Outlook 2018: Greater China equities
Greater China equities have staged a strong rally in 2017, with the MSCI China index up close to 50% year-to-date. This has mainly been driven by a few key factors, including:
- Signs of cyclical recovery – Chinese economic growth has stabilised in the past year in response to a prolonged period of strong credit growth, fiscal stimulus and support of the property market.
- Improving earnings momentum – We have seen a bounce in energy and material prices in the last year as well as robust strength in the internet and technology sector.
- Liquidity support – Liquidity remains robust and is further supported by southbound flows from the Chinese mainland to Hong Kong under the Stock Connect schemes1 which connect the stock exchanges of Shanghai and Shenzhen with the exchange in Hong Kong.
Market valuation has become stretched after the strong market rally. As of November 2017 the index is trading at close to 15x forward price-to-earnings ratio (PER) and 1.9x price-to-book2, which are above historic ranges. Excluding cheap Chinese banks, the index is actually trading at 22x 2017 PER. Given that risk-reward at this junction has become less favourable, we have adopted a more conservative approach going into 2018.
At the recently-concluded 19th Congress of the Communist Party of China, the Chinese government seemed to place much more emphasis on the quality of economic growth to ensure stability and wealth equality, rather than focusing on a quantitative GDP growth target. As a result, the Chinese economy is expected to grow at a slightly slower pace in 2018 in light of the following factors:
- After the strength of China’s GDP in the first nine months of 2017 – which averaged 6.9% year-on-year – some of the cyclical momentum is losing steam. This is due to growth having to match a higher starting base (the high base effect) and the implementation of restrictions on property purchases, which can negatively impact demand for housing. Further cyclical acceleration from here would be challenging.
- There is also downside risk to the economy emanating from the property market. President Xi’s comments at the party congress that “property is for living, not for speculation” is telling, and the property market is expected to slow down in 2018.
- Although the Consumer Price Index (CPI) has been moderate despite a sharp pick-up in the Producer Price Index (PPI) this year, we are mindful that rising raw material prices may exert margin pressure on select mid-stream consumer and industrial companies while also triggering inflationary pressure in 2018.
- Deleveraging of the non-bank financial sector is likely to continue in 2018. While it is positive in the long run, it is likely to slow economic growth in the near term.
On a positive note, consumption of goods and services will provide a buffer to growth, which has remained strong on the back of overall positive structural trends.
Over in Taiwan, expectations for the new Apple iPhone X are high, but we believe there is room for disappointment as handset markets remain very competitive. Adding to this is the rising competition from Chinese component players over the past few years, which has resulted in increased headwinds for downstream and mid-stream electronic companies.
Liquidity and policy
For China, monetary policy is expected to remain neutral next year. On the one hand, the regulator has finally attempted to deleverage the non-bank financial sectors following a sharp growth in wealth management products and non-bank financial assets in recent years. On the other hand, there is still room to cut the Reserve Ratio Requirement (RRR) for banks in order to partially offset policy tightening and mitigate negative impacts on the real economy. The RRR currently stands at 17% for the big four banks and 15% for smaller banks.
In addition, the interest rate cycles in the US and Europe should have bottomed. The US Federal Reserve will likely start shrinking its balance sheet and there will also likely be further rate hikes, which could put pressure on the renminbi.
There have been marked upgrades in Asia in earnings per share (EPS) growth in 2017 after six consecutive years of downgrades, which is one of the main reasons for the market rally in 2017. A similar pattern is seen in China, as the latest round of earnings upgrades are concentrated in sectors such as technology/semiconductors, materials, consumer discretionary and services.
Looking ahead, EPS growth is likely to moderate in 2018 and we find it hard to envisage the recovery becoming more broad-based, given the cyclical momentum in the economy is likely to slow. In addition, margin pressure will be more obvious for the midstream consumer and industrial companies, especially for those without pricing power. High raw material prices and financial costs will either be translated into higher product prices (inflationary pressure) or result in a squeeze in company margins at some point.
We can still see better earnings momentum in 2018 in some financial sectors including insurers in China and major banks in Hong Kong given the bottoming out of the interest cycle. We are also positive on selected travel-related, healthcare, consumer goods and services companies. They may continue to see further earnings growth on the back of strong demand amid continuous consumption upgrades.
The MSCI China – on a 12-month forward-looking basis – is now trading at close to a 15x 2017 PER (22x excluding banks) and at one standard deviation above the long term historic average. Risk reward has obviously become less favourable. There is also extreme divergence and concentration in stock performance. From a bottom-up perspective, many of the stock valuations are looking stretched, trading close to or above our analysts’ fair values.
MSCI China 12-month forward PER (x)3
Source: Factset and Citi Research, as at 8 November 2017
Going into 2018, we will continue to focus on companies with solid cashflows, dividend yields and balance sheet strength. We maintain our preference for consumer/service sectors including internet, tourism and education on the back of our positive long-term outlook for consumption demand in China.
Meanwhile, in light of the bottoming out of the interest rate cycle and attractive valuations, we also favour select insurance names.
For the other 2018 outlooks please visit here
1. The Shanghai-Hong Kong and Shenzhen-Hong Kong Stock Connect schemes allow Mainland Chinese investors to invest in the Hong Kong stockmarket (Southbound) while international investors are permitted to invest in China’s domestic stockmarkets via Hong Kong (Northbound).↩
2. Both PER and price-to-book are ratios used to value a company’s shares.↩
3. Forward-looking PER is used as a conventional method of gauging how expensive/cheap stockmarkets are, on a valuations basis. ↩
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