HK/China Equity Perspectives [September 2019]: The Resilience of the Domestic Sector

Another Roller-Coaster Ride in August

The HK/China equity market experienced yet another roller-coaster ride in August. On 1 August, US President Trump raised tariff against China immediately after FOMC’s decision to lower interest rate by 25bps, and MSCI China dropped as much as 8% in response, while RMB crossed the psychological threshold of 7 against the US dollar exaggerated the turbulence.

In mid-August, President Trump postponed the higher tariff on some products, and triggered a mild equity market recovery, which did not last long.

July Producer Price Index (PPI) Dropped to Deflationary Zone

Domestic macro data remained weak as expected, particularly July producer price index (PPI) dropped to deflationary zone – the first time since August 2016, adding further pressure on industrial profits, while infrastructure investment remained soft despite more local government loan issuance

On a slightly positive note, thanks to VAT cut and other fee reductions, which helped to cushion some pressure on profits, 1H19 earnings so far came in-line with consensus estimate, particularly in the MSCI China universe.

In our view, the Loan Prime Rate (LPR) would improve monetary policy transmission, leading to lower corporate financing costs. On the other hand, banks’ demand for bond could increase in near-term as returns on loans fall.

Lending Rate vs GDP Growth

All-in-all, in the context of trade tension and a slowing economy, we take the reform as a stealth moderate easing by the PBoC.

Nevertheless, the question is how efficient is the reform, as so far, the lower market rates have failed to pass through to the real economy.

Deja Vu: MSCI China 2011-12 VS 2018-19

We recognise striking similarity in market conditions between 2011-12 and 2018-19.

However, near-term uncertainties over trade-tension and political standstill in HK may increase volatility and limit upside potential.

As we do not expect any meaningful trade agreement to be reached by China and the US in the near-term, we prefer domestic sectors – Consumer Discretionary, Communication Services, Healthcare, as well as insurance for the better earnings resilience and more supportive regulatory environment.

On the other hand, macro sectors – Banks and Energy, on the back of slowing global economic outlook are less attractive.

As we see a depreciation trend of RMB developing, we are cautious over companies with higher US dollar denominated debts – mainly the airlines and selective high-gearing privately-owned real estate developers.

Summary of our Latest Views on Some Key Sectors

OVERWEIGHT - COMMUNICATION SERVICES

• A traditional defensive sector.
• The more rational 5G capex plan among telcos should reduce investors’ concerns about near-term earnings dilution, and therefore we see them as less risky vehicle to invest in the 5G technology theme.

OVERWEIGHT - CONSUMER DISCRETIONARY

• We particularly like education companies in the sector due to the inelastic demand, which is virtually insulated from the trade-tension.
• Their strong and highly visible cash flow is an additional positive under the current environment. With policy overhang now behind us, we see further upside potential from valuation re-rating.

UNDERWEIGHT - ENERGY

• The on-going trade tension is expected to keep oil prices in check in the near-to-medium term, while the depreciated RMB presents an extra negative.
• We see limited catalyst in the near-term to drive share price outperformance.

UNDERWEIGHT - BANKS

• PBoC is likely to introduce Reserve Requirement Ratio and Medium-term Lending Facility rate cuts, rather than outright benchmark rate cut, to minimise the negative impact on banks’ net interest margins and return on equities, but the squeeze is unaviodable.
• PBoC Bank Lending Rate reform is going to lower the lending rate, but funding cost is getting higher as non-performing loan (NPL) formation is the on rise.
• With concerns about big banks required to perform national services to bailout smaller ones, we see limited chance of a meaningful valuation re-rating.

OVERWEIGHT - HEALTHCARE

• We further increase weighting in healthcare sector, as the recently announced revised drug purchase policy only expands the geographical coverage but does not expand the list of drugs under the policy.
• In our view, the market has priced in a much worse scenario, and therefore, we expect earnings expectation as well as valuation to gradually improve.

OVERWEIGHT - INSURANCE

• Most insurance companies delivered strong 1H19 results so far, with signs of recovery in Value of New Business (VoNB) growth due to improving productivity of life insurance agents.
• While investment return remains a concern in the near-term due to high equity market volatility and lowering bond yield, the much strong earnings outlook should drive share price outperformance against other subsectors in financial.