Outlook 2019: China equities
Following a cyclical recovery in 2017, driven by robust domestic demand and supply-side reforms, the emphasis in China has since shifted to the quality of economic growth.
With political power consolidated under President Xi, this focus on quality growth as well as economic and social stability brought renewed efforts to shrink the shadow banking sector. The government’s effort to deleverage the economy and increase regulatory oversight led to concerns around economic growth coming into 2018. Indeed, we saw credit conditions tighten on the back of reduced shadow banking activity. Tighter credit led to a rise in credit defaults this year, while areas including industrial production and fixed asset investment also lost momentum.
Against the backdrop of a slowing economy and escalating trade tensions with the US, China has introduced various measures to help support the economy:
- The delayed implementation of regulations on wealth management products
- Cuts in banks’ reserve requirement ratio (RRR)
- The accelerating issuance of local government bonds
- The encouragement of banks to increase lending to small and medium enterprises
- The State Council’s guideline to support domestic consumption
- Changes to the income tax scheme for individuals.
We believe that these policies are aimed at cushioning the economy on the downside rather than providing large scale stimulus. A weak renminbi and high debt levels also limit the ability of the government to stimulate aggressively. The government will need to continue to balance its agenda for deleveraging and introducing structural reforms, whilst maintaining reasonable economic growth.
On the trade front, our base case remains that a wide-ranging destructive trade war is not in anyone’s interest. The risk to Chinese and Asian earnings remains hard to gauge given the announced tariffs to date are relatively narrow in scope and will have little impact on the listed corporate sector. We see limited scope for Chinese manufacturing to be re-shored to the US, or substitution of US goods in place of Asian imports. However, it is the second order impact on capex and investments, and potentially on consumption, that is harder to measure.
The renminbi is an unlikely tool should trade tensions continue to escalate given the risks of inciting capital flight, but currency weakness may be seen as a result of US dollar strength.
The risks of a full-scale and protracted trade war are longer term in nature, with China’s strategic industrial policy blueprint and a Sino-US technology arms-race at the heart of the issue. China has shown its willingness to negotiate and compromise on trade issues to narrow the trade deficit, reduce import barriers and further liberalise its domestic market. However, China is unlikely to move on its strategic vision to transform itself into a technology leader.
Defensive stance, though value is emerging
Earnings-per-share growth is currently forecast to be in the mid-teens, but we think that is likely to moderate going into 2019. Margin pressure for mid-stream consumer and industrial companies remains high, especially for those who are unable to pass on higher costs.
We remain relatively defensively positioned going into next year given the current environment, with most of our exposure concentrated in domestically-focused names and sectors showing long-term growth trends. We remain underweight to technology stocks given uncertainties brought about by regulatory headwinds. We prefer the energy sector given discipline on the supply side and on pricing. We also favour Chinese insurance companies, and names benefiting from domestic consumption, where we are seeing a pick-up in offline consumer activity.
Valuations for China equities have become more attractive and suggest upside for investors over the medium term. However, investors are likely to remain cautious in the near term given the likelihood of further cuts in earnings forecasts, continued uncertainty on the trade front, and continued increases in US interest rates in the next few months.
As bottom-up investors, our focus remains on those businesses best equipped to navigate the current slowdown and also exploit the favourable longer-term trends we continue to see in the market.
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