Re-Entering The Dragon

China: A long overdue correction eventually arrived

We mentioned in early February that the market looked overbought and complacent, as a  correction looked long overdue. The recent correction since then did not come as a surprise to us. Concerns over spike in US yields, tighter China liquidity conditions, tightening in China’s property sector, and the anti-trust rules targeting China’s tech giants all served as triggers of the recent drawdown. 

The onshore A-share market, which is largely driven by retail investors, could be even more volatile. This is the major correction for the CSI 300 Index (-15%) since its rebound from March 2020 lows (+59%). Historical corrections in A-shares tend to take 2-3 months with over 15% drawdowns. We do not expect significant downside from here on, but the consolidation may take some time with turnover to shrink further in coming weeks. As the domestic stock market is more sentiment-driven, new catalysts are required to boost confidence.

Some areas that worth closely watching are: (1) economic data particularly credit data, (2) upcoming earnings results, and (3) any soothing comments from the PBoC. 

No aggressive tightening as no aggressive easing to begin with

China’s economic and earnings fundamentals are expected to continue to improve. There is still a lot of pent up demand to be released going forward, especially in private sector capital spending and household consumption. The PBoC stressed that there will be no sharp U-turn in monetary policy. In the recent National People’s Congress (NPC), one of the key economic targets is for M2 and credit growth to move in line with nominal GDP growth (our estimate is 11-12%, down slightly from 13% last year) to stabilize the debt to GDP ratio.

Unlike many other countries, China did not embark on super easing during the Covid crisis. Hence, the ongoing policy normalization as the economy is recovering with no inflationary threat at the moment would be gradual. However, there are exceptions in areas such as the property sector where the government is concerned about a bubble (administrative measures have been used rather than macro tightening) and some other areas in shadow banking where the government would allow some non-profitable SOEs to default on their onshore bonds in an attempt to break moral hazard.  

There are also no signs of tightening in China’s monetary conditions. Despite the sharp spike in US yields, China’s government bond yields and interbank rates have stayed steady. The 7-day SHIBOR rate, widely viewed as one of the PBoC’s policy reference benchmarks in its interest-rate corridor operations, has eased considerably after the Lunar New Year holiday.

A lot of negative newflows have been priced in China techs

We downgraded Asian tech sector from positive to neutral in early February after the spectacular rally, and we will look for opportunities to upgrade the sector again. While further anti-trust regulatory guidelines to rein in powerful internet platforms is not ruled out in the near term, we believe that the Chinese authorities are not aiming to curb the development of internet companies or fully breaking them up given that the platforms bring innovation and digitalization to the overall economy. This is one of the top priorities that had been reiterated during the latest NPC. We believe the aim is to shape a more balanced and competitive landscape to achieve a more sustainable growth. 

We believe that the risk has been increasingly priced in, and revenue impact on the sector as a whole should be manageable. Hence, the deep corrections offer good re-entry points for medium-term investors to accumulate selected, high quality tech names in tranches, particularly in grocery e-Commerce/food delivery, mobile gaming, online entertainment, online travel agency and advertising. 

Increasing “new economy” stocks to drive inflows to Hong Kong

Following the inclusion of some “new economy” stocks in the Hang Seng Index (HSI) and the launch of Hang Seng Tech Index last year, which drove significant inflows into the HK stock markets, Hang Seng announced recently the proposed enhancements to the HSI which would further increase weighting to “new economy” sectors (IT, consumer and healthcare) from 44.5% to 52.4%. Some key changes are:  (1) to increase the number of constituents from 55 at present to 80 by mid-2022 and to 100 ultimately; (2) to expand representation to 7 industry groups; (3) to shorten inclusion of new listings to 3 months. Overall, these changes not only would attract more advanced companies to listed in HK, but also engage more global asset allocators to track HSI. In addition to the continued “Homecoming” theme with the China ADRs listed in the US returning to HK for secondary listings, we expect significant inflows into HK stock market in the years to come (Hong Kong has seen 30th consecutive week of foreign net inflows as of end-Mar 2021).

Longer-term US yields could stabilise before an orderly rise

We have been long the reflation theme since last September given our view on the vaccine coming earlier than market expectations. So far this year there has been a faster than expected roll-out of the vaccine in the US, $1.9 trillion additional fiscal stimulus, and continued loose financial conditions creating a sweet spot for US economic growth. As a result, we have upgraded US GDP assumption to 6.9% for 2021, which is above consensus. We are also above consensus for global economic growth.

The rise in US treasury was one of the causes of the correction in China equities, but also a moderate, temporary correction globally, as investors feared inflation and overstimulation of the economy. Clearly, the sudden sell down in US 10-year treasury note may have been overdone, which has now triggered some systematic buy signals.

We recognise the improved outlook for both growth and inflation in the US. However, we believe there is sufficient labour slack, as broader measure of unemployment, the U-6 unemployment rate is still 10.7%. In addition, inflation will be largely transitory in nature, rising to 2.5% in 2021 before falling back to 2.2% in 2022.

We forecast the UST 10Y yield reaching 2% in 12 months time. We anticipate the Fed’s announcement of the reduction in asset purchases in 4Q21 with implementation in 2Q22 and a first rate hike in 3Q23.

Yields could stabilise in the near term as volatility subsides, before a more orderly rise going forward, which may prove to be a robust environment for risk assets.  

Conclusion

Cyclical and structural factors are in place to drive the uptrend of domestic A-shares, Hong Kong-listed China equities, and select high quality tech companies. Also, US longer term treasury yields may look to stabilize before a gradual climb upwards, which will be beneficial for risky assets. Any weaknesses represents good buying opportunities to re-enter the Dragon!

Click on the link below to download the full report in PDF