Macro Research

Can the best-performing equity market this year sustain its stellar returns?

As the first country to enter and exit the Covid-19 lockdown, China's successes in dealing with the Covid pandemic this year is shoring up in its fast recovering economic data. As a result, China equities easily top the chart in terms of performance this year so far. But will China be able to retain its lead ahead?

iFAST Macro Research Team
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Published on 19 Sep 2020

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China's macroeconomic and high-frequency data have largely rebounded and came in better than expected, extending the lead against most economies in terms of economic recovery.

While many have expected the combination of Covid-19 and US trade war to weigh down demand for Chinese products, export and manufacturing data suggests otherwise.

China equities has a concentrated domestic revenue exposure of roughly 87%. Thus, the robust economic recovery helped support a profit rebound where earnings are expected to grow 20-24% in FY21/22, exceeding pre-Covid levels.

Valuation are also around fair level and an attractive upside of 20% by end-2022 is expected. We are holding China's star ratings at 4.5 stars “Very Attractive” .

On aggregate, majority of China’s economic data have performed better than expected, including leading indicators such as PMI and retail sales figures

As one of the first countries to enter and exit the Covid-19 lockdown, China have had great successes in dealing with the Coronavirus outbreak situation this year. The rapid implementation of its drastic containment strategies enabled China to keep its new infection cases down, which in turn empowered policymakers to loosen social distancing rules and encourage the reopening of businesses faster than the rest of the world.

While the rest of the world were still bewildered by the sudden spikes in Covid-19 cases within their communities in the second quarter, China has already returned to ‘business as usual’.

Since then, macroeconomic indicators and high-frequency data have largely painted a resilient China – one that was recovering steadily from the Covid-19 shock in the first quarter. While the Q1 data were expectedly horrid, the rebound to positive GDP growth of 3.2% year-on-year (YoY) in Q2 presented us with the encouraging signs that its economy was quickly moving back on track. It was then that we doubled down on our thesis that China will lead a global economic recovery this year.

Chart 1: We believe China will lead the world in terms of economic growth this year and possibly next year

On the steady pathway to growth in third Quarter 2020

China’s economic data in Q3 continued to display strength, affirming a steady economic recovery since Q1’s contraction – China’s first quarterly decline in more than forty years. The readings across July and August indicates that activities in China are returning quickly to pre-Covid-19 levels, fuelled by strong policy support and infrastructure investments.

On aggregate, majority of China’s economic data have performed better than expected, including leading indicators such as PMI and retail sales figures.

Chart 2: Majority of China’s economic data have come up better than expected in Q3 so far

Among the better-than-expected activity data in August is the China’s industrial production, which have maintained four straight months of growth, as many factories were able to return to pre-Covid level of operating capacity as early as March this year. This strongly suggest that China’s industrial engine is back up and running, while the rest of the world remains incapacitated by Covid-19 pandemic (Chart 3).

While we initially expect the combination of Covid-19 pandemic and US trade war to weigh heavily down global demand and demand for Chinese products, the astonishing surge in China’s exports in July and August seems to suggest that the world may not be ready to sever ties with China’s manufacturing capabilities just yet (Chart 4).

Despite the industrial sector having a strong head-start in China’s recovery, domestic demand has been worryingly lagging this year, as shown in the weak retail and imports figures across 1H20. However, we are optimistic that things are about to turn for the better. We think consumer confidence is starting to return, as retail sales grew for the first time this year in August (Chart 5).

Overall, these latest economic indicators demonstrated that China’s recovery is broadening out beyond its industrial sectors into the consumer and services sectors, which policymakers are depending on to spur economic growth, especially in a backdrop where the nation is being fiercely targeted on its external sectors.

As the momentum in exports and services consumption continue into September, we are growing more optimistic that China’s GDP is on track to return to its pre-Covid potential growth level by the end of this year. At the same time, we expect growth to easily surpass peers this year and the next. We echoed the same views as OECD, which recently stated that China is going to be the only G20 economy to register positive economic growth in 2020.

Chart 3: China industrial activities quickly rebounded to expansionary territory in May, as majority of its factories were back in operation as early as March

Chart 4: While under siege of the US aggressive trade policies and drop in global demand due to Covid-19, China’s export to the world continues to surge across Q3

Chart 5: Rebound in retail sales back to positive territory is backed by a resurgence in consumer confidence in China

Strong economic momentum bodes well for China equities

Back in April, we shared our view that China will lead a global economic recovery this year, and consequently standing a good chance in outperforming the other equity markets in 2020.

A quick glance at the FSM Indices shows that our thesis has turned out well for us so far. Chinese equity funds are amongst the best-performers on aggregate this year, registering a year-to-date gain of almost 20%, just slightly trailing the global technology funds – the latter’s outperformance was due to the robust digital economy trends that we have also highlighted since the start of this year.

Chart 6: FSM Indices for China is the top-performing geographical region this year so far

Source: iFAST compilations.
Data as of Sep 2020.

Despite the stellar performance of Chinese equities so far, we think there is still ample room for further upside potential ahead (+20% by end-2022). We remain convinced that the strength of the economic rebound will translate to a robust corporate earnings recovery, which in turns drive the Chinese equities markets.

However, before we dive deeper into the earnings prospects of Chinese equities and its valuation, we would like to draw our investors’ attention to the change in our benchmark used to gauge the performance of Chinese equities here onwards.

Chart 7: China equities have outperformed global equities by a huge margin this year, but we think there is ample headroom for growth.

Change in Benchmark to MSCI China Index (from HSML100 Index)

We have changed our index of choice for China from Hang Seng Mainland 100 Index (HSML100 Index) to MSCI China Index.

We think that MSCI China Index provides a better representation of China equities, as compared to HSML 100. Currently, there is a transition from ‘Old economy’ (i.e. Industrial, Financial etc.) to 'New Economy' (i.e. IT, Comm Services etc.) stocks, and the latter accounts for much of the growth leaders in China. Also, with the larger presence of digital economy stocks, we can expect further upside for consumers and IT sectors.

Unlike HSML100 Index which consist only of H-shares, MSCI China Index capture large and mid-cap representation across the various share classes like China A shares, H shares, B shares, Red chips, P chips and foreign listing (ADRs). Among which, the top three constituents are Alibaba, Tencent and Meituan Dianping – massive Chinese internet titans which we hold favorable opinions on.

Chart 8: MSCI China encompasses various kind of Chinese equities share classes, unlike HSML100 Index which only tracks H-shares.

Corporate profitability tethered to the domestic economy

China corporates (gauged by MSCI China) has an overwhelming concentrated revenue exposure where roughly 87% of the revenue are derived domestically. To put things in context, this is a staggering concentration when compared to major EMs and DMs where domestic revenue exposure typically ranges between 50% - 60% (Table 1).

Even on a sector level, domestic concentration of revenue remains fairly broad-based (Table 2). Only IT, Health care and Energy sector has a lower domestic exposure for revenue, albeit still elevated around 68% – 79%. As a result, a robust economic growth often translates to broad-base improvement in earnings for China equities.

With such an outsize domestic revenue concentration, China’s corporate profitability is often a reflection of its economic growth as the sales environment are largely tethered to the domestic economy. Amid a backdrop where China’s economic recovery is extending its lead against many others, having an outsized domestic revenue concentration is a big positive for China equities.

Table 1: Revenue exposure by country for major DMs and EMs

Source: Bloomberg Finance L.P., iFAST compilations.
Data as of Sep 2020.

Table 2: Revenue exposure per sector for MSCI China

Source: MSCI Economics Exposure Data, iFAST compilations.
Data as of Jun 2020.

China leading corporate profit recovery, underpinned by robust economic recovery

With the backdrop of a steadily-improving economy, downgrades for forward earnings has gradually eased in 2Q/3Q and more recently, upgrades has started to surface (chart 9). We believe upside in China’s economic recovery and continued liquidity injection may spur further upgrade. Again this is a positive sign considering many equity markets are still facing downgrades or are not seeing any up/downgrade momentum.

Chinese corporates are also expected to face a relatively milder contraction in earnings (-6.9%) this year, a stark difference against major EMs (around -30%) and DMs (around -20%). We attribute China’s earnings resiliency to three factors - successful virus containment and earlier re-opening, rosier macro picture (heavy domestic revenue concentration) and sharp recovery in key industries.

Chinese companies are currently leading the charge in the earnings recovery globally. Against its peers, we expect China equities to display the fastest recovery to pre-Covid earnings levels. This is underpinned by the following factors:

(i) Milder impact from Covid-19 on heavier-weighted sectors (i.e. Cons. Discretionary, Comm. Services, IT). These are also high growth sectors which contribute more to the aggregate earnings.

(ii) Heavy domestic revenue concentration enables a stronger revenue growth (VS peers) in an backdrop where China’s economic growth leads others.

(iii) Support from liquidity injection. Positive credit impulse growth (Growth in aggregate credit to private sector as a percentage of GDP) is supportive of economic growth which has historically lead to stronger corporate sales and earnings growth (chart 10).

Chart 9: MSCI China index net earnings revision have just turned positive

Source: I/B/E/S data by Refinitiv.

Data as of Sep 2020

* Three-month moving average of the number of forward earnings estimates up less number of estimates down, expressed as a percentage of the total number of forward earnings estimates.

Chart 10: Strong credit impulse growth leads to improvement in sales and earnings growth

Valuation hovering at fair levels with ample room for re-rating

In our opinion, China equities are still fairly priced. Its forward price-to-earnings ratio (PER) of 13.5X, with FY 2021 earnings, is at the level of our fair PE ratio (13.5X) (chart 11). We believe the PE ratio for China equities deserves a premium and therefore, our assigned fair PE ratio is higher than the historical average of 12.5X.

The four reasons for the premium are broadly categorised into two viewpoints – from a growth and structural perspective. From a growth (economic and sector) perspective, the premium reflects i) China’s long-term economic growth potential and ii) transition to a new economy comprising of higher growth sectors (sector composition is still evolving).

From a structural perspective, China equities have historically received iii) lesser and lower quality coverage by analysts, leading to mispricing and opportunities. Also, iv) investors tend to have a structural underweight to them due to liquidity and access issues. Collectively, this means that China equities are generally undervalued and hence, our premium seeks to address these issues.

Given where current valuation level stands, we see ample of headroom for valuation expansion should positive catalysts materialise, paving the way for further upside.

Chart 11: Valuation trading around fair level using forward PE ratio

Sizeable potential upside despite recent gains

Despite returning a dramatic 41% from March low and 15% in the year-to-date, we still see attractive upside potentials in China equities ahead. We are expecting a potential upside of 20% (table 3) by end-2022 for China equities, underpinned by robust expected earnings growth. Also, we note that the potential upside may be extended by valuation expansion above the fair PE ratio given the ample headroom.

Compared to some of the markets/ regions that we covered, the potential upside might not be on par. But we note that the potential upside for those markets/regions are a reflection of their ‘catch-up’ gains while China’s has already pared its losses since March lows and the upside is a reflection of further gains.

Overall, the fundamental picture from both the economic and corporate side is turning rosier, especially on a relative basis, where China’s recovery is widening against its peers. Further reinforced by an attractive upside potential, decent valuation, we are holding our star ratings at 4.5 stars “Very Attractive” for China equities.

Chart 12: MSCI China price performance vs EPS

Table 3: Forecasts for MSCI China

China Market (MSCI China Index)	FY2019	FY2020	FY2021	FY2022
PE Ratio (X)	13.6	16.8	13.5	11.3
Expected Earnings Growth (YoY %)	1.0%	-6.9%	24.0%	20.5%
Earnings Per Share (EPS)	6.3	5.8	7.2	8.7
Projected Fair Price (Based on 13.5X historical average PE Ratio)	-	-	-	118
Potential Upside from Today (%)	-	-	-	20%
Source: Bloomberg Finance L.P., iFAST estimates. Data as of Sep 2020.

Recommended products for exposure to China

Category	Products
Actively Managed Fund	· UBS (Lux) Equity Fund - Greater China P Acc SGD
Passive Tracking ETF	· iShares MSCI China ETF

The Research Team is part of iFAST Financial Pte Ltd.

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