China’s economic rebalancing is accelerating, on the back of faster structural reforms after last year’s Party Congress. Investors should position their portfolios to capture long-term investment opportunities in China, and we see favourable and sustainable trends in consumer, environmental and information technology sectors. While MSCI China is trading towards the high-end of its range over the past five years at 14x 12-month forward P/E, 12-month forward earnings growth is forecasted to be relatively robust at +15- 16%. We are constructive on consumption, environmental and telecom sectors. For IT, we believe it will offer long-term structural growth, but investors will have to be mindful of valuations in the near-term.
Within the “old” economy, we are more constructive on Chinese banks. Investment opportunities are emerging in China’s banking sector on the back of improving asset quality, receding downward pressure on return-on-equity (ROE) and relatively attractive valuations. With numerous regulatory tightening measures in place and corporate earnings on an uptrend, we see a lower systemic risk in the financial system. Within the sector, we prefer large banks with resilient net interest margin (NIM), relatively less exposure to shadow banking business, and relatively attractive valuations.
Another major theme for the Chinese market is the inclusion of onshore equities, or the A-shares, into the MSCI indices. The A-share market will offer more unique investment opportunities in sectors like consumers, healthcare and IT. It represents a major milestone even though the initial impact would not be significant. With a 5% inclusion factor, A-shares will initially account for less than 1% of the MSCI EM index. Upon full inclusion, A-shares will eventually account for 18% of the Index. However, investors should be mindful that the full inclusion would be a lengthy process, and the A-share market is more volatile and sensitive to policy and regulatory risks.
Reiteration of quality of growth rather than quantity of growth
China concluded its annual Central Economic Work Conference (CEWC) last month, highlighting the government’s key focus and policy plans for 2018. “Progress amid stability” will be the guiding principle with an explicit emphasis on “high quality development” instead of the speed of growth, which is consistent with the key message at the recent 19th National Congress. Three key policy objectives have been reiterated for the next few years, namely risk containment, poverty reduction and environmental protection. The CEWC called for proactive fiscal policies this year which could involve gearing budgetary spending towards areas like environmental protection etc. We also expect further financial supervisory tightening this year, reflecting the government’s resolve to curb China’s financial systemic risks. Overall, however, there should not be any pressure for a big change in macroeconomic policy settings. We believe a moderately weaker exchange rate will be useful to mitigate the potential impact of domestic adjustments, and we forecast USDCNY at 6.80 by end-2018.
Favourable structural trends for consumption, environmental protection and IT sectors
China’s economic transition into a consumption-based economy with a sizeable middle-income population should continue and accelerate, with focus shifted to new growth areas like medium and highend consumption. China’s domestic consumption should be well supported on the back of buoyant consumer confidence, rebounding disposable income growth and consumption upgrading. Notably, despite the recent moderation in the consumer confidence index, it is still at a decade high level; an accelerating real disposable income growth back to 7-8% as of 3Q 2017 added to the momentum.
Within the consumer space, we like WH Group (288 HK) and YUM China (YUMC US). We also like Ctrip (CTRP US) which is a leading travel service company, a key beneficiary of rising middle-class income in China, and a key player in the new economy.
Education is a niche segment within the consumer space, and it is enjoying full-blown demographic, social and policy tailwinds that are favourable to sector growth. We are positive on China’s K-12 after-school tutoring sector as demographic and social trends look set to support demand and spending in the medium term. The K-12 after-school tutoring services are expected to enjoy a CAGR of 10% in 2016-20E, according to Frost & Sullivan. The rising disposable income in China is likely to further boost the spending on children’s education. While we prefer leading providers like New Oriental Education (EDU US), which will stand to benefit from the structural tailwinds, recent run-up of share prices has left limited upside to the current level. We recommend investors to accumulate on share price pullback.
Environmental protection – the third key policy objective highlighted at the CEWC – also presents a host of opportunities. As illustrated in the chart below, China is plagued by severe air pollution. Further clarity on policy support in addressing environmental issues would provide catalysts for this lagging sector to catch up with performance. The government has also committed to deal with water pollution and has set an investment target of RMB546bn for municipal sewage treatment as part of the 13th Five Year Plan. We like China Longyuan (916 HK) and see positive catalysts from new revenue stream from carbon emissions trading scheme for the power industry launched in Dec-2017 and reduction in subsidy receivables. The stock is trading close to historical trough and is below replacement cost with an improving ROE. We also like Beijing Enterprise Water (371 HK), which is trading towards the low-end of valuation, and is a top player and key beneficiary in the sector. Ongoing improvements in cash flow and account receivables could be a positive performance catalyst.
Beyond long-term policy targets, China’s heavy emphasis on technological innovation as the key driver for its growth and the quality of that growth continues to be the dominant narrative. The IT sector is very much at this heart of this picture, amid the torrent of new ideas and implementations for internet, big data and artificial intelligence. As labour costs continue to rise, robotics revolution will also become important for industry upgrades. At the same time, financial technology has seen a rapid development, in response to China’s fast e-commerce penetration and under-served retail banking customers.
However, while the IT sector will offer structural growth upside for the long term, investors should be mindful of its valuations, which have priced in expectations for robust earnings growth. The sector is trading at the high-end of the range at 31x 12-month forward P/E vs a 28% forward earnings growth, leaving share prices vulnerable to any earnings disappointment. Hence, we have a Neutral stance on the sector. We view any share price pullback in the IT sector as potential accumulation opportunities. To lock in on the sector’s emerging segments, look at data technology, cloud and artificial intelligence. Improving data technology will support growth across different sub-segments in the sector, playing a key role in enhancing user experience and supporting monetisation, which are the key success factors for key players in the sector. As for artificial intelligence, it will increasingly integrate into our daily life with the rising popularity of smart devices.
Meanwhile, we view the telecom sector as one of the key beneficiaries of China’s move towards a wider adoption of big data. Indeed the government’s policy support for data infrastructure should prove supportive in the long term. The sector has been a laggard and we see deep value in China Mobile (941 HK) which also offers an attractive yield of 4.6% in 2018e. We also like China Telecom (728 HK) which is well positioned within China’s public cloud space as the second largest player after Alibaba (BABA US). China Telecom’s revenues from data centres, cloud and big data services amounted to RMB17.9bn in 2016, surging 30% yoy and accounting for 12% of total revenue.
China A-shares to be included in MSCI indices
MSCI announced in June last year that A-shares – onshore Chinese equities – will be included into its major indices in two phases, 1 May 2018 and 2 August 2018. The process will start with a 5% inclusion factor, which will see A-shares accounting for merely 0.88% and 0.73% of MSCI Asia and MSCI EM indices respectively. It is estimated the initial inclusion could bring around US$3bn passive inflows and US$12bn active inflows into the A-share market leading up to August 2018. These inflows are only less than 1% of the A-share market cap.
Despite the limited initial impact, the inclusion represents a major milestone, paving the way for A-shares to integrate with the global market. This can help buoy sentiment in the short term.
China is the world’s second largest stock market in terms of market cap after the USA. Hence, upon full MSCI inclusion, the A-share market is estimated to take up a more significant share in global equities market, potentially accounting for 18% of the MSCI EM index. It is also estimated that full inclusion could bring some US$300bn (or more than 10% of A-share’s market cap) incremental inflows. However, judging from the experience of Korea and Taiwan – six to nine years to achieve full inclusion – this could be a long and lengthy process for A-shares.
Unique investment opportunities in A-shares
As the A-share market opens up further and gradually becomes more investable, investors may find more interesting on-shore opportunities to take position on consumer, IT and healthcare sectors. Quality stocks in these sectors compare well with their global peers and have been favoured by overseas investors.
Taking a closer look at the selected 222 A-shares to be included, the range of options are heavily skewed towards financials in terms of market cap, as many A/H dual-listed financial stocks will be included. A smaller number of industrial and consumer discretionary stocks will also become available. The initial sector weighting is similar to that of CSI300 index. At the initial inclusion, the MSCI A-share universe will also have a relatively higher exposure to State-owned enterprises (SOEs), again due to the inclusion of dual-listed and large caps stocks.