11 June 2020
GAM Investments’ Rob Mumford says the outlook for active China equity exposure remains strong given it is underpinned by a range of positive structural themes.
Despite near term uncertainty, including the economic fallout from Covid-19 and a recent re-escalation of US China tensions, we remain positive on the outlook for China equities. In a growth and yield scarce environment, we believe China equities offer the attractive combination of structural growth, the policy firepower to sustain that growth, an improving quality of growth and attractive valuations.
Structural growth themes
There are several powerful and positive structural investment themes occurring in China which we believe should help mitigate investor concern regarding near-term uncertainty. These include the emerging consumer trend, driven by the continued momentum of urbanisation and disposable income growth, enhanced by new technology and infrastructure. China has the advantage of leap frogging the use of legacy traditional infrastructure, driving a much faster level of growth through online platforms across a range of industries. In China, e-commerce sales in 2019 grew by over 20% and represented 26% of its total retail sales in 2019 versus 11% for the US. Healthcare reform is a further structural growth theme. In China, currently 10% of the population is over 65 years old. This is set to increase to 20% over the next two decades. We believe a historic underspend and lack of focus around healthcare (and related derivatives) is therefore likely to lead to strong growth ahead with huge opportunities across a range of related services and products across innovative medicine, services, health and pension related insurance products. Renewable investment is yet another secular growth theme. China’s emissions growth in recent years has decelerated sharply, underpinned by tighter environmental regulations and a focus on green investments, including areas such as renewable energy and electric vehicle infrastructure1. Therefore, even with macro uncertainties, there remain a range of sustainable growth themes that we believe are likely to drive premium growth rates and investment opportunities for active managers.
Firepower to sustain growth
China was first into the Covid-19 virus growth shock and is leading the way out, but the recovery has been uneven and risks remain, particularly around employment. As a result, China’s policymakers during the recent twin legislative sessions announced further significant additional fiscal policy to mitigate downside risks. We witnessed timely and forceful policy action in February, with ample liquidity and moderately flexible monetary policy to counter short-term negative growth pressure. March and April produced a positive but uneven recovery driven by ongoing movement constraints, inventory run-down, overseas order cancellations and weakness in services. In early May, given ongoing risks, the Politburo announced further strong proactive stimulus under the banner “normalisation of the pandemic control on the six stabilities” while the People’s Bank of China (PBoC) has spoken of “powerful” and “diversified” policy shifts ahead. Estimates of the final augmented fiscal stimulus for 2020 are as high as 12-14% of GDP while ongoing reserve requirement and interest rate cuts are expected over the rest of the year.
Improving quality of growth
Historically, economic cycles have led to large earnings per share (EPS) downgrades in China in the region of 15-20%. What has been notable of late is the improving resilience of earnings among corporates despite a challenging environment. In 2018, despite concerted domestic de-leveraging and tightening USD rates and liquidity, earnings finished flat year-on-year and similarly in 2019, earnings were also flat despite the challenges of weak global growth and the US–China trade disputes. In a similar vein, even with the huge disruption from Covid-19, the MSCI China Index is expected to remain flat in 2020. This contrasts sharply with historic previous downturns like 2015-2016 and reflects the fundamental shift of the economy towards sustainable domestic consumption and is also a reflection the significant equity market weighting of high quality, large-cap consumer stocks, such as Alibaba, Tencent and JD.com. Another key point regarding an improvement in quality of listed companies is the concerted effort by the regulators to improve the quality of accounting, auditing and governance which has made positive strides and ties in with negotiations with MSCI for greater inclusion of the domestic equity and bond markets in international indices.
Despite recent uncertainty the equity market as a whole is not showing as “cheap” on some traditional metrics but is attractive nonetheless, in our view, particularly at the stock level. The index, at a low teens price to earnings ratios (ie a high single digit earnings yield), reflects the legacy volatility of the economy and market which as described above is now unfounded. A second important point is that the index make up has changed significantly with the addition of the large internet names mentioned above. These companies are appropriately priced as growth stocks which make comparisons of the index to historic ranges less relevant and also could imply the index at fair value versus history, making other sectors in the index appear significantly undervalued versus history.
Forecasts for China GDP growth are at a premium this year and even looking at a potential recovery next year the International Monetary Fund (IMF) forecasts China to grow at twice the rate of the rest of the world. This is reflected in the China equity market with earnings growth forecasts for the next few years at a significant premium to the rest of the world while the valuations remain at a discount to rest of the world. At the sector level we see attractive opportunities in terms of both growth and valuation across consumer discretionary, technology, non-bank financials, renewables and healthcare.
While near-term challenges remain, we believe the outlook for active China equity exposure remains strong, underpinned by a range of positive structural themes (at attractive valuations) with policymakers in the wings with significant additional firepower to mitigate downside risks. Global growth and yield scarcity in the current and likely post Covid-19 virus era make China more attractive than ever, in our view.
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. June 2020.