China’s equity markets have been on a wild ride in recent years. After peaking in 2015 to its highest level since 2007, the Hang Seng China Enterprises index plunged almost 50 per cent by February 2016. Since then, the bull market has returned, with the index rallying 37 per cent – and we believe this bull market can continue, for five reasons.
1) A more stable economy
China’s economy has stabilised after a number of years of fiscal, monetary and credit easing. Although growth has been on a secular downtrend since 2010, the government has a growth target for 2017 of ‘around’ 6.5 per cent. The stabilisation in economic activity – which is confirmed by the so-called ‘Li Keqiang’ index which tracks underlying economic indicators such as bank lending, rail freight movement and electricity consumption – has helped calm nerves, slowing down capital outflows in recent months. A resilient economy, combined with a broadly range-bound US dollar and official measures to restrict fund outflows, has helped stabilise the yuan.
2) Increased domestic liquidity
Beijing’s efforts to tighten capital controls have resulted in increased domestic liquidity. As capital can no longer flow as freely overseas, it is finding its way into domestic asset markets, including equity and real estate. Although administrative controls have tried to control the pace of property price appreciation, Shenzhen and Shanghai have witnessed more than 50 per cent and 20 per cent price gains respectively over the past 12 months. Moreover, the so-called ‘sell-through rate’ – percentage of housing units sold at project launch – has risen in recent months as buyers return to the market.
‘New economy’ sector earnings are expected to grow 21 per cent this year, compared with 7 per cent growth in ‘old economy’ sectors such as energy, industrials and materials
3) Rising corporate earnings expectations
The improvement in underlying economic activity is showing through in rising corporate earnings expectations. Consensus forecasts estimate a 16 per cent earnings growth for the MSCI China index for 2017, up from a contraction of 8 per cent in 2016.
While the main drivers of the earnings recovery centre on the telecom and consumer staples sectors, ‘new economy’ sectors such as technology, consumer discretionary and healthcare are the clear favourites. This is backed by strong earnings estimates – ‘new economy’ sector earnings are expected to grow 21 per cent this year, compared with 7 per cent growth in ‘old economy’ sectors such as energy, industrials and materials. Moreover, the technology sector dominates China’s equity markets, accounting for a 32 per cent share of the MSCI China index, making it a key driver of the overall market.
4) Inexpensive equity market
China’s equity market remains inexpensive relative to peers. The market is valued in line with its long-term average, but is cheaper than major market indices such as the S&P500 index.
5) Benefits of a stabilising US dollar
A stabilising US dollar should help attract foreign fund flows back to Asia, which is likely to benefit China, the largest market in the region. China’s policymakers are likely to prevent any significant yuan depreciation as they tighten controls to limit capital outflows. This may contribute to continued excess liquidity in the domestic economy, buoying asset markets including equities.
China’s equity bull market has longer to run
Investors in China’s equity markets have had a rocky ride in recent years. Some risks have not gone away, including elevated debt levels at companies and the possibility of a stronger US dollar and weaker yuan as the US Federal Reserve accelerates the pace of rate hikes. Another risk is President Trump enacting punitive trade policies against major exporters such as China. Any of these factors could raise the risk of a sharp deterioration in China’s economic growth.
However, we see a low probability of such an outcome. For now, the combination of China’s policy-led stabilisation in economic growth, strong earnings growth driven by consumption-led new economy sectors, attractive valuations and ‘trapped liquidity’ as a result of tighter capital controls give us confidence that the equity bull market has longer to run.