China momentum – pause for effect

China’s July macro data has shown us the first signs of moderation since the PBoC and central government undertook targeted stimulus measures at the end of March. 

Source: Bloomberg

In general, industrial activities decelerated from the months before. Tepid industrial production reads persisted as conventional industries in power generation, oil production, chemical imports, freight volumes and port activity all slowed markedly, despite exports remaining strong. Investment in fixed asset investment (FAI) also retreated across the seventy cities of note, which is the first time this has occurred since last June.

However, market reactions to the July data were quite resilient, and I remain tactically bullish on Chinese equities for the following reasons:

- Investors’ sentiment in equities remains upbeat and they continue to search for other avenues to invest (outside of property).

- Liquidity settings remain conducive for equities and liquidity settings remain positive for sentiment, although fixed asset credit is plateauing.

- Structural reforms to the equity market systems remain net positive (i.e. the Shanghai-Hong Kong Connect project and increased foreign access to mainland markets).  

With these points in mind, which indices and/or stocks are appealing and which industries/sectors in China should we be leveraged to?

Key stocks to watch

Over the last four years, Chinese markets have been range-bound for several macro and micro reasons. Looking deeper into the Chinese market landscape, the pause in industrial and manufacturing over the past three periods has seen conventional China plays underperforming, while modern China plays have been bid up as they tap into the emergence of Chinese consumption.

Modern China

By ‘modern’ China I am referring to new industries such as internet solutions, entertainment, discretionary spending, e-commerce and environmental solutions. Plays such as Baidu, Qihoo 360, Huaneng Renewables and SINA Corporation are clear examples, as are Weibu and the upcoming Alibaba IPO.

Some would argue that these stocks are overvalued compared to conventional China plays as valuations on modern China demand a premium. However, I see their outperformance as a positive, as the modernisation of China has seen earnings growth in all these of industries, which is only likely to accelerate as the middle class continues to expand. The other advantage that these industries have is earnings quality; profitability is higher due to margin strength, better cash flows and better use of leverage, which suggests the premium price is likely to stay and is justifiable.

‘Conventional’ China

Conventional China has seen strong debasement over the past year, as fiscal policy has a great influence on these names. They have more exposure to the fluctuations in industrial production, traditional manufacturing and the developed property market. Names such as Sinopec, Shanghai Industrial holdings, Agricultural Bank of China and Vanke all fall into this category.

On an interim view these names have upside potential as domestic policy remains accommodative and the data in July is likely to correct over the coming months on seasonality. Macro growth will stabilise, which will impact positively on these play. Valuations in conventional China are low comparatively, and the drive for alternative investment paths from Chinese investors will see these large cap stocks bid up as they look to diversify investments from the more preferred investment vehicle of property.

However, by the same token conventional China is exposed to the sensitivities around financial policy and economic conditions. This can be seen in the share price reaction from the banks, property and commodity plays when the repurchasing rates have been lower or disbursements have been increased from the PBoC.

Where to look

Both conventional and modern China stocks are appealing on current settings. Macro conditions remain accommodative which is likely to benefit traditional industries, as lending can continue to flow and investment in manufacturing and property will continue. This could possibly see conventional plays outpace modern plays in the interim; however the rising demand for high-end services and manufacturing products has continued throughout the downturns and pauses in macro data.

With the increasing wealth, urban population and service-based employment, modern China is not only expected to continue, it is likely to maintain its premium price and outpace its conventional rivals in the medium term.

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