We take a neutral position on China equities to balance structural reform benefits and credit default risks as the peak trust fund repayment period is approaching in June to August.
We do not see a clear resolution of China’s local government debt problems in the coming months, but equally do not expect a systemic crisis. Market fears of a Lehman-style financial crisis in China are overblown.
In response to weaker-than-expected economic data in the first quarter of this year, the Chinese government has quickly introduced targeted stimulus to stabilize growth. Further fiscal stimulus measures in the public infrastructure and social housing sectors are likely to support a tactical rebound in the China market in the coming weeks, but a sustainable market recovery requires more convincing progress in structural reforms to contain systemic risks.
Divergent performance between the winners and losers of structural reforms is expected to extend in medium term despite short-term rotation from the high-growth new-economy stocks to the bombed-out old-economy counters.
In contrast to many emerging economies, China has a sizeable current-account surplus, war chest of $3.8 trillion in foreign-exchange reserves and a largely closed capital account. With the world’s highest savings ratio at 51% of GDP and system-wide loan-to-deposit ratio averaging below 70%, China’s ample domestic liquidity should help mitigate the risk of a systemic crisis.
The low level of central government debt at 21.7% of GDP allows room for the central government to take on the debt of financially trouble local governments if the need arises.
To position for China’s prolonged deleveraging and economic restructuring, we favour structural growth themes and domestic reform beneficiaries in the internet, financial, healthcare and new energy sectors, and avoid exposure to the overcapacity sectors and small and medium-sized Chinese banks which are more vulnerable to shadow banking risks.
Burkhard Varnholt, head of Investment Solutions Group and CIO, Bank Julius Baer:
We are adding China, because there are clear signs of stabilization. Further recent economic data in China have been on the weaker side recently, but appear to stabilize at current levels.
While some easing of the growth dynamics had to be expected as a consequence of the ongoing reforms, the government is rather unlikely to tolerate a more severe economic slowdown. Therefore, the probability of additional fiscal or monetary stimulus measures has risen.
The recently decided reforms are also likely to have a positive medium- to longer-term impact on the profitability of Chinese corporations. Therefore, our allocation to Chinese equities within the emerging Asian equity exposure will be increased.
The ongoing reforms in China mean that defaults and de-listings of Chinese bond issuers will continue to take place. Thus, careful differentiation among Chinese bond issuers is needed. At this stage, we also keep our exposure to offshore Chinese renminbi (CNH) bonds as the currency is expected to appreciate again from the current levels.
We argue that the wide divergence in Asian equity market performance in 1Q cannot continue. Markets are too pessimistic about a slowdown in China and the perceived fragility in its financial sector. We now turn overweight on China equities due to extremely low valuations, and expectations of policy response to slower growth set the stage for equities to rebound.
John Woods, Asia Pacific fixed income head, Citi Private Bank:
We are overweight China risk and have been since late June 2013. We think a lot of China’s economic challenges are adequately and appropriately reflected in its price. There is no doubt growth is slowing which will bring a host of challenges to its banking system and property sector to name but two. But with equity valuations even through global-financial-crisis lows, we think investors are being compensated for the risks involved.
As/if synchronized G3 growth gains traction, we believe China will benefit from improving export performance and a likely acceleration in inward investment. Indeed, as US rates start to durably rise – a phenomenon to which domestic China is largely impervious – we suspect an equity rotation out of rates-sensitive southeast Asia will accelerate, with value-seeking flows benefiting north Asia in general and China in particular.
We do not underestimate the risks China faces, but we believe the economy enjoys sufficient flexibility to manage such risks. For example, investors should rightly be cautious of China banks if, for example, they believe reserves set aside for loan loss provisioning are insufficient for future asset impairment; that profit growth at the large banks is likely to turn negative; and that the state would be unwilling to step in and offer a back-stop degree of support if required.
But such assumptions are not our base case. Indeed, we believe the reverse to be true. As such, we suspect China’s deleveraging will continue to grind on for the next three or four years, with risk assets responding with sideways-to-positive momentum from current levels.
Admittedly it’s not a particularly spectacular or immediately compelling price-appreciation story, but China is woefully under-owned, and once the market accepts that neither a crash-landing nor financial crisis is likely over the next two or three years, we would expect to see consistent albeit modest price action.
We believe the current bout of pessimism on MSCI China is overdone. The property market will slow down but not deteriorate sharply and the ongoing weakness of the CNY is due largely to the widening of the trading band, which is not sustainable given China’s strong fundamentals.
MSCI China is currently trading at trough valuations. In 12-month forward terms, the market is trading at 8x, which is a significant 25% discount to its five-year average and also to its regional peers in MSCI Asia ex-Japan.
Our baseline scenario is that growth will stabilize in the next two quarters thanks to the global recovery and better policy clarity after the National People’s Congress, and that monetary and credit conditions are unlikely to be tightened given the economy’s current softness. In that sense, growth, liquidity and policy are likely to become more positive for the stock market in the near term.
However, the slower growth momentum and potential credit default events might weigh on sentiment. Hence, although we maintain our most-preferred rating on China, we reduce our weightings on the market.
Reform in China is reallocating political, economic and business interests, and has created two, distinctly different Chinas: old China and new China. And there are beneficiaries and casualties of that reform.
The collateral damage is mostly infecting old China, specifically state-owned enterprises such as banks, major oil companies and big telecom companies – the ones who benefited from their monopolistic positions, protected by the state for 60-plus years. The private sector is benefiting from reform, especially emerging industries such as technology, pharmaceuticals, logistics, agriculture and consumption.
So, when we think of China, we think in that framework. We are positive on companies and industries that are very well-positioned in the new China, but we are underweight old China. That’s the structural trade. Our tactical trades vary, but that old versus new China structural trade remains fairly consistent and will continue to be for the foreseeable future.