Bottom-up, the way to go in China
The market currently forecasts the earnings-per-share of MSCI China companies to grow by 10.6% on average this year.
The Chinese equity market continues to offer attractive opportunities even as the government remains mindful of liquidity conditions and risks at certain key sectors. Against this backdrop, investors would do well with a selective approach that favors winners from China’s structural reforms.
China’s economic recovery has continued to gain momentum, as recent data and leading indicators have confirmed. Total social financing, a measure of overall lending and a gauge for economic activity in the next two quarters, has grown robustly since the middle of last year. This suggests that the recovery is likely to pick up pace, which should support equity valuations.
Meanwhile, corporate earnings in 2012 were mostly in line with investor expectations, and we think profits will rebound in 2013 driven by recovering demand and operating scales. The market currently forecasts the earnings-per-share of MSCI China companies to grow by 10.6% on average this year.
Policy uncertainty clouds outlook
However, policy uncertainty has intensified recently. Authorities started to tighten the property market and monetary conditions earlier than expected, even though the overall inflation backdrop has remained relatively benign. As home-prices had continued to rise at the beginning of the year, the government issued five national measures in February, and city-level measures followed in March.
Furthermore, the banking regulator tightened rules on wealth-management products, also in March. The move, which bodes well for the stable long-term growth of the Chinese capital market, could slow down the rapid growth of these products in the near term.
We therefore believe liquidity conditions in China have peaked this year and credit growth is likely to slow, thus impeding the potential gains of the equity market. For these reasons, we have downgraded China from Most Preferred to Neutral.
A year of stock-picking
With improving economic fundamentals on one hand and policy uncertainty on the other, the Chinese equity market will find it difficult to pull through and outperform its peers in Asia excluding Japan. The possibility of further credit-tightening in the second half of the year could also weigh on the financial sector, which comprises nearly 40% of MSCI China.
To uncover more attractive opportunities, investors will do well to take a bottom-up approach, in our view. Investors should not forget that China is still one of the world’s fastest-growing economies, and the structural reforms it is undertaking – from income redistribution to resource pricing to urbanization – will bring significant opportunities to related sectors and companies. Our "China demographic changes" investment theme focuses on companies that benefit from China’s population-aging and urbanization megatrends.
Buy into the consumption trend
Chinese policymakers have pledged that household incomes will not grow at a slower rate than the overall economy until 2020. This should benefit industries poised to grab a good share of household spending, including consumer staples, consumer discretionary, property, and technology.
We favor technology in particular. The rising adoption of 3G and, soon, 4G networks will benefit leading smartphone-equipment makers, while China’s seemingly insatiable appetite for new media will benefit internet service providers. Leaders in these industries are often financially prudent and have ample cash flows, so China’s monetary policy cycle should have little impact on their operations.
Energy to charge portfolios
The heavy air pollution in Beijing and other major Chinese cities earlier this year was a wake-up call for policymakers to step up environmental protection. To this end, they recently took a series of measures toward more market-based energy pricing and to improve energy efficiency.
These include changing the oil-product pricing mechanism, removing limits on thermal-coal contract prices, and setting targets for the installation of clean energy sources. These structural developments will benefit not only players in clean energy, such as natural gas companies and equipment makers, but also traditional independent power producers and refineries.
In conclusion, though the uncertain policy outlook has created obstacles to investing in China, the market has not run out of opportunities – it just takes the right approach to find them.
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