Rebooting the World’s Factory

Phase 2 Sino-US trade war remains the biggest near-term overhang

As we pointed out before, Sino-US Trade war dispute will continue to linger in the medium term. Phase 1 trade deal, in which China is committed to purchasing USD219 billion of goods from the US this year, is only ~17% achieved between January and April 2020 due to disruption by COVID-19 outbreak.

Trump is likely to continue to leverage on China as an important bargaining chip in order to win the upcoming Presidential Election. Thus we continue to expect a bumpy negotiation process on the Phase 2 trade deal in the near term. This should bring increasing volatility to the HK/China equity markets. 

Challenging economic landscape ahead

On the macro economics front, sub-segments of the Purchasing Manager Index (PMI) have collectively pointed to an across-the-broad decline in most economic sub-segment (Diagram 1). 

Deflation will be another headwind in the next two quarters as PPI (Producer Price Index), a leading indicator for CPI (Consumer Price Index), continues to worsen in April.  Sooner or later, this will be translated into declining corporate profits, thus possibly leading to a rising P/E multiples for the overall China market.

More downside for near-term earnings downgrade

On the other hand, market forecasts are still not yet fully reflecting the economic challenges ahead. The current 2020E consensus earnings growth for MSCI China still stands at low single digit growth, which looks a bit too optimistic compared to March industrial profits decline of 37.9% year-on-year (yoy). 

We expect the Q2 results to worsen versus Q1, which could trigger more analyst downgrades in listed companies’ earnings growth in 2020. But if history is of any reference, this should almost mark the bottom in terms of earnings decline.

Bad economic news = Good policy news

For equity investors, however, bad economic news sometimes translate into good news from the policy front, as the Chinese authority is likely to step up stimulus measures to reboot the world’s factory. We expect more large-scale stimulus policies to be released ahead of the 13th National People’s Congress (to be reopened on 22 May 2020).

This serves as a strong near-term market catalyst. Moderating CPI along with PPI, for example, means that the People’s Bank of China (PBoC) now has more room for an interest rate cut; this also means that Total Social Financing (TSF) (Diagram 2), sometimes known as aggregate financing to the domestic real economy, would have a lot more flexibility to provide additional funding to revive the private sector, especially for the small-and-medium sized enterprises (SME) which were the most hard-hit in the pandemic outbreak. 

Sweet Window to Enter the Market, with selected sector offereing high leverage to eceonomic recovery  

With bad economic data suppressing recent share market performance and massive stimulus measures yet to be fully kicked in, this leaves Chinese equity investors a sweet window to enter the market. 

The BNP Wealth Management’s CIO team has recently upgraded China to Overweight, as both Hang Seng Index and Shanghai Composite Index are trading at an undemanding valuation of close to -1x standard deviation (Diagram 5 and 6). 

In particular, we believe selected cyclical sectors, which have significantly underperformed the market during the COVID-19 pandemic (Diagram 7 and 8), would be poised to outperform the broader market in this round of rally: 

Consumer – With close to 100% work resumption ratio in China, strong pent-up demand should drive a sharp rebound in consumption in the near term. While China's overall retail sales dropped 16% yoy in March (vs. -21% yoy in January/February 2020), auto sales decline narrowed the most.

We think the worst for auto sales decline is behind us (Diagram 9). With an increasing number of cities implementing auto stimulus measures e.g. increase car plate quota and rural subsidies, a rebound in auto sales is likely in the coming months.

Sportswear companies also saw healthy offline sales recovery in March/April 2020, not to mention that online channel sales outperformed peers during COVID-19 shutdown period. 

Oil and gas – Near-term oil price disruption induced by oil futures trading activities seem to be temporarily over, while aggressive cut in dividend and capex by the large oil majors give us confidence that they will be able to weather this storm, and probably grow even stronger and bigger by acquiring troubled global small players at a discounted price.

More importantly, unlike their US/ European peers, Chinese large oil companies are in an unique position – they are all state-owned so their financial positions generally remain robust in a depressed oil price environment, thanks to Chinese government’s unlimited support.

Short-covering could be another near-term technical support factor to drive near-term performance, as energy sector has seen massive outflow last month and is a consensus underweight.

Looking into 2Q, earnings will likely continue to be pressured by upstream losses, as well as further inventory losses. On a more encouraging note, the downstream segments could see quarter-on-quarter (QoQ) improvement in utilisation rate and volumes, as well as stabilising refining margins as economic activity resumes. 

Real Estate - In April 2020, contracted sales of major developers grew 2% year-on-year, rebounding from a very weak Feb/Mar 2020. Year-to-date, contracted sales for major developers are still 11% lower than the first four months of 2019 (Diagram 10).

In April, Average Selling Price (ASP) for major developers on average rebounded 20%+ month-on-month – close to levels prior to the virus outbreak. Given financing stress has largely subsided, we see sales performance as the largest driver for stock performance in the near term.

We are positive on May sales as new launches catch up (Diagram 11), but we are more cautious about demand sustainability in 2H20. We continue to like large developers which have good access to liquidity, are beneficiates of policy easing in higher tier cities, with ability to deliver stable earning per share (EPS) growth in 2020, and have potential event catalysts e.g. listing of property management units. 

Aviation - In total, the Civil Aviation Administration of China (CAAC) announced 16 measures - from financial support to infrastructure investments for both the airlines and airports, which have been hit by the COVID-19 outbreak.

Traffic is likely to recover over the next few months, to be lifted by two key catalysts including easing travel controls on better virus situation and potential policy stimulus.

However the two bottom-line variables are:

1) low oil prices and a weak international traffic would depress demand on kerosene – the Big 3 earnings will be hurt by 7 to 16% for every 1% rise in oil price,

2) RMB steady at 6.9 - 7.2 range versus the USD.

Valuation is undemanding: 0.6x P/BV is at historical trough (Diagram 12) and we believe travel demand should continue to restore from here (Diagram 13). 

Education (offline) – In China, universities will gradually resume classes in Qinghai Province, Xinjiang Uygur Autonomous Region, Shanxi Province and Jiangsu Province in April 2020. 

Graduating students and post-graduates with research tasks should be given priority in resuming classes, according to Ministry of Education (MoE). On a separate note, the MoE has sped up the approval process for independent college conversions, and approved 11 conversions year-to-date. (Diagram 14)

It is probably the best time so far in 2020 to re-visit China stocks.

On the one hand, bad economics data has been keeping share valuation subdued; on the other, massive stimulus from the upcoming NPC should revive market confidence gradually.