENSUS EARNINGS GROWTH ESTIMATE OF DIFFERENT SECTORS
Some of the positive sides of Chinese economy are being overridden due to the low valuation projected by the recent HSML100 Index. Nevertheless, signs are implying that the economic conditions in China would start to improve gradually in the coming quarters. We believe that the continuous rebalancing of the economy will benefit particular sectors, and there will be a healthy corporate earnings growth. Despite the disappointing earnings forecast for the HSML 100 Index (estimated earnings growth of -6.2% for 2016, as of 10 August 2016), the valuation reflected by HSML 100 Index only stands at 10.1X for 2016(as of 10 August 2016), which shows a significant difference as compared to our Fair PE of 12.0X. Therefore, H-share market remains our top rated single-country equity market with a 5.0 stars “very attractive” over a three-year investment horizon.
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