2021 positioning – Stay with the Dragon

SUMMARY

Liquidity continues to flow into Hong Kong and China markets

Overseas fund inflow to Hong Kong and China markets remain strong since August 2020. China markets are still considered value plays (HSI/ HSCEI/ CSI300 trading at 2021E P/E of 12x/ 9.5x/ 15.5x), particularly considering the visible China economic recovery in 2021. Some Chinese investors have also been switching their US-listed American Depositary Receipts (ADRs) into Hong Kong-listed stocks in view of the policy uncertainty regarding Chinese ADRs.

China tech weakness represents a good re-entry opportunity

Although China’s first anti-trust draft regulation in long-term is constructive to the China tech industry development, the short-term market reaction will likely remain negative. We believe the Beijing government remains committed and supportive of the China’s technology development – albeit in a more regulated and controlled manner going forward. We take this consolidation in tech stocks as a good chance to add long-term positions.

Deepening depth and widening width in Hong Kong/China stock markets

The Chinese government continues to relax its main board trading flexibility in order to include more new economy stocks onto the traditional trading platform. This move should increase the markets’ fund raising opportunities, while deepening the market breadth of the main boards in both Hong Kong and China.

Maintaining a balanced portfolio with bias towards cyclicals

Looking ahead in 2021, on the back of earnings growth potentials, pro-cyclical sectors (e.g. electric vehicle makers, cement producers, education, healthcare and Medical Tech) deserve close attention. We continue to underweight the Chinese banks while overweight insurance. We believe the overall China equity bull market will not be derailed, underpinned by growth-led reflationary trades and increasing foreign inflows. We recommend investors to stay with the dragon in their 2021 equity positioning. 

SECTOR PREFERENCE

We reduced our weighting in select tech stock to lock in profits on escalating near-term policy risk, while starting to accumulate infrastructure stock as value play. We also increased weighting in a China education name on its strong operating numbers. 

Liquidity continues to flow into Hong Kong and China markets

As a vote of confidence, overseas inflow to Hong Kong and China markets has continued since August 2020. This is not a total surprise to us, given Sino-US tension has been lingering for years already, thus most pessimism should have been priced in.

Besides, while COVID-19 cases keep rising in the US and the UK with more infectious strain of the virus, so far China has managed to maintain the victory in the war against the virus with no meaningful signs of the convicted cases strong rebounding. Compared to the US equity markets, China markets are also considered value plays (HSI/ HSCEI/ CSI300 trading at 2021E P/E of 12x/ 9.5x/ 15.5x), particularly considering the visible economic recovery in 2021.

Given the significant outperformance of the US markets in 2020 (especially on growth stocks), it makes sense for the prudent investors to lock in some profits, while reinvesting some of their profits into the undervalued China stocks. 

From a fund flow perspective, some Chinese investors have also been switching their US ADRs into Hong Kong-listed stocks in view of the policy uncertainty regarding Chinese ADR in the US. This is technically feasible, as both equities are fully fungible. Transaction costs are also minimal, and not to forget that most Asian investors actually prefer to trade in Asian hours. Meanwhile, some recent developments in government regulation in China and the US have, and will continue to, dominate the market sentiment.

China unveiled the first anti-monopoly draft regulation

In mid-November 2020, the State Administration for Market Regulation unveiled the first anti-monopoly draft regulation for China, which targets to root out monopolistic practices in the China’s internet industry.

The authorities further held an administrative guidance meeting on "Regulating the Order of Community Group Purchases" on 22 December 2020. There are altogether nine types of prohibited items (Table 1). 

Short-term correction in China tech represents good long-term buying opportunities

The issuance of this draft regulation is well expected, as we have addressed this topic in the November 2020 issue. Although the regulation above in  long-term is constructive to the China tech industry development, the short-term market reaction is likely negative. As for the recent anti-monopoly fines, it may hamper internet giants’ ability to strengthen their domestic ecosystem through merger and acquisition in the future. Nonetheless, we expect the big China tech’s earnings drivers remain strong, especially in e-commerce and Cloud.

Some investors are also concerned that this new regulation may destroy these fast-growing China tech giants. In fact, in our view, the Beijing government remains committed and supportive of China’s technology development – albeit in a more regulated manner. Held on 16-18 December 2020, China’s annual Central Economic Work Conference set the tone for the macroeconomic policies for 2021, which also marks the start of China’s 14th Five Year Plan (FYP 2021-2025). Technology industry remains an important focal point. Important tasks highlighted at the meeting include enhancing the national strategic science and technological strength, as well as the stability of the industrial supply chain.

Similar to the previous regulatory tightening episodes in China, we would take this round of consolidation in China technology stocks as a good chance to add long-term positions.

Sino-US conflicts remain medium-term focus

Apart from the local anti-trust regulation, there are two US-China geopolitical uncertainties clouding the market recently, which brings additional uncertainty to select China tech companies:

i) the US Holding Foreign Companies Accountable Act (which accelerates the process of Chinese ADR re-listing in both A-share and H-share markets; and

ii)  the US executive order to prohibit any US person from undertaking any Communist   Chinese military companies.

The Holding Foreign Companies Accountable Act is ready to become law

On 4 December 2020, the US House passed the Holding Foreign Companies Accountable Act, which might result in the delisting of US-listed Chinese companies if they have failed to comply with auditing requirements within three years. The Chairperson of the US House Financial Services Subcommittee on Investor Protection and Capital Markets re-emphasised the purpose of the bill is not to de-list any company but to persuade China to allow the audit oversight that US investors need. In fact, the Public Company Accounting Oversight Board (PCAOB) has established formal cooperative arrangements with foreign audit regulators in over 50 foreign jurisdictions to ensure the bill should incentivise Chinese regulators to reach similar agreements.

In general, the market is not surprised. In fact, investors are more interested in understanding:

i) When secondarily listed names in Hong Kong will be eligible for Southbound Stock Connect trading

ii) When offshore listings and Chinese Depository Receipts (CDRs) will become fungible

The US military blacklist includes more Chinese companies

In mid-December 2020, The US Department of Defense (DoD) added another dozens of Chinese companies to its defense list of alleged Chinese military firms, including the country’s top chipmaker and drone manufacturer. 

This brings the total number of blacklisted Chinese companies to 60. Effective 11 January 2021, the order forbids any US person to purchase these impacted securities. For their existing holdings, they have one-year grace period (till 11 November 2022) to divest.

Deepening depth and widening width in Hong Kong/China stock markets

Meanwhile, the Chinese government continues to relax its main board trading flexibility in order to include more new economy stocks into the traditional trading platform. This move should increase the markets’ fund raising opportunities, while deepening the market breadth of the main boards in both Hong Kong and China.

For example, the Shanghai Stock Exchange (SSE) has just issued a notice regarding the Stock Connect universe expansion. Currently all stocks listed on the Shanghai Science and Technology Innovation Board (STAR Board) are not eligible to join the SSE180 index or SSE380 index. However, the China Securities Indexes Co. (CSI) just changed its methodology, opening the door to these names starting from the December 2020 reviews.

After the index inclusion, the three stock exchanges (Shanghai Stock Exchange, Shenzhen Stock Exchange and Hong Kong Exchange) will start preparation work and testing, aiming to include STAR stocks to Northbound from 1Q21 onwards.

Maintaining a balanced portfolio with bias towards cyclicals

Despite the above-mentioned near-term concerns, looking ahead in 2021, on the back of earnings growth potentials (Chart 1), we believe pro-cyclical sectors in China (e.g. electric vehicle makers, cement producers, education, healthcare and Medical Tech) deserve close attention. Despite recent rebounds, Hong Kong utilities and Hong Kong developers also look undervalued with good dividend yield support, making them good bond proxies.

We continue to underweight Chinese banks (on non-performing loan (NPL) and policy risk), while overweight insurance (thanks to strong reading of value of new business growth). 

Conclusion

We believe that the overall China equity bull market will not be derailed, underpinned by growth-led reflationary trades and increasing foreign inflows. We recommend investors to stay with the dragon in their 2021 equity positioning.