• Investment
  • 16 July 2020

Not just a bull in a China shop

Highlights

  • China A-share equities have been on a tear
  • Potential for rally to have more legs, driven by a macro recovery supported by stimulus
  • Potential escalation of US-China tensions remains a key risk for markets

China, the first to experience the devastating impact of the Covid-19 pandemic, has also emerged first from the economic malaise set to plague the globe in 2020-2021. Starting from 29 June 2020, China onshore A-share equities have been on a rip, with a rally in the CSI 300 Index of 18% over the past two weeks, bringing the trough-to-peak performance of the index up to 37% from 23 March to 13 July 2020. And in currencies, the USDCNY cracked the 7.00 level on 9 July for the first time since March. The risk-on rally coincided with state-backed media reports, with a front-page editorial in the China Securities Journal on 6 July stating that fostering a post-pandemic “healthy bull market” is now more important to the economy than ever. 

Exhibit 1: A-share margin financing balance has risen sharply but remains well below 2015 peak

Source: Bloomberg, Wind; as at 9 July 2020

The strong performance was driven by the technology and new economy sectors and has been supported by improving economic data and rising retail investors’ participation. A-share daily turnover exceeded CNY1.5 trillion for five consecutive days, while the A-share total margin financing balance reached CNY1.3 trillion, the highest since September 2015 (Exhibit 1). That said, margin financing as a percentage of free-float market cap remains at a comfortable level of 4.1%, vs. the average of 4.5% over the past five years. Onshore mutual funds issuance has been robust with more than 70 new equity funds launched in 2Q20 and CNY38 billion raised, suggesting strong liquidity and risk appetite. Foreign investors likely added to the A-share rally. Inflows into onshore Chinese equities via Northbound Stock Connect accelerated in early July to reach USD7.5 billion, similar in size to the inflows for the whole of June (Exhibit 2).

Exhibit 2: Cumulative inflows into onshore Chinese equities via Northbound Stock Connect

Source: HKEX, JP Morgan; published 7 July 2020

The question on investors’ minds is whether this bullish sentiment is sustainable or just a flash in the pan. Are there longer-term implications, and what are the risks at this stage of the recovery? We see the potential for this rally to have more legs:

1) Effective Covid-19 containment measures:

According to Chinese authorities, the total number of confirmed Covid-19 cases nationwide as at 12 July was 83,602, with eight new cases added that day. There were no new confirmed cases reported in Beijing for the seventh straight day, suggesting that an outbreak in the capital last month linked to a wholesale food market has been successfully contained.

2) Macro recovery, helped by fiscal stimulus and easier monetary conditions:

China is emerging from the Covid-19 crisis faster than the US, Europe and Japan. China suffered the worst of its coronavirus outbreak in 1Q20 – rather than in 2Q20 for most other major economies. But the country’s faster rebound also reflects the authorities’ early success in flattening the curve of new Covid19 infections.

China’s outperformance will be highlighted in its 2Q20 GDP report due on Thursday (16 July). We forecast China’s economy will have expanded by just over 2% year-on-year compared to its sharp plunge of -6.8% YoY in 1Q20. Thus economic activity will already be growing again in YoY terms.

China’s growth will still be well below its precrisis trend rate near 6.0% YoY. But China’s strong economic rebound contrasts sharply with its peers – we currently forecast the US, Eurozone and Japan to contract by 4.3%, 7.7% and 3.6%, respectively, in 2020. This makes us favour the yuan over the dollar.

Near term sentiment on China’s economy is being supported by several factors at the start of 3Q20.

First, the economic outlook is benefiting from firmer credit growth. Broad measures of lending are expanding significantly around 13% YoY, boosted by increased government bond issuance to finance fresh public sector spending.

Second, subdued inflation will allow further monetary easing to support the economy’s recovery. June’s CPI inflation rate is set to weaken from 2.5% YoY as last year’s surge in pork prices starts to fall out of the year-on-year calculation of inflation. Thus, the People’s Bank of China has scope to make further cuts in large banks’ required reserve ratios (RRR) in the second half of the year to support growth – after its 50 bps reduction to 12.50% at the start of January.

Third, financial markets, including equities, are looking past increased US-China tensions over Hong Kong’s new security law. This month, China’s foreign minister, Wang Yi, gave a significant speech signalling that authorities in Beijing want to ease tensions, saying: “What is alarming is that the China-US relationship is one of the most important in the world and it is facing its most serious challenge since diplomatic relations were established [in 1979] … China has never had the intention of challenging or replacing the US and has no intention of entering into total confrontation with the US.”

Similarly, financial markets do not expect the US government to increase tariffs any further on Chinese exports ahead of November’s presidential election. Instead, the prospects of a victory for Democratic nominee Biden are seen as lowering trade tensions in the long term to the benefit of China’s currency.

The yuan has thus managed to strengthen through 7.00 against the dollar for the first time since March. We expect further appreciation, and we recently revised our one-year USDCNY target higher to 6.80.

A rising yuan is also a key signal for further US dollar weakness globally. China runs the largest trade surplus with the US of all of America’s trading partners. Thus strength in the yuan implies the US trade deficit with China – and by extension America’s deficit with the rest of the world – is not being funded at current exchange rates, and therefore requires a lower dollar to balance trade and capital flows.

Weakness in the safe-haven greenback against the yuan, euro and other major currencies supports investor sentiment and benefits equities, commodities, emerging markets and other risk assets, including China.

Real estate market stability and funding:

National residential sales volume has recovered since April, across all city tiers. 1H20 national sales were understandably weaker at -4% YoY, but we expect sales to catch up in 2H20 based on the existing good recovery momentum. High yield (HY) developers under our coverage achieved 35%-45% of FY2020 target contracted sales by end-June 2020; this is consistent with the historical 40:60 split in sales between 1H and 2H in a calendar year. We expect these developers to achieve the aspired 0-10% growth in 2020.

Chinese high yield property issued USD35 billion of bonds in the offshore market in 1H20, vs USD45.8 billion in 1H19. Subject to investors’ demand, we expect 2H20 supply to be moderate at around USD20-25 billion (1H19: USD22 billion).  

This is based on two factors: First, the National Development and Reform Commission is perceived to be more generous in granting offshore bond quota in recent weeks. Second, there are hefty maturities in 1H21 where offshore maturing and puttable bonds are estimated at USD32 billion, and developers may pre-fund some of those in 2H20. Currently, the offshore bond market continues to have relatively good appetite for Chinese developer bonds, thereby limiting refinancing risk.

In equities, we feel largely positive over the sector outlook after attending virtual meetings with several Chinese developers. The key takeaways include i) focus on ramping up on operations and sales with more saleable resources in 2H20; ii) reiteration of full-year contracted sales targets; iii) looser credit conditions with most developers aiming to lower their borrowing costs; iv) stable housing policy direction; v) some margin pressure given higher land prices over the past few years; vi) areas of focus and recovery include Yangtze River Delta and Greater Bay Area. Besides the continued momentum in contracted sales of developers we track, official real estate data from the National Bureau of Statistics also point to a recovery.

3) Capital market reforms

China has embarked on a series of initiatives to liberalise its capital markets over the past few years, notably with China Connect (Shanghai, Shenzhen) for equities, followed by Bond Connect and most recently Wealth Management Connect announced in June. This latest initiative announced by the People's Bank of China and the Hong Kong Monetary Authority will allow north- and southbound investments into eligible financial products in Hong Kong and the Greater Bay Area, subject to individual and aggregate quotas.

The onshore China wealth management market is estimated at CNY23 trillion (~USD3.3 trillion) in size, and most of it is invested in fixed income and credit. We postulate that if demand shifts offshore, familiar credits such as Chinese developers with both onshore- and offshore bonds, would be a natural investment choice.

In equities, prolonged US-China tensions and the potential enactment of the US Holding Foreign Companies Accountable Act could prompt Chinese companies listed in the US via American depositary receipts (ADRs) to seek alternative listings. Secondary listings in Hong Kong are seen as a preferred option due to the convenient conversion between ADRs and shares in Hong Kong, shorter process and fewer disclosure requirements compared to primary listings, which bodes well for capital inflows into the Greater China region. We have identified 18 ADRs eligible for listing on the Hong Kong Exchange (HKEx), with an aggregate market capitalisation of ~USD415 billion. Assuming 5% of the new shares of these eligible ADRs list in Hong Kong over the next 12 to 24 months, an estimated ~USD20 billion could be raised.

What are the risks?

The potential escalation of US-China tensions heading into the US Presidential election will continue to be a key risk to the market. Within China, key risks to monitor are potential cooling measures by regulators if market exuberance grows out of proportion, and any disappointment from corporate interim results in August.

Exhibit 3: In fixed income, China high yield still offers good value relative to China investment grade

Source: JP Morgan Asia Credit Index (JACI) data; as at 3 July 2020 Note: HY = High Yield, IG = Investment Grade

Over the weekend, regulators – the China Banking and Insurance Regulatory Commission (CBIRC) and China Securities Regulatory Commission (CSRC) – announced strict measures to strengthen supervision of capital flow and to investigate leverage and speculation.

The focus will be on regulating over-the-counter (OTC) leverage. The CSRC stated it would crack down on illegal arbitrage, regulate cross-market capital transactions and strictly prohibit financial institutions such as banks and insurance companies from participating in OTC margin financing. The announcement over the weekend happened a few days after CSRC vowed to strengthen monitoring of OTC margin financing, which suggest that regulators are carefully monitoring the current market rally and want to avoid an “unhealthy” bull market with strong emphasis on risk management.

Separately, the CBIRC highlighted concerns on re-emergence of high-risk shadow banking businesses, with new forms and features. The leverage ratio of enterprises, households and other sectors rose higher, and some funds have flowed into the real estate market illegally, pushing up the asset bubble. Furthermore, the regulator has notched up cooling by announcing more share sales by state funds such as the National Social Security Fund and the National Integrated Circuit Industry Investment Fund, after the warning on tightening up of OTC margin financing. As such, we expect more price volatility ahead.

What does this mean for investors?

China offers investors access to selective growth opportunities against the backdrop of economic recovery and broadening structural reform. As we emerge from the Covid-19 recession and enter the next expansionary cycle, we see the longerterm risk-reward from equities to be sound. On a long-term investment horizon, the first phase of a new cycle of expansion is generally attractive for investment, and this underpins our equal weight stance in equities in our asset allocation strategy.

In the equities space, the Hang Seng Index (HSI) is trading at about 11.2x 12-month forward P/E, which is around the historical average. Notwithstanding near-term geopolitical uncertainties, the HSI’s valuation appears inexpensive versus the broad market mostly trading near the high-end of its historical range. We have an overweight stance on Hong Kong equities, and our latest index forecast for the HSI reflects a base case scenario of 27,330 which points to a 7% upside ahead.

In addition, we believe that the A-share rally could have more legs as onshore liquidity factors in China strengthen further, and could drive Southbound flows into the Hong Kong equity market ahead. At this juncture, the valuation of the onshore A-share market (the CSI 300) appears relatively undemanding versus the offshore market (MSCI China). The CSI 300 is trading at 13.7x 2021e P/E, which is at +1.5 s.d. to its historical average vs. MSCI China at 14.2x 2021 PE, which is well beyond +2 s.d. above its historical average.

That said, investors should be cognizant that the risk of near-term equity volatility is likely higher than average, in our view, given that valuations have priced in a large part of the initial sharp phase of the re-opening recovery, and that major risks related to the US elections and US-China geopolitics loom large in the backdrop.

In fixed income, we still prefer Chinese high yield to investment grade into 2H 2020. China high yield still offers 568 bps over China investment grade currently (Exhibit 3), compared to only about 423 bps prior to Covid-19 in Feb; and we still see good relative value in the former.

Overall, we continue to see value in the China high yield segment given its higher yield relative to other geographic and industrial sectors. In particular, the high yield Chinese property sector still has good value, although spreads have tightened since March. Year to date, the Chinese high yield property sector returned about 2.86% and the average yield to maturity is currently at 8.63%, according to JP Morgan Asia Credit Index data.

One of the downside risks to this call may come from trade-induced risk-aversion, which in turn affects the demand and liquidity of risk assets. High-beta, lowly rated bonds will be most vulnerable to such swings in sentiment. Therefore, we continue to prefer BB over B rated property bonds, and within B we prefer tenors of about 3 years or shorter. In July, China high yield new issuances saw mixed performance in the secondary market, showing some signs of fatigue in new issue momentum. We therefore encourage investors to be selective on credits with good risk-reward payoffs.

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Version: July 2020