22 July 2020
China equities have had a healthy consolidation recently driven primarily by policy fine tuning but GAM Investments’ Rob Mumford believes attractive secular growth themes remain an opportunity for investors.
A benign virus progression, strong policy support and a domestic focus has led to an impressive economic recovery in China, driving strong equity market returns year-to-date. With increasing evidence of policy fine tuning, flood disruption and on-going geopolitical tension we have recently seen a healthy consolidation. However, we believe investors should remain on the front foot in terms of increasing exposure to active China equity funds given strong multi-year secular growth trends.
A strong recovery is met with policy fine tuning
The China equity market (MSCI China) was up 15% over the first two weeks of July supported by an impressive recovery from the virus outbreak including strong top down data such as the June composite purchasing managers’ index (PMI) at 54.2 – the highest since early 2018. The strength of this recovery in the context of extremely easy financial conditions could be a concern given fears of policy tightening and a potential negative impact on equity market performance. Indeed, the equity market has seen a consolidation recently including since the reporting of an impressive Q2 GDP of +3.2% year-on-year – (beating forecasts of 2.4%).
While select money market benchmark rates were cut at the end of June we have seen interbank rates edge up over the past few weeks. In line with this trend and a strong risk on environment we have seen China government bond yields trend significantly higher with the benchmark ten-year bond yielding as much as 3.1% in early July (last 2.95%) from late April lows of 2.48%.
However, the macro economic data above paints of rosy picture and ignores frailties regarding domestic employment, weakness in overseas economies and the risk of elevated foreign policy tension. In addition, south and central China has experienced serious flooding in recent weeks affecting dozens of provinces and displacing millions with significant investment required to help the region.
As a result, broad monetary and fiscal policy is likely to remain supportive for some time. However, with pockets of over exuberance appearing in sections of the market it was no surprise to see some policy fine tuning which has come in various forms including a marginal tightening of liquidity and policy guidance with encouragement from the China Securities Regulation Commission (CSRC) of a “healthy bull market” and warnings regarding certain stock market activity ranging from illegal margin loans to excessive fund raising.
Another reason for the policy backdrop to remain supportive is the geopolitical outlook which is likely to remain difficult particularly with the US presidential election entering its latter stages. With Joe Biden ahead in a number of polls there is concern that an increasingly desperate President Trump steps up anti-China policies, the most radical of which would be to rip up the ‘phase one’ trade deal. Alternatively, there is a chance we see more robust reactions from China regarding actions taken by the US so far. However given economic frailties in both countries and risks that excessive action or reactions could potentially cause significant disruption (which would not help domestic support for either government) we expect the US-China relationship to remain pragmatic though rhetoric is likely to remain elevated over coming months.
Tighter liquidity, policy fine tuning and the risk of elevated foreign policy tension are reasons for at least a consolidation of the equity market near term. However, we believe active funds – where secular growth themes are strong and reinforced by the virus outbreak experience – present an opportunity. At the same time, we believe it is best to avoid areas of the market that may be hindered by new and on-going shifts in the economic structure, sectors and companies that may be exposed to the risk of shouldering policy burdens and also overvalued segments of the market, including in positive thematics.
An attractive growth and carry destination, but be selective
It is significant that the Chinese renminbi strengthened to dip below the psychologically important seven mark against the US dollar last week and reflects a superior growth and yield path with China government bonds reflective of a rate environment at significant premiums to developed economies and higher rated Asian emerging markets. Despite the growth and yield advantage, given elevated geopolitical tensions, the path of the renminbi may be volatile near term if the experiences of previous episodes are a guide.
However, we believe China equity markets continue to offer strong return potential appealing to growth, value and yield investors. Even with pockets of the market at elevated valuations, current 2021 forecasts predict the MSCI China to generate an earnings yield of 7%, free cash flow yield of 10% and a dividend yield of over 2% (with higher yields on offer in some segments) while earnings are expected to grow in the mid-teens.
While market valuation charts versus history look at upper of end of ranges, there are significant distortions given the increased weight and in some cases relatively new arrival of the internet platforms. For example, food delivery company Meituan Dianping only listed in 2018 and is now almost 4% of the MSCI China Index. Stripping out these names illustrates that much of the broader market is trading at attractive levels relative to history and in some cases close to crisis lows in an economy which is showing the fastest recovery trends and is primarily domestic focused.
In our view, select exposure to the domestic A-share market is preferred, avoiding a range of potential pitfalls including exposure to overinflated areas of the market where government support, large fund raising and active retail participation have led to bubble like valuations in some areas. As per 2015 and 2018, if the authorities do decide to rein in excess exuberance, liquidity and leverage more aggressively at some point it will be frothy segments of the A-share market and overvalued growth concepts which will see downside. Other potential issues include an increasing pipeline of restricted stock becoming available for sale and supply of paper with the shift to accelerated registration based initial public offerings.
Strong secular themes
The recent downturn has enhanced strong secular themes across consumer spending and behaviour, new technology infrastructure and renewable companies.
As examples; the leading consumer internet platforms have seen an increase in both their addressable market while also increasing market share at the expense of marginal players due to superior execution over the outbreak. Online market share of retail reached close to 30% over the first half and even with a small pull back as the economy opens up is expected to trend higher. New infrastructure relates to this shift including more work and broader activities from home (or out of city) resulting in both upstream (for examples data centres) and downstream (5G components) beneficiaries of these trends expected to generate strong earnings growth for the years ahead. A shift to a healthier lifestyle is also likely sustainable while on health more generally the need for a robust, effective healthcare system is more important than ever. Outside of vaccine related bubbles, attractive investments remain across pharmaceutical, life science and services. In general the thrust of fiscal spend is likely to be a lot more targeted than in previous cycles and the ‘green investment engine’ we think will continue to be a focus of policy over many years with significantly more directives expected in the new five year plan which is due in 2021. As a result, we are positive towards specific solar, wind and waste companies.
There are significant areas of the market we do not think are attractive. For example, telecom operators and large banks may have to shoulder part of the burden of significant policy support which may subdue future returns. In addition certain companies exposed to positive themes including those mentioned above particularly in technology and pockets of the A-share market have valuations that may prove hard to grow into and offer poor risk reward at this stage.
Ultimately, however, we believe China equities are in the enviable position of showing cyclical (including virus) resilience, strong secular growth, an improving quality of growth at attractive valuations (though selectivity is required).
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. The companies listed were selected from the universe of companies covered by the portfolio managers to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. July 2020.