At the Inflection Point?
Timothy Fung, Head of Equity Advisory, Asia
Meaningful market correction in March 2021: Concerns over spike in US yields, tightening China onshore liquidity/ property market, and the American Depository Receipt (ADR) delisting/ regulatory overhang on China’s tech giants all served as triggers of the recent drawdown. This does not come as a total surprise to us. Our CIO team has mentioned in early February 2021 that the market looked overbought; we also mentioned in our February 2021 issue that China tech stocks needed a correction as valuation was stretched.
Tightening onshore liquidity could be the culprit: Despite years of financial reform, the China onshore equity markets are still highly liquidity driven, which is increasingly affecting the Hong Kong market as China-HK Connect deepens. Recent weakness in RMB, triggered by narrowing China-US yield gap, also adds salt to the wound.
Bottom-searching process will take a while: We are still confident that the stock market uptrend will resume, supported by undemanding valuation and strong earnings fundamentals. Not to forget that there is still lots of global pent up demand to be released going forward, as the western world continues to re-open post-pandemic.
China internet could be close to the inflection point: Despite recent share pull back, we expect a robust outlook for China’s internet sector thanks to a lift in the growth ceiling in many sub-segments led by structural changes post COVID. Regulatory risk is also increasingly being priced in. On sectors, we remain constructive on e-commerce, mobile gaming, fast growing online entertainment names, and increasingly, the travel and leisure industry. We also believe that China ADRs’ volatility around fears of delisting is overdone.
So what will trigger a market rebound?: A rebound would likely be driven by a clear monetary loosening signal by the People’s Bank of China, bottoming valuation of Chinese equities, or a U-turn in US-Sino trade relationship, which may be particularly relevant in triggering a strong rebound in China ADR and tech stocks. We start to see valuation support on the China tech stocks, with the Hang Seng TECH Index (HSTECH) Price-to-Earnings Ratio dropping from ~50x to ~37x now. Long-term investors may take advantage of this round of market consolidation as an opportunity to start accumulating China tech stocks and China A-Shares, but we would consider to do so in batches as market visibility remains rather low in the immediate future.
We reduced exposure to select tech stocks with recent results reporting suggested a challenging near-term outlook. We added health tech stocks as valuation becomes attractive after recent correction. We also added exposure to consumer sector to play on the re-opening theme.
The HK/China equity markets have experienced a meaningful correction in March 2021, with the Hang Seng Index and CSI300 correcting ~10%/ ~15% respectively from February 2021 peak. Technology stocks were hit even harder as the Hang Seng Tech Index lost more than 30% from the peak. For the onshore A-share market, this is the major correction for the CSI 300 Index (down approximately 15%). Concerns over spike in US yields, tightening China onshore liquidity/ property market, and the ADR delisting/ regulatory overhang on China’s tech giants all served as triggers of the recent drawdown.
This does not come as a total surprise to us. Our CIO has mentioned in early February that the market looked overbought and complacent that a correction was long overdue. We also mentioned in our February 2021 issue that China tech stocks need a correction as valuation stretched. We downgraded the Asia and China tech sector accordingly.
Tightening onshore liquidity, not fundamentals, could be the culprit
Year-to-date, the US equity markets continue to climb the wall of worries to make new high, suggesting global liquidity environment remains accommodative. This is in sharp contrast to HK/ China markets’ lukewarm performance, and we believe tightening onshore liquidity could be the key culprit. Historically the China A share market has a strong correlation to the local liquidity environment (represented by total social financing (TSF)) (Chart 1).
The Beijing policy makers set out a conservative stance in the Two Sessions, clearly putting a higher priority on financial risk prevention than growth stimulation, as they set target money supply growth largely in line with nominal GDP growth. The China Banking and Insurance Regulatory Commission (CBIRC) chairman also warned on asset bubble risks. Given this backdrop, liquidity will likely remain tight in the very near term.
Despite years of financial reform, the China onshore equity markets are still highly liquidity driven. In recent years, the higher mutual fund flows via China-HK Connect even export this trading pattern to the HK markets.
Adding salt to the wound is the recent weakening in RMB, which have been highly correlated to the local equity indices (Chart 2). This is triggered by the narrowing of China-US treasury yield gap, as US 10Y treasury spiked. This serves to reduce foreign flows into the Chinese bond market, thus reversing the RMB uptrend.
On the other hand, we note that macro fundamentals remain equity friendly, as recent Chinese economic data suggests a continuous V-shape recovery (Chart 3).
Bottom-searching process will take a while
While HK/China markets will continue the bottom-searching process in the near term, we are still confident that the uptrend will resume, supported by undemanding valuation and strong earnings fundamentals, as witnessed in the stable 2021E EPS upward revision in the A share market (Chart 4). Not to forget that there is still lots of global pent up demand to be released going forward, especially in private sector capital spending and household consumption, as the western world continues to re-open post-pandemic.
China internet – Getting close to the inflection point
Hang Seng Tech Index, since peaking in mid-Feb 2021, has pulled back ~30% and is now trading near 200 day moving average support (Chart 5). While we do not rule out further downside potential, we think the speed of the correction has been too fast and furious to be sustainable.
We expect a robust outlook for China’s internet sector as we see a lift in the growth ceiling in many sub-segments led by structural changes post COVID e.g. change in consumer habits, growth in user base, user time spent, and market penetration rates.
Regulatory risk is increasingly being priced in, with further clarity on the impact on the fintech sector. We await the results of the antitrust investigation into the biggest e-commerce operator in China, which may turn out to be a positive catalyst and the lifting of a key overhang.
In addition, regulatory oversight will set the ground for a more even competitive playing field and will be beneficial for Tier 2 players within the industry. We like the tech giants as core holdings, but also urge investors to consider
diversifying into smaller, up and coming players on this sharp correction.
On sectors, we remain constructive on ecommerce, mobile gaming, fast growing online entertainment names, and increasingly, the travel and leisure industry (e.g. online travel agents) which is more leveraged to re-opening.
On a last note, we think upcoming quarterly result announcements may result in some volatility due to moderation in margins and heavier investments to solidify long term growth, especially for ecommerce players. But that will also create excellent entry points for medium/ long term investors.
China ADRs’ volatility around fears of delisting overdone
China Internet ADRs have been seeing sharp downward pressure in the second half of March 2021 on news around the Holding Foreign Companies Accountable Act (HFCA), where the US Securities and Exchange Commission (SEC) has issued interim final amendments (IFA) and is seeking public comment. This is another step towards requiring foreign companies to allow US regulatory review of their financial audits.
Companies without secondary listings in HK have been hit the hardest.
China has long refused to allow the US Public Company Accounting Oversight Board (PCAOB) to examine the audits of local companies. With the HFCA having been signed into law from Dec 2020, the SEC has adopted IFA to implement this Act. Implementation calls for identifying those ADR companies that are audited by an accounting firm located outside the US, where the PCAOB has determined that US audit inspection is not allowed.
This is not “new” news - we view the stock price reactions are overdone. Over the last 2 years we have seen many of the large cap internet names steadily list their shares in HK – where shares are fully fungible between HK and US listings. We expect this trend to continue given rising political tensions between US and China. We just see two more large cap Chinese ADR successfully concluding their secondary HK listings in March 2021, with more communicating plans to do the same as soon as this year. Moreover, there is uncertainty as to when the SEC will officially implement the said requirements. In addition to that, companies will have 3 years to comply with the new rules.
So what will trigger a market rebound?
A rebound would likely be driven by a clear monetary loosening signal by the People’s Bank
of China (probably via reserve requirement ratio cut or other liquidity injection measures), bottoming valuation of Chinese equities, or a U-turn in US-Sino trade relationship, which may be particularly relevant in triggering a strong rebound in China ADR (and hence China tech stocks). We start to see valuation support on the China tech stock, with the HSTECH Index PE dropping from close to 50x to 37x now (Chart 6).
We do not expect significant downside from here, but the bottom searching process will take a while longer as sentiment and liquidity environment will stay weak for a while, especially as the Archegos incident continues to unfold. Long-term investors may use this round of market consolidation as an opportunity to start accumulating China tech stocks and China A-Shares, but we consider to do it in batches as market visibility remains rather low in the near term.