China 2H 2021 Outlook – Ready for a Rebound?
Timothy Fung, Head of Equity Advisory, Asia
Summary
Get ready for a post commodity-led inflation rebound - In 2H2021, we remain structurally positive on consumption, alternative energy and healthcare sectors owing to their high earnings visibility, backed by supportive policy and macro tailwinds. We are tactically positive on materials and transportation sectors in order to capture the reflation and recovery alphas. Policy uncertainties are expected to cloud the performance of tech, fintech and after-school tutoring, hence we are waiting for better window to re-enter. In respect of the property market, we prefer property management to developers due to its asset light business model and lower regulatory risk.
Market concerns are overdone – There are three major market concerns on China, namely rising margin pressure from a reflationary economy, tightening market liquidity and ongoing regulatory uncertainty on major index-heavy sectors, such as internet, fintech, finance and property developers. However, if history is to repeat itself, these concerns are proven to be temporary, and more importantly, they seem to have been priced in already.
Prefer onshore A-share over Hong Kong-listed H shares/ red chips. We continue to favour onshore over offshore China equities given:
i. Its 5% discount in forward PE vs. MSCI China; and
ii. Less exposure to sectors under regulatory uncertainty.
This is because internet, fintech and education account for circa 1% of CSI300, versus >45% for MSCI China. Domestic A-share market has gone through steady reform efforts since 2014. We believe such reform direction will not be derailed in the long run, which will further improve the markets’ investability for institutional investors.
We significantly reduce our exposure to property stocks in view of rising policy risks, while increasing our weighting on renewable energy space as we expect more policy streamlining and supportive measures. We also added more copper names as an inflation play.
Three market concerns that seem overdone
We believe there are three major market concerns on China:
- Rising margin pressure from a reflationary economy;
- Liquidity tightening on the market which could curb P/E multiple expansion; and
- Ongoing regulatory uncertainty on major index-heavy sectors such as internet, fintech, finance (asset management corporation/ banks) and property developers.
Global economies are also worrying about rising inflation. China, which is a major buyer and supplier in global markets, frightened the world with its surging Producer Price Index (PPI) inflation (Chart 1). In history, there are two rounds of PPI inflation over 2016-17 and 2021 YTD which are comparable. In 2016, gross margin (GM) of A-share non-financials rose 29 bps, driven mainly by expansion in the up/midstream sectors (+78 bps). Most importantly, after the commodity prices moderated in 2H17, margin rebounded 90 bps in 2017.
From a sector perspective, home appliances gross margin are up +119 bps, autos +68 bps, and machinery +38 bps. In essence, all sectors which have high raw material input demand, mostly recorded an unexpected margin expansion in 2016. Last but not least, the latest State Council’s executive meeting ensured the supply of commodities and keep prices stable in order to maintain a steady economic environment. We believe the post pandemic re-opening-led inflation pressure will fade when economies are normalised in the absence of any wage-price spiral pressures. As a result, inflation volatility is expected to rise in the coming months but it may not be sustained. Hence, the potential peaking (or moderation) of PPI should help alleviate market concerns about GM pressure.
For the second and third market concerns, we believe both are dynamic in nature and depend on how corporations react to the new rules. Potential reversal (or relaxation) of policy direction would lead to liquidity improvement.
Take China internet as an example. So far, we observed that major e-commerce players have been responsive to the new policies and the adaptation progress for this sector is encouraging.
How to position ourselves in 2H2021?
China consumption – the trend is always your friend. We continue to suggest accumulating earnings winners, with the consumer sector remaining our top choice. Within the consumer discretionary space, we stay bullish on China autos and electric vehicles, electric home appliances, and smart healthcare & services. We like consumer staple names with strong earnings track records. As shown in Chart 2, based on the latest Southbound net flows in April 2021, media, consumer durables and retailing have attracted the most inflows during the month.
Transportation – nimble on recovery picks. We stay nimble on stock picking and do not suggest investors to chase after further upside on shipping due to:
i) Oil price volatility has become higher on the back of politics recently, which should pass onto tankers; and
ii) Profit-taking given the improving demand side outlook are priced in for container shipping sector after Feb 2021-to-date share price rally. We continue to suggest investors to focus on travel re-opening and life style change beneficiaries.
Renewable energy – go with the wind. More supportive measures are expected for the renewable energy space, if not, China’s aggressive de-carbonization target can hardly be achieved. Within the green energy space, we prefer wind to solar. This is because compared with solar panels, wind turbines release less CO2, consume less while produce more energy.
According to elemental green research, one wind turbine can generate the same amount of electricity per kilowatt hour (kWh) as about 48,704 solar panels altogether.
Materials – tactical positioning on copper leaders. In 3Q21 we see tactical opportunities in the reflation cycle beneficiary – for upstream commodity, we remain positive on the longer-term demand especially for copper that has supply constraints.
China healthcare – beneficiary sector from hospital re-opening. In addition to our positive stance on med tech (life style change beneficiary), we reiterate our Buy call on traditional drug manufacturers which have strong innovative pipeline. With physical hospital activities normalised, we see emerging opportunities on biologics, chronic disease pharmaceutical leaders, as well as medical equipment players.
Tech – stay cautious now; observing re-entry window. We have seen various value traps in March-May 2021 on China tech sector and a few e-commerce giants have tied up plenty of portfolio liquidity for these buy-on-dip investors. We stay cautious on tech in 3Q2021 but are observing for the re-entry window. Based on all the policy measures implementation years (as seen in Chart 3: 2013-15 on anti-corruption, 2016-3Q17 on capital outflow clampdown, 2018 on services tightening), the market normally consolidates at the beginning and then generates solid returns after. Overall, we believe that Chinese government will focus on promoting fair competition, preventing systemic risks, and ensuring that internet giants shoulder a certain level of social responsibility, but not to severely limiting their growth.
Education – High policy risks on after-school tutoring (AST) but mostly priced in. President Xi approved the Opinions on Reducing the Burden of Homework and After-school Tutoring for Students in the Compulsory Education Stage on 21 May 2021 and the event continues to ferment. We maintain our view that the risk of a complete ban on tutoring is low, though the risk of a suspension of the rapid expansion of AST is higher. The market is now expecting public schools might be allowed to provide AST between 3:30pm and 6:00pm during weekdays. We doubt such a move will post serious threats to existing private AST leaders because they are in different market segment and public school service quality is way below private AST players. Last but not least, two AST leaders have already stopped classes before 6pm on weekdays since 2018. Volatility will continue in ASTs before July 2021 but policy risks are already priced in with Feb 2021-to-date share price correction.
China property sector – prefer property management to developers. The two key reasons why we prefer property management to developers are: asset light and lower policy risk. Despite the attractive valuation of China property sector, we think policy risk and margin concerns will continue to be an overhang. Recent news flow about the pilot scheme on property tax reform could also be viewed as a stringent policy tone to respond to the resilient momentum in both land and property markets.
Energy – appealing risk-reward. Although oil prices have recovered to pre-pandemic levels, Chinese oil majors’ risk-reward remains attractive with energy transition under the spotlight. In particular, valuation of some China offshore explorers are still lagging despite being a pure upstream play with a low cost base, and an increasing production growth profile. We believe the overhang from US sanctions is largely priced in.
Conclusion
We prefer onshore A-share over Hong Kong-listed H shares and continue to favor A-share vs. offshore given:
- Its 5% discount in forward PE vs MSCI China; and
- Less exposure to sectors under regulatory uncertainty.
This is because internet, fintech and education accounts for circa 1% of CSI300 vs >45% of MSCI China. Domestic A-share market has gone through steady reform efforts since 2014 (launch and expansion of Stock Connect, MSCI A-share index inclusion, QFII/ RQFII program).
We believe such reform direction will not change in long-term and further improve the investability for institutional investors.