Economic Recovery Is in Sight
One of our core arguments for the return of the emerging market bull run is the recovery of the Chinese economy. As we have advocated in “Are Concerns Over A Chinese Hard-Landing Overblown?”, the slowdown in the Chinese economy has bottomed out and the new economic sectors have performed highly resilient. Recent economic indicators have been encouraging as they point to gradual signs of improvements. The Li Keqiang index, a widely-recognised leading economic indicator named after the current Chinese premier has climbed to the highest level since December 2013 (as shown in chart 1 below), thanks to the strong rebound in power production. In fact, the index has consistently improved after hitting the bottom in September last year. Similarly, the Caixin Manufacturing PMI, which closely tracks smaller-capitalised private companies, came in at a 50.1 reading in September, officially returning to expansionary territory. These observations are also consistent with other economic data as we found most of the data in August offered upside surprises.
Chart 1: Keqiang Index Climbs To The Highest Level Since 2013
Watch For Industrial Reflation & Restocking Ahead
Another significant evidence of amelioration of economic conditions is the industrial reflation. After contracting for 55 consecutive months, deflation in China's Producer Price Index (PPI) is expected to end by end of this year. China's PPI has declined merely by 0.8% year-on-year in August 2016 and is likely to rebound from a low base recorded in the second half of last year (see chart 2 below). Negative PPI in the past has weighed on industrial profits as profit margins were under sustained pressure. Easing PPI deflation is positive to corporate earnings trends, especially for the upstream sectors. In fact, the official industrial profits data has regained momentum in the second half of this year, and it shot up by 19.5% year-on-year growth in August 2016, which was the fastest pace of increase seen over the previous three years.
Chart 2: China's PPI Deflation Is Expected To End By End Of 2016
In addition, the industrial destocking cycle in China this time around lasted for 22 months and is likely to take a turn for the better moving forward (see chart 3 below). This is considered as one of the longest and strongest destocking cycle given that it has lasted more than the historical average of 17 months (for the previous 4 cycles) and inventory growth was at a record low level. With the economy starting to pick up steam and inflation expectations back on the radar, we expect a restocking cycle to begin. In fact, the pace of decline in the finished goods inventories of industrial enterprises has softened from the trough of -1.9% in June to -1.6% in August. More importantly, this positive trend has been underappreciated, giving ways for more consensus upgrades if the economy ameliorates further – a genuine possibility in our view.
Chart 3: Industrial Destocking Cycle Is Likely To Take A Turn For The Better
Earnings Growth Is Improving; We Expect More Consensus Upgrades
The recovery in economic indicators are gradually translating into better corporate earnings, as evidenced via the acceleration of industrial profits growth to 19.5% year-on-year in August (see chart 4). This high frequency (monthly) data point (industrial profits growth) is often served as an early guidance for the estimated earnings of the non-financial sector. Therefore, a jump in industrial profits in the past two months should provide a huge boost to the market's earnings prospects given the high correlation between industrial profits growth and non-financial companies' earnings. Moreover, if PPI and GDP growth recover in the coming quarters, it is possible for non-financial companies' revenue growth to rebound at an even faster pace in the second half of the year.
Chart 4: Industrial Enterprises' Profits Surged The Highest Over The Past Two Months
The estimated earnings of the Chinese H-Share market (represented by Hang Seng Mainland 100 Index) for 2016 has been revised up by 0.4% in September following a series of earnings downgrades (around -7.0%) on a year-to-date basis. In view of a firmer economic backdrop for China, the earnings upward revision cycle may be only just beginning and it is reasonable to see more earnings upgrades in Chinese stocks moving forward.
The HK & Chinese Markets Will See An Upward Valuation Re-rating
We believe Hong Kong and China's markets will be seeing a valuation rerating in the coming one to two years. Historically, the Hang Seng Index has been trading at higher valuation levels. Back to the period during 1999 to 2010, Hong Kong equities mostly traded at above PE ratios of 15.0X (see chart 5 below). However, the Hang Seng Index has never seen such valuation levels since 2010. We believe the main reason is because of the inclusion of more Chinese companies, which dragged down the overall index's PE ratio. As at 28 October 2016, the estimated PE ratio for 2016 is standing at 12.7X.
Chart 5: The Estimated PE Ratio of the Hang Seng Index (HSI)
Similar to the Hang Seng Index, the Chinese H-Share market (as represented by the Hang Seng Mainland 100 Index) once traded at a higher valuation level than today's (as shown in chart 6 below). Back to the period during 2006 to early 2008, the PE ratio of the H-Share market was also above 15.0X. However, the Hang Seng Mainland 100 Index has never seen a PE multiple higher than 15.0X since 2010. The market is trading at 10.4X 2016's estimated earnings as of 28 October 2016.
Chart 6: The Estimated PE Ratio of Hang Seng Mainland 100 Index
Even after the recent rebound, both the Hong Kong and Chinese equity markets are still trading at a big discount relative to their historical average levels. The discount reflects the market’s scepticism of the recovery story of China’s economy and may have overlooked some of key trends that we have highlighted above. In line with our call on the valuation re-rating for the emerging market, we expect the PE ratio valuation for the Hong Kong and Chinese equity markets to be re-rated back to 15.0X over the next two years when markets fully recognize the recovery and earnings turnaround.
For Hong Kong equities, we believe the re-rating will be mainly driven by the Chinese financials/ banks and real estate companies which have been trading at a depressed level for the last few years, while non-Chinese companies are generally trading at a higher premium.
For the Chinese H-Share market, approximately 53.4% of the index constituents are still trading below a PE ratio of 15.0X, which reflects a better bargain when compared with the Hang Seng Index's constituents. Similarly, we believe the re-rating will be mainly driven by the Chinese banks and real estate companies.
Hang Seng Index To Hit 32,000 By End-2018
As at 28 October 2016, the estimated earnings growth for 2017 and 2018 is at an achievable level of 9.3% and 10.4% respectively. As we expect the market’s estimated PE ratio to be re-rated back to 15.0X, the Hang Seng Index will hit 32,000 by end 2018.
Chart 7: Hang Seng Index to Hit 32,000 By End-2018
Chinese H-Share Market Will Deliver A 60% Potential Upside By End-2018
As for the Chinese H-Share market, the market predicts earnings to grow at 11.5% and 11.0% for 2017 and 2018 respectively. With an upward valuation re-rating to 15.0X PE, this will translate into a potential upside of 60% by end-2018.
Chart 8: Chinese H-Share Market Will Deliver 60% Potential Upside By End-2018
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