• While China’s GDP growth has slipped, amid domestic and external challenges, there is no need to be too pessimistic about the economy. Looking ahead, the economy is poised to improve with the series of supportive policies from the central government.
• Leading indicators, which include all of China’s PMIs have rebounded in August, highlighting a recovery in economic activity. While external demand moderates, domestic demand continues to display robust signs of resiliency.
• With economic growth expected to remain resilient ahead, corporate earnings in China is set to expand at a robust double-digit pace in the next two years.
• China’s undemanding market valuation, alongside a robust earnings growth outlook, present an upside potential of more than thirty percent by end-2021.
• We maintain our star rating of 4.0 stars “Very Attractive” for China A equity market.
Updated (17-Sep-19): The choice of fund has been updated to Aberdeen Standard SICAV I - China A Share Equity A Acc USD, as a better representative of China A-share market exposure.
Waves of economic data reflecting mixed economic growth have washed up on the Chinese shores as the cold winds of trade-dispute continue to chill China’s growth (chart 1). Standing before a potential fresh round of tariffs (just delayed for two weeks at current writing) on Chinese goods, investor sentiments towards China and its dynamic equity market have consequently dwindled.
While unnecessary tariffs on Chinese goods and domestic disturbances in Hong Kong have possibly delayed an economic recovery, we believe China’s economy remains fairly robust. In our assessment, the nation’s downtrend in economic growth, was already heavily influenced by China’s deleveraging and rebalancing efforts before being exacerbated by the barrage of tariffs. As China’s deleveraging and rebalancing campaign strides towards completion, growth will likely revitalise as the aforementioned headwinds dissipates while sentiments reflate.
The impact of prior monetary easing and fiscal stimulus, in our view, is finally taking effect. With multiple indicators rebounding and displaying resiliency, we believe there is no need to be too pessimistic about China’s economy.
At the current juncture, the world’s second largest economy is displaying robust signs of resiliency from a (1) recovering manufacturing and services sector; (2) accelerated investments in growth-boosting industries; (3) accelerated credit flow; and (4) ramping up of stimulus support.
Chart 1: China’s Quarterly GDP growth
Chart 2: GDP growth still high compared to regional peers
Leading indicators are recovering
China’s purchasing managers index (PMI) for composite, manufacturing and services has all rebounded in August (chart 3). A leading indicator for economic conditions, China PMI’s rebound underscored a recovery in economic activities. Both manufacturers and service providers experienced improved rates of business activity growth and have returned to expansionary territory (above 50).
At the composite level, the growth of new orders, an indicator with leading prowess by itself, was the quickest seen since April. The upturn was led by the services sector, which are more impervious to cyclical tendencies of the Chinese economy. Conversely, new export business fell as foreign demand declined, reflecting the adverse shock of the trade conflict.
Comparatively, China’s service sector is faring better against its manufacturing counterpart as the latter gets blasted by headwinds from the trade dispute. While production activity has picked up, overall demand for manufactured goods has yet to show significant signs of improvement. We believe a sustained recovery in manufacturing is undoubtedly necessary to combat the slowdown and revitalize economic growth. Looking ahead, we see pillars of support for China’s manufacturing firming up (discussed below) amid an improving trade narrative.
Chart 3: China’s PMI have rebounded
Domestic demand stable and resilient
The contrast between new orders and new export business for China’s composite PMI (discussed above) suggests that domestic demand remains strong, amid a slackening external demand. This is reinforced by sky-high consumer confidence level, nearing its 10-years high, and a pickup in median disposable household income since 4Q 2018 (chart 4). As such, economic data suggest that Chinese consumers have the ability and willingness to consume more, which once again strengthens our view on China’s domestic demand.
Government stimulus have also heavily lifted domestic demand and with the recent release of further stimulus and polices (while current ones are taking effect), it is expected to hold up strongly in our view. Domestic demand remains cardinal to the Chinese economy today, as it is the single largest driver of GDP growth, contributing to more than 60%. Resiliency in domestic demand underpins both the manufacturing and services industries, and therefore keeps the broader economy buoyed.
Chart 4: Consumer confidence near 10 Year high while disposable income has grown steadily
Metal prices support recovery in manufacturing
As one of the largest consumer for global metals, China’s fluctuating demand will have significant influences on metal prices. Therefore, gyrations in metal prices can be telling on demand conditions in China, which makes the metal market a prime indicator for the Chinese economic activity (chart 5). A detailed look across history suggests that metal prices (as gauged by the LMEX index) leads China’s official manufacturing PMI.
The recent spike in proposals of infrastructure and construction projects in China alongside an improvement in trade talks have been priced in the metal market (chart 5). This reaffirms a potential boost manufacturing activities in China’s economy and therefore, support a rebound in economic growth.
Construction activities, a deliberate simulative effort by the Chinese government, have accelerated in recent months. This is backed up by the higher steel production, which serves to meet the underlying need for greater construction materials (chart 6). Broadly, greater construction activities is a boon for economic growth, one of the few effective simulative measures, due to its large spill over effect on the economy (i.e. labour market) and on corporates (i.e. revenue boosting).
Chart 5: Metal prices point to recovery in the manufacturing sector
Chart 6: Construction activity has improved as supported by higher steel production
Investments in growth-boosting industries continue to pick up
The importance of fixed asset investment (FAI) in China has soared in recent years, reflecting Chinese policymaker’s usage of it as a stimulative weapon to incite economic growth, in the backdrop of deleveraging and rebalancing efforts. Fixed asset investment can be viewed as a measure of capital spending by the Chinese government to stimulate economic growth.
In the year-to-date, China continues to see faster growth in fixed-asset investment in the secondary and tertiary industries. Broadly, FAI has improved after tariffs were implemented in June 2018 (chart 7) as the Chinese government ramped up investment in technologies. China’s secondary and tertiary industries contributes significantly to its GDP. The former account for 40%, while the latter, making up the lion’s share of the contribution, accounts for 52% of China’s GDP. Continued investments in these key sectors not only adds resiliency and support to China’s recovery but also bolster economic growth in the long run.
Looking ahead, we anticipate FAI to accelerate further as policymakers have just ramped up infrastructure spending by approving 12 fixed-asset investment projects (worth an estimated 70.5 billion yuan) in July. With the significance of FAI as a catalyst to growth (chart 8), we expect China’s economic growth to be buttressed at the very least as FAI picks up.
Chart 7: FAI has improved after tariffs were implemented in June 2018
Chart 8: FAI, an important catalyst for growth, is expected to pick up
Credit impulse continues to recover, supporting corporate earnings
China’s deleveraging campaign and crack-down on shadow finance has impaired credit growth over the past couple of years. The liquidity contraction weighed heavily on economic growth and the Chinese equity market as innumerate hapless corporates saw a compression in margins. Nonetheless, recent data suggests that China is seeing some success in boosting the supply of credit to counter the moderating economy.
As observed from chart 9, China’s credit growth rebounded in August where (1) total social financing (funds provided by China’s domestic financial system to the private sector) picked up; (2) China’s banks extended more new yuan loans; (3) broad M2 money supply grew. The aforementioned data reinforced the government’s success in credit boosting efforts and increased support for the real economy.
Having remained weak for a long time, credit impulse (a measure of the growth of credit, relative to the size of its economy) is also showing signs of a rebound, further reaffirming improving credit conditions in China. The Chinese government’s recent easing measures should unlock further credit growth for the rest of 2019, while the extra ammunition to further open its credit tap grants China the ability to potentially mitigate negative impacts from additional tariff hikes.
Greater credit in the economy has historically lifted corporate earnings, albeit with a lag, as rising credit growth supports corporate investments, business expansion and the broader sales environment via stimulating consumption. Moreover, given the large weightage of the financial sector in the A and H-shares index, there will be an outsized boost to aggregate corporate earnings for these indices.
Chart 9: Data points to a pickup in credit in China’s economy
Chart 10: Credit impulse showing signs of a rebound thereby supporting earnings
New round of stimulus to further support growth
In our assessment, the waves of mixed economic data will likely embolden policymakers to implement further stimulus measures in the form of aggressive monetary easing, fiscal stimulus and growth-boosting policies.
Chinese policymakers have recently cut banks’ reserve requirement ratio by 0.5ppt and this is expected to release an estimated RMB 900bn in liquidity to shore up the real economy. On the fiscal front, the latest fiscal expansion allows local governments to issue special purpose bonds in advance to stabilise growth while enlarging the scope of the local government special purpose bond.
The above concoction of stimulus will administer a host of positive impacts on the Chinese equity market and economy as we expect the (1) releasing of extra liquidity to help China banks alleviate NIM pressure; (2) improvement in market sentiment and investor’s confidence; and (3) earlier issuance of special purpose bonds helps speed up recovery.
Resilience in economic growth lends support to robust corporate earnings growth
It is our core belief that, on a fundamental basis, economic growth (as measured by GDP) is the primary driver of corporate earnings growth across the global economies. This relation holds especially true in China, where over the last twenty years, the correlation between the two growth rates has been quite strong (Chart 11).
Hence, with the GDP growth for China projected to remain resilient ahead, at a stable pace of six percent or more, we believe that the corporate earnings in China will likely to maintain its robust double-digit pace for the next two years ahead.
Chart 11: Strong correlation between GDP growth and earnings growth in China A shares market
Corporate earnings growth (measured using CSI300 Index) this year is projected at positive +9%, despite the earnings contraction expected for global and Asian markets. Looking ahead the next two years, China equities are projected to generate impressive earnings growth of 13.5% and 12.2% for FY2020 and FY2021 respectively.
The double-digit growth for China equity market also meant that it is set to outpace earnings growth that of other global and Asian equity markets. With a 3-year CAGR of 11.6% for this year till end-2021, China’s earnings growth rate is close to double that of MSCI AC World Index and thrice that of Asia ex-Japan Index (Chart 12).
Chart 12: Earnings growth of China A shares set to outpace both that of global and Asian markets.
While we do not rule out the possibility of near-term downside risks, such as a slowdown of national economic growth, increasing inflationary pressure and a challenging external environment (heightened tension in trade relations), we think that the much of the negatives have already been factored in via negative earnings revisions this year so far (Chart 13).
The estimated earnings growth for CSI300 Index for this and next year have been adjusted downwards by -8.8% and -10% respectively, compared to consensus estimates from one year back. While further earnings downgrades remains plausible in the near-term, we see limited room for any drastic downwards revision. Earnings underpinning the China A-share Index are likely to stay resilient, via the robust organic growth driven by domestic consumption.
Chart 13: Much of the negatives have been accounted for through earnings downgrades across this year.
Major sectors within China equity market to thrive from consumption-driven economy
Our index of choice for the China A-share equity market is the CSI 300 Index, which is composed of 300 Mainland Chinese companies spanning a wide variety of industries. Among which, Financials, Industrial and Consumer sectors account for the bulk (roughly 70%) of the index (Chart 14).
As mentioned in the previous section, we expect earnings growth of China equity market to be at double-digits rate of 11.6% for the next two years. This impressive growth is primarily driven by the resilience in its underlying sectors, many of which are enjoying robust organic growth amid China’s structural shift towards a sustainable consumption-driven economy.
Chart 14: Financials, Industrial and Consumer sectors make up the bulk of the CSI300 Index.
The Consumer sectors, particularly consumer staples, are poised to experience above-average growth rate, above thirty percent year-on-year for this and next year. China’s massive consumer market is poised to remain resilient, supported by the large population base and continuous consumption upgrade (Chart 15).
Looking ahead, we expect domestic consumption to become even more important for GDP growth, given the prevailing US-China trade war tension (which likely continue to drag on exports growth). While the prolonged trade war might also affect consumer sentiment negatively, we believe the series of favourable fiscal policies (e.g. VAT reduction implemented since April) to serve as effective offsets, as their impacts materialise across the next few months.
In addition, the Chinese government has displayed strong tendency towards supportive policies to boost consumption, and we expect more consumer-oriented policies to be subsequently implemented in the next few quarters. Hence, consumer sectors are set to benefit as the government continue to utilise domestic consumption as the key driver for its economic growth.
Chart 15: Earnings growth of CSI300 Index driven by the robust growth of its underlying sectors.
The largest sector, the Financials, which comprises of mainly banks and insurance firms, are projected to generate strong and stable earnings growth ahead, as earnings conditions continue to improve for them.
Thanks to the recent reserve requirement ratio (RRR) cuts, alongside liquidity injections via targeted medium-term lending facility (TMLF), credit and loan growth have rebounded across the first half of this year.
Looking ahead, the series of financial supply side reforms, with respect to adjusting credit structure and target lending to private sector and SMEs by banks, would continue to encourage directing funds to real economy. Therefore, we believe balance sheet expansion would continue to edge up, amid the loosening monetary condition.
While net interest margin (NIM) will be on a general decline, with interest earnings assets yield is edging down, we believe that the continuous NIM contraction urge banks to develop more diversified income sources.
We also expect non-performing loan (NPL) ratio and asset quality to stabilise and improve in the following quarters. Banks are increasing their write-off to weather further uncertainties, and the enhanced provision coverage provides a substantial risk buffer to any systematic liquidity shocks.
Attractive Upside Potential from a combination of robust earnings growth outlook and undemanding market valuation
CSI300 Index is currently trading at a forward PE ratio of 12.9X, which is near our fair PE ratio of 13X. However, looking further ahead, its end-2021 forward PE ratio is at 10.1X, which represent an upside potential of more than thirty percent (Chart 16).
Table 1 details the end-2020 and end-2021 potential upsides of an investment in China equity market from today.
Despite the presence of near-term risks, amid a challenging external environment), we think that the negatives have been factored in the negative earnings revisions this year so far. We think CSI300 Index 3-year earnings CAGR of 11.6% for this year and next two years is highly achievable via the resilience in its underlying sector.
Table 1: Robust earnings growth with an undemanding valuation results in an attractive upside potential for China-A market.
CSI 300 Index | FY2018 | FY2019 | FY2020 | FY2021 |
12M Forward PE Ratio (X) | 10.7 | 12.9 | 11.4 | 10.1 |
Expected Earnings Growth %YoY | 8.0% | 9.3% | 13.5% | 12.2% |
Earnings Per Share (EPS) | 281 | 307 | 348 | 391 |
Projected Fair Price | - | - | 4,527 | 5,079 |
Potential Upside (%) from Today | - | - | 18% | 32% |
Source: Bloomberg, iFAST Compilations Data as of Sep 2019
Chart 16: Despite an impressive run-up YTD, CSI300 Index still trade below its 10-year average PE ratio.
The combination of a robust earnings growth outlook and an undemanding market valuation present an attractive upside potential of over thirty percent for investors who are willing look ahead by one to two years’ time (Chart 17).
Even with the impressive year-to-date run-up of the China A-share market, the upside potential of China equities still rank among one of the highest within markets under our coverage.
Overall, we maintain our star rating of 4.0 stars “Very Attractive” for China A equity market.
Investors seeking an actively-managed solution can consider the following fund for exposure to the China A-share market, Aberdeen Standard SICAV I - China A Share Equity A Acc USD.
For investors who want exposure to China H-shares market, they can consider our recommended fund Fidelity China Focus A-USD.
If you are interested to find out the differences between the China A-shares and H-shares markets, we will be writing an article soon on this topic so do keep a lookout!
Chart 17: Robust double-digit earnings growth rate will be key in uplifting the Chinese equity market.
The Research Team is part of iFAST Financial Pte Ltd.
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