China story turns more positive

Scott Longley

a sunflower on a table

Bulls on the China story will have been encouraged by a spate of positive macroeconomic news that suggests the economy is on track for its best year since the turn of the decade but recent research shows the degree to which the different indices can provide very divergent performances.

The news this week that Chinese GDP grew by 6.9% in the second quarter, matching the first quarter figure and two basis points rise on the 6.7% for 2016.

Should that trend continue for the second half it would mean the country's economy had grown at a faster rate than the previous year since 2010.

Equity strategists at HSBC Global Research pointed out that the GDP figures were backed up by other data. This includes a rebound in the Chinese manufacturing PMI to 51.7 from 51.2 the previous month and beating the consensus figure of 51 and an acceleration of trade data last month.

While export growth rose 11.3% year-on-year, import growth was stronger at 17.2% helped particularly by machinery and electronics and hi-tech.

Pointing to its own 'Chinometer' gauge for European corporate sentiment regarding prospects in China, the HSBC analysts say the companies involved are more cautiously optimistic than they were three months ago, albeit that it is running below the long-run average level.

"The key take- away here is that market optimism is not so excessive (like we saw in 2011) that it would make us reconsider our overweight stance on the China theme within our European sector portfolio," the analysts wrote to their clients. "Note, we are overweight materials, consumer durables and capital goods, three sectors all with relatively high sales exposure to China."

Of the 28 constituents of the 'Chinometer' gauge, the anecdotal evidence is upbeat with 17 having made generally positive comments versus only three negative and the remainder having not said anything or mixed. They reiterate their view that the growth opportunities offered by China - and more broadly emerging market - exposure is more attractive than domestic European opportunities.

Diving in different liquidity pools

For those looking for exposure direct to Chinese stocks, there were some words of caution from the equity strategist team at SocGen who pointed out that the differing liquidity pools of the various indices was having a marked effect on the performance.

In a note issued in mid-June that depending on the benchmark chosen, Chinese equities can be seen to have either outperformed or underperformed Asia.

In the year to date, the Shenzhen composite is down 6%, the Shanghai composite up 1%, the CSI 300 up 8%, the HSCEI is up 12% and the MSCI China up 25%. In comparison, the MSCI Asia has risen by 18%.

"The divergence in returns reflects widely different liquidity pools and index methodologies," say the SocGen analysts.

Onshore and offshore equities tap into different liquidity pools, they added. "Onshore equities are essentially held by domestic investors, a significant portion being individual investors. In our opinion, the current ongoing regulatory tightening weighs more on onshore equities. On the other hand, offshore equities benefit from the abundant Connect Southbound flows (i.e. the flow of money into Hong Kong through the Stock Connect programme), which currently represent 10% of the traded value of HK-listed stocks."

There are also different index methodologies. Unlike the HSCEI, the MSCI China index includes more than just H-shares; it also includes high growth consumer-related stocks, consumer discretionary and technology names which together constitute close to half of the index.

While more representative of the Chinese economy, valuation is becoming demanding," says the analysts. "MSCI China trades at 14.7 times trailing earnings, a 90%-plus premium to the more state-owned enterprises-oriented HSCEI index. On average, consumer discretionary and technology trade at 35 times trailing earnings," they add.

"The consumer story is bright and May macro indicators show that consumption momentum remains strong. There is however a risk of overpaying for growth. We are concerned on valuation and (have) reverted to a neutral position on China offshore equities."


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