Light at the End of the Tunnel

Summary

March 2022 was an extraordinary month that demonstrated how fast market sentiment could change. The first half of the month was overshadowed by waves of negative news. The market was massively oversold in mid-March 2022 and was vulnerable to short squeeze. However, we witnessed a sudden vigorous rebound in the second half of the month. It appeared that market participants were impressed by the government’s rhetoric on boosting the financial markets, as well as higher-than-expected dividends and guidance for moderate growth in 2022.

Sizable share buybacks driven by deep value –  The China Securities Regulatory Commission (CSRC) recently reiterated its encouragement for more share buybacks and mergers and acquisitions (M&As) by listed companies. As such, we have been witnessing many sizable share buyback programmes initiated by numerous Chinese companies, in particular with the telecom/technology sectors. We should probably expect more share buybacks in the next few months. Share repurchase is an efficient way to return value to shareholders, as well as instilling market confidence.

Cautiously optimistic – The Hang Seng Index has retraced about 50% of the decline between 21 January (recent peak) and 15 March (multi-year trough) this year. We think the market has restored rationality, and further recovery requires new catalysts such as implementations of fiscal stimulus in China. However, we are cautiously optimistic in the medium term while remaining selective in the near term. The million dollar question is when and how the pro-economy policies will be rolled out.

Notable developments in selected sectors

• China internet and ADRs1: Chinese ADRs underwent broad sell-offs after the SEC2 identified five US-listed ADRs of Chinese companies for potential delisting. Meanwhile, Chinese regulators are showing willingness to make concessions to resolve the long-running China-U.S. audit gridlock, which reduces the probability of a worst case scenario and bodes well for sector sentiment. We remain constructive on the China internet sector in the medium term, but we also remain selective, focusing on higher-quality companies. We are cautiously optimistic that a year-on-year trough in growth rate can take place in 2H22.
• China financials: China banks and insurance companies have been darlings of yield-thirsty investors. However, we see emerging risks in the China financial sector. We are particularly unnerved by the government’s public request that financial institutions should lower loan interest rates and cut fees. 

Light at the end of the tunnel

March 2022 was an extraordinary month that demonstrated how fast market sentiment could change. The first half of the month was overshadowed by waves of negative news: Russian invasion of Ukraine with no end in sight, worsening geopolitics across Europe, fears of sanctions against Russia being extended to China, rising probability of forced de-listing of Chinese ADRs, rumours of regulatory scrutiny against China fintech, reported layoffs at China internet leaders, and the resurgence of COVID cases in mainland China. The stock market was dominated by extreme bearishness that the 14-day relative strength index (RSI) of the Hang Seng Index fell below 15 on 15 March 2022, which was even weaker than the last trough during the initial global COVID outbreak in March 2020. The market was massively oversold in mid-March 2022 and was vulnerable to short squeeze.

However, we witnessed a sudden vigorous rebound in the second half of the month. It appeared that market participants were impressed by the government’s rhetoric on boosting the financial markets. In addition, a number of companies surprised investors with higher-than-expected dividends, which we believe had lured back value investors. As we pointed out previously, earnings expectations were not high when the Hong Kong stock market entered this year’s results reporting season. In hindsight, the market was generally satisfied with companies’ FY21 results and their guidance for moderate growth in 2022.

Sizable share buybacks driven by deep value

The CSRC recently reiterated its encouragement for more share buybacks and M&As by listed companies, which would enhance market liquidity, reduce unnecessary interference in trading, and create a level playing field for investors. Indeed, we have witnessed many sizable share buyback programmes initiated by numerous Chinese companies, particularly within the telecom/technology sectors. Some other large-cap companies joined the fray with ad-hoc on-market buybacks, though no headline committed targets were provided. We should probably expect more share buybacks in the next few months, as companies wrap up their FY21 results announcements. Besides having CSRC’s blessings to execute buybacks, corporates’ management should see deep values in their own companies. Hence, share repurchases would be an efficient way to return value to shareholders, as well as instilling market confidence.

Cautiously optimistic

The Hang Seng Index has retraced about 50% of the decline between 21 January (recent peak) and 15 March (multi-year trough) this year. We think technical rebound has done its work and the market has restored rationality, while further recovery requires new catalysts such as implementations of fiscal stimulus in China. However, we are cautiously optimistic in the medium term while remain selective in the near term.

China’s Two Sessions this year, which set the tone for the country's development in 2022, outlined a raft of targets including: (i) GDP growth of around 5.5%, which was at the high-end of the market forecast range, (ii) creating over 11 million new urban jobs, after adding 12.69 million in 2021, and (iii) CPI growth at around 3%, which requires a reacceleration from 0.9% in the first two months of 2022. We believe the rather high GDP and CPI targets imply that the government is ready to adopt monetary easing policies to fuel economic growth. The million dollar question is when and how the pro-economy policies will be rolled out.

Nonetheless, we are less enthusiastic about Chinese banks because of the government’s requests for lower interest rates, fee reductions and potentially other means to “support the economy”.

Notable developments in selected sectors

1) China internet and ADR listing

Chinese ADRs underwent broad sell-offs after the SEC identified five US-listed ADRs of Chinese companies for failing to adhere to the Holding Foreign Companies Accountable Act (HFCAA) in early March 2022 (see Chart 1). Passed near the end of 2020, the Act permits the SEC to delist companies from US exchanges if American regulators are not able to review the company’s audits for three consecutive years. The Chinese regulators had taken a very tough stance against revealing data of China internet companies to the US regulators until the first batch of China ADRs being identified as non-compliance of HFCAA. But the stance had changed since then, as the CSRC issued a press release emphasising that a collaborative arrangement that meets the legal and regulatory requirements of both China and the US could be reached as soon as possible. Vice Premier Liu He also said China and the US are working on a concrete co-operation plan on ADR auditing. In late March 2022, one of the state-owned newspapers reported that regulators had required certain Chinese firms to prepare for more audit disclosures for FY21 as a way to maintain their listing status on the US exchanges.

However, compliance issues with ADRs of Chinese companies are not “new news”, and over the last few years we have seen many of the large-cap ADR names steadily list their shares in HK – where shares are fully fungible between HK and US listings, and investors can easily convert their ADR holdings to HK shares. In the worst case scenario of individual companies being delisted from the US stock exchanges, admittedly there will be some short term liquidity impact on their shares. But at this juncture, companies shortlisted by the SEC are given two years to adhere to HFCAA. The earliest date of the first delisting would be in 2024, which offers the companies and investors some buffer to minimise adversities. Meanwhile, the Chinese regulators are showing willingness to make concessions to resolve the long-running China-US audit gridlock, reducing the probability of a worst case scenario and boding well for sector sentiment.

Read HK China Equity Perspectives, March 2022  - Sailing through the Storm

Apart from the fear of forced China ADR delisting from the US market, regulatory newsflows also slanted to the negative: (i) a ride hailing company’s planned listing in HK was suspended as its proposal to prevent security/data leaks fell short of regulatory requirements; (ii) rumours that the People’s Bank of China will fine a fintech platform for breaching anti-money laundering rules; (iii)  regulators wanted internet companies to support small and medium-sized enterprises impacted by COVID-19; (iv) the sector reportedly would lay off large numbers of workers; and (v) worries that the revival of COVID outbreak in China will dent economic growth. These overhangs contributed to the increased volatility of China internet stocks.

On the other hand, for the ecommerce players, we think potential consolidation in the community group buy business is something positive, which should improve the unit economics of the business and lower losses in the medium term.

Generally speaking, we remain constructive on the China internet sector in the medium term.  Nonetheless, we also remain selective on the sector, focusing on higher-quality companies. We are cautiously optimistic that a year-on-year trough in growth rate can take place in 2H22 for the sector, should the COVID situation improve and further stimulus measures flow through. While Beijing’s message is that regulatory reset for big internet may be reaching an inflection point, we need to see more concrete developments, for example, the restart of mobile game approvals.

2) China financials

China banks and insurance companies have been darlings of yield-thirsty investors. The China financial sector has outperformed the broader Hang Seng China Enterprise Index (HSCEI) year-to-date (YTD) (see Chart 2). We attribute the resilient performance of China financial shares to their high dividend yields – most of them trades on over 7% yield – and deemed backstop from the government. However, we see emerging risks in the China financial sector, including:

• The government has explicitly asked financial institutions to lower loan interest rates and cut fees, which inevitably will erode banks’ profits.
• Poor performance of the A-share market and therefore lower investment incomes. CSI300 index has lost 15% YTD, as of 28 March 2022.
• Potential impairments/loan loss provisions associated with distressed China property developers, which may impact dividend payments.
• Rising systematic risks related to western sanctions against Russia could spill over to China via the Cross-Border Interbank Payment System, which Russia is using to bypass SWIFT and settle foreign trades, though the risk is very remote at present in our view.

We are particularly unnerved by the government’s public request that financial institutions should lower loan interest rates and cut fees. If history is any guide, China’s State Council called on banks to surrender RMB1.5 trillion to stead the economy in June 2020. The subsequent 3-month downfall of banks’ share prices should have taught us a good lesson.

It is undeniable that shares of China financials trade at undemanding low Price Earning Ratios (P/Es), low Price-to-Book Ratios (P/Bs) and high yields, which should underpin share prices. However, most of the time, publicly traded assets are cheaply valued for valid reasons. Our prudent advice is to take the current market rebound as a chance to switch into high quality names.