China equities: Strong re-rating

China equities recovered strongly, demonstrating their resilience and uniqueness
Chief Investment Office04 Aug 2020
Photo credit: AFP Photo

Recovery in sight. Global equities staged an impressive rebound after hitting a recent low at the end of March, as 1) Investors started to look forward to post-COVID opportunities and 2) Confidence was instilled by central banks’ and governments’ monetary support and stimulus measures.

During this period, China equities demonstrated their resilience and uniqueness among global equities. In USD terms, China equities gained 13% total return year-to-date (YTD) up to the end of July while onshore Shanghai equities rose 11% (Figure 1); ahead of their global peers which remain flat YTD. Investors took the cue from the successful dual-listing of (9618 HK) and NetEase (9999 HK) on the Hong Kong Stock Exchange (388 HK), setting precedence for more such dual-listings going forward.

Improving sentiment and fundamentals. Signs are pointing towards improving sentiment and rising investor participation, including increasing market turnover where the combined turnover of A-shares on the Shanghai and Shenzhen exchanges reached a five-year high of CNY1.5t (USD213b). Likewise, the combined market capitalisation of Shanghai and Shenzhen A-shares rose to USD7t, the highest level in the past two years.

The domestic economy has shown encouraging recovery as the government embarked on proactive measures to drive the world’s second-largest economy out of the slowdown brought about by COVID-19. China’s 2Q20 gross domestic product (GDP) rebounded to 3.2% y/y growth after a decline of 6.8% in the previous quarter (Figure 2). The much-watched industrial production (Figure 2) and manufacturing purchasing managers’ index (Figure 3) are also recovering.

China equities a good fit in the Barbell Strategy. China equities fit well in the growth side of the Barbell Strategy, with secular growth themes of e-Commerce and its ecosystem, e-Sports, fintech, new economy, big data, cloud, social media, semiconductor, and insurance.

Figure 1: Performance of China equities (Dec 2019 = 100)

Note: As at 31 July 2020
Source: Bloomberg, DBS

Uniqueness of investing in China equities:

  1. China equities have low correlation with major equity indices. A-shares have a correlation of less than 0.5 with global equities over the past three years. Including A-shares in a diversified global portfolio would optimise the risk-return profile.
  2. Economic activities are rebooting. Corporates have resumed their operations to generate revenue and earnings. Many companies have surpassed the 75% capacity utilisation mark and could reach higher levels in the coming months. This bodes well for further recovery in domestic consumption and corporate earnings.
  3. Higher revenue mix from domestic economy. China stocks generate the majority of their revenue from domestic operations, usually more than 90% of their revenue, and a considerable number of them derive their entire revenue stream locally.
  4. Government stepping up stimulus measures. Beijing announced a CNY4t economic support plan in May, the largest on record. This includes tax exemptions, lower financing rates, and reduced utilities costs, and will be implemented alongside the earlier announced CNY2t fiscal spending. The government has also assured the market it would introduce fiscal, financial, and additional policy support without hesitation should the need arise.
  5. Higher index representation. China equities now account for a larger portion in the MSCI Global and Emerging Market equity indices, at nearly 5% and 37%, respectively (Figure 4); up from 1.7% and 17% more than 10 years ago. We anticipate the inclusion factors to be gradually increased over the next few years, which will continue to attract investor participation, including global and regional institutional and passive funds.
  6. Prudent policy adjustment. Regulators raised the investment limit on equities for insurance firms to 45%, from 30%. This should further add to equity investment participation over the long term.

Emergence of new economy stocks. Among the 30 largest index constituents in the MSCI China Index, the 11 new economy stocks (e-Commerce, education, speed delivery, ADR, fintech, technology) account for more than 40% of the total index weight. The compelling and evolving investment themes (refer to previous CIO Perspectives “e-Commerce: the secular winner” on 8 June 2020, “New opportunities in China ADRs secondary listing” on 1 June 2020 and “Stay with China investment themes” on 26 May 2020 respectively) will remain strong drivers for China’s new economy stocks. 

Figure 2: 2Q20 GDP rebounded

Source: Bloomberg, DBS

Figure 3: FAI and PMI are recovering

Source: Bloomberg, DBS

Figure 4: Rising index representation for China equities in EM and global indices

Source: Bloomberg, DBS

A-shares on firmer footing. The combined market capitalisation of A-shares reached USD7t in July (Figure 5), surpassing the previous high in 1Q18 against the backdrop of rising investment fund flows.

Unlike in 2015 when the surge in equity prices coincided with similar trends in the opening of new margin accounts and margin purchase balances, the recent wave of rising equity prices did not appear to have high correlation to the manageable level of margin account opening and the outstanding margin purchases (Figure 6).

China domiciled funds are growing quickly. China has become the world’s fifth largest fund domicile. The rapid growth of its fund industry has propelled China to the fifth position in a ranking compiled by the European Fund and Asset Management Association and the US’s Investment Company Institute. With its expanding GDP and growing middle class, the outlook is bright for its funds industry and equity market.

We expect the ongoing fundamental re-rating to continue over the long-term as China equities have yet to narrow the gap with the decade-long performance of US and global equities.

Figure 5: Onshore A-shares at USD7t market value

Source: Bloomberg, DBS

Figure 6: Not due to margin purchases

Source: Bloomberg, DBS

Room for re-rating. The recent solid performance of China equities was driven by:

  1. Investors assigning more generous valuation multiples to the current revised-down earnings forecasts owing to impact from COVID-19.
  2. Supply chain returning to production especially for technology, components, manufacturing, building materials, and health care.
  3. Government stimulus initiatives taking shape.
  4. Expansion in new economy sectors.
  5. Increasing investment interests on A-shares among regional and global investors.

Valuations are not demanding. While the forward price-earnings ratio (PER) of onshore Shanghai A-shares (Figure 7) is ahead of the historical mean, we expect improvement in forthcoming earnings forecast to be among the leading factors for further upside. Notably, the price-to-book valuations remain supportive (Figure 8), setting the stage for further upside potential.

Figure 7: Recovery in earnings forecast to support valuation rerating

Source: Bloomberg, DBS

Figure 8: Room for valuation expansion

Source: Bloomberg, DBS

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