Chief Investment Officer Mike Shiao analyzes how Chinese equities could fare amidst known uncertainties.

Nov 19, 2019 | Mike Shiao
 

 Key takeaways

• Accommodative fiscal and monetary policies will support growth in 2020, but the government will find a fine balance between quality and quantity of growth.  
• Trade tensions might stay for a while. It will lead to supply-chain relocation, particularly for lower value-added products
• Chinese companies are expected to deliver double-digit earnings growth in 2020. Risk-reward remains attractive at current valuation
• Financial liberalization makes it possible to adopt an all-share approach (investing across share classes irrespective of listing locations). We view this as the best approach in our view to invest in China.   

Trade and policy actions are two defining factors for Chinese equities in 2019. Investors are scrutinizing newspaper headlines to get grappled with their latest developments. They directed major market turns; a strong rebounding at the beginning of the year thanks to expectations on stimulus and negotiation breakthrough and a following decline as hopes faded (Figure 1). As we enter 2020, it doesn’t seem that those two factors will go away any time soon. In a period of known uncertainties, how should investors orchestrate their investment strategies towards China? We, as a long-term investor in the country, will share our latest thoughts in this piece.      

Policy support will drive growth in 2020

The consensus expects economic growth to reach 5.9% in 2020¹. We believe there are upside risks to the forecast. We expect accommodative policies through both the fiscal and monetary channels to continue and to get strengthened if downward risk persists. The supportive policy actions will help stabilize the economy.

On the fiscal side, we expect the government will use more direct policies aiming at improving aggregate demand through expediting the execution of infrastructure projects and stimulating consumption, for example, providing subsidies for autos and household appliance. These will be on top of the reduction in personal and corporate taxes that the government has done. We believe lowering taxes are positive for enhancing the competitiveness in the long-term, but the intended positive benefits will take time to play out and hence more targeted measures on the demand are expected.

On the monetary side, we have seen positive progress made in redirecting lending rates to a more market-driven mechanism that effectively shifts the pricing of new lending to regularly adjusted market rates. We believe this shift will enable more active management of liquidity and improve the transmission of monetary policy. In 2020, we should see this start to benefit credit growth.

That said, we expect government stance to be more contained compared to the 2008-2009 easing cycle in order to avoid long-term issues such as over-capacity and high debt level. There has been a clear shift to quality of growth from quantity of growth in recent years and we believe the government will be more tolerant towards slower growth as long as the economy can generate enough employment and there are positive structural improvements.

Trade tension will push for changes

The trade friction between China and the US has perplexed the most sophisticated investors. We believe it might be still early days to conclude when the full resolution will be reached despite positive progress made since October. In the end, trade is just the tip of the iceberg that hides the strategic rivalry between the world’s two largest economies. We believe the trade issue will likely be with us for a while, but along the twists and turns we are going to see some structural changes.

We maintain our view that it is challenging to relocate the entire supply chain given China’s high labour productivity, efficient supplier ecosystem enabled by the well-built infrastructure and supportive government policies. However, we believe some countries such as Vietnam can become a major beneficiary thanks to the relocation of lower value-added products that has started long before the trade dispute, and we should continue to see this in 2020. Indeed, we have seen the rising tariffs have impacted trade flows and dislodged China as the largest exporter to the US. On the impact to foreign direct investments (FDIs), we have not seen a noticeable change in FDIs into China and the rest Asia since the start of the trade dispute. We believe China will remain a major destination for inbound investment flows. Despite its rising status, Vietnam’s FDIs are below 10% of China’s FDIs (Figure 2).

Risk-reward remains attractive

Even though macro growth has been moderating, micro growth remains strong. The consensus expects MSCI China companies to deliver double-digit earnings growth in 2020. Earnings growth for the structural growth sectors, including consumer-related, healthcare and information technology, will be particularly strong, achieving more than 20%². The supportive government policies will create a stable macro backdrop for the growth of competitive Chinese companies that are benefiting from the structural economic rebalancing to a consumption- and services-led economy.
 
We believe the cheap valuation has provided a window of opportunities in 2020 to position into high-quality companies unfairly discounted by negative sentiments. Chinese equities traded at around 11.0x 12-month forward P/E as of end September, below its historical average and at a large discount to developed market equities (15.7x 12-month forward P/E)³.

Financial liberalization enables a best approach towards China investing

We believe financial liberalization measures will continue in 2020, driving structural liquidity into both onshore and offshore markets. We have seen some positive efforts in 2019. In September, China announced the removal of purchasing quota for QFII and RQFII programs, signaling an important step towards further opening up domestic markets. In October, Shanghai and Shenzhen Stock Exchanges announced the inclusion criteria for stocks with weighted voting rights (WVR), which will expand the southbound inclusion universe to high-growth companies such as Xiaomi and Meituan.

We believe those measures will allow a best approach to access Chinese equities. It is an all share approach that selects the best opportunities across markets, for example, A, H shares and ADRs (US-listed Chinese shares), irrespective of listing locations. We believe there are unique opportunities listed in each market and they together offer a complete universe that represents the true picture of Chinese economy. Given the improving market access, we believe investors can adopt such an all share approach that combines the best opportunities across markets. 

Conclusion

In our view, China will continue to offer stable growth and be an intact long-term positive story. Despite slower macro growth, companies that can capture the structural demand will deliver strong growth. We believe investors can eventually take an all share approach towards investing in China as we see continued market liberalization measures help enhance the accessibility of both onshore and offshore markets. In the near term, we see risk-reward remain favourable for Chinese equities and investors should look out for attractive opportunities that are unfairly sold down due to the trade concern.     

Major risks we believe investors should watch for in 2020 include policy mistakes and trade tension. Growth could be lower than the consensus estimate without sufficient stimulus; and on the other hand, if supportive measures were overdone, re-leveraging would generate long-term financial risks. The key we believe is to be data dependent and maintain a fine balance between growth and containing risks. We believe trade tension is another key risk weighing on Chinese economy in 2020. The situation could turn either direction, posing positive or negative risks.    

Mike Shiao is Chief Investment Officer, Asia ex-Japan at Invesco.

^1    Source: Bloomberg, Invesco. As of October 2019. 
^2    Source: FactSet, Invesco. As of October 2019. 
^3    Source: FactSet, I/B/E/S, MSCI, Goldman Sachs Investment Research. As of September 2019.
 

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