Brave new world

PUBLISHED : Monday, 11 June, 2012, 12:00am
UPDATED : Monday, 11 June, 2012, 12:00am

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China equities experienced another big sell-off last Monday. The Hang Seng China Enterprises Index, which tracks Hong Kong-listed China stocks, dropped 2.5 per cent. The index has shed about one-quarter of its value over the past year.

Steven Sun, head of China equity strategy for HSBC, says investors' concerns can be summed up as the three Gs: Greece, governance and growth.

Greece is shorthand for euro-zone debt problem, which acts a constant backdrop of grief pulling down markets.

Investors understand well the uneven governance of mainland firms.

Growth is the relatively new problem - the slowdown in mainland gross domestic product is happening faster than expected.

'The April data showed weakness across the board - the economy is slowing down very quickly,' says Shuang Ding, senior China economist for Citigroup. Ding says that industrial production grew 9.3 per cent in April year on year, the lowest increase since May 2009.

The mainland economy is going through a major adjustment, and this requires a bold new equities strategy.

There are near-term and long-term implications. The most immediate issue on investors' minds is what kind of stimulus Beijing will deliver in response to the downturn. Economists say China wants to prop up growth, but that it won't rain money down on the economy in the style of the four trillion yuan (HK$4.9 trillion) package of 2008-09, which distorted the economy and saddled the banking sector with hundreds of billions of yuan of bad debt (see sidebar).

Today's stimulus is less about extra government spending and more about easing policies.

'I don't use the word stimulus, which means extra easing compared to what has been included in this year's economic plan. It's more the acceleration of pro-growth measures,' says Haibin Zhu, chief China economist for J.P. Morgan.

Zhu, for example, expects China's central bank will keep cutting its reserve requirement ratio, which is a way of increasing bank lending and, therefore, of supporting the economy.

The central bank, indeed, surprised the market on Wednesday with a 0.25 per cent cut in lending rates. The move set up the bank for more cuts this year, all for stimulus.

Economists also expect the government to push forward infrastructure spending, such as on high-speed rail projects.

Meanwhile, the government is pressing on with a series of consumer subsidies. The State Council announced on May 16 that 26.5 billion yuan in subsidies would be used to stimulate purchases of energy-saving products - mainly cars and household appliances.

This comes on top of other measures, such as a trade-in programme (trade your old appliance in for a new one) and subsidised appliance purchases targeted at rural mainlanders. The Ministry of Commerce wheeled out a Consumer Promotion Month, which ended on May 1. All of this was done in the name of energising China's domestic demand.

The government has also cut taxes for small to medium-sized enterprises and is experimenting with various tax reforms that will eliminate up to 500 billion yuan of taxes this year, says Ding.

It is also forging ahead with an aggressive public flats programme. In the first four months, total social housing investment reached 247 billion yuan, says Ding.

In short, the state has responded - and will keep responding - with a litany of policy easings and accelerated spending on existing programmes. 'There is a lot of policy initiative ongoing that has been overlooked by the market,' says Sun.

This all has implications for investors in China equities. First, the government has made clear it is comfortable with the slowdown. Zhu says the government will tolerate a managed decline to the 7.5 per cent level. That is its red line. But until it falls below the level, Beijing will embark on no fresh spending or bailout.

So there's slowing growth with no new cash stimulus on the horizon: that's bad news for investors.

The good news is that most of that news is already reflected in the price of China equities. For those thinking optimistically - that markets will quickly stabilise with money flooding back into China shares - this translates into a huge buying opportunity.

On a price-to-earnings-ratio basis, China shares are hitting the lows last seen in 2009, during the global credit crisis. You only have to believe that the current crisis is not as severe as the one in 2008 to get interested.

'The smart thing is to dive into high beta stocks [stocks that move in line with the general market] because the derating has played out,' says Erwin Sanft, chief strategist for pan-Asia equities, BNP Paribas.

For those who think the China economy will bounce back, you can take your pick of potential bargains.

An investor can participate in this upturn by buying an exchange-traded fund linked to an A-share index - there are plenty out there. They could also buy so-called cyclical stocks, or stocks that are highly responsive to an upturn in the economy. These include energy stocks, such as Sinopec, or banks, such as Bank of China.

Bank stocks will also get a boost if the central bank keeps cutting interest rates, as now seems likely.

Alternatively, an investor can take a more focused view and try to play the expected policy response to the downturn.

For example, strategists like rail sector stocks (such as China Railway Construction) because the country is accelerating its railway spending. The state put all its rail projects on hold in mid 2011 following the high-speed rail collision near Wenzhou, Zhejiang. But the state is quickly reactivating rail projects, says Zhu.

Strategists also like infrastructure stocks (for example, Zoomlion Heavy Industry Science and Technology), on the view the government will accelerate infrastructure spending to pick up the economy.

'We think an infrastructure spending drive is under way,' says Sanft. He says the National Development and Reform Commission, which allocates government spending for development, has given out hundreds of approvals for infrastructure spending in the past few weeks.

Those who believe the government is accelerating spending on things like rail, infrastructure and public housing, an investor can also just buy cement stocks (such as China Resources Cement), cement being a key ingredient of all such projects.

But there is a bigger picture. This view holds that China's economy is going through profound structural shifts, of which the growth slowdown is a mere symptom.

'China is at a critical juncture: three decades of supercharged growth has caused the country many serious problems, including labour shortage, stretched global resources supply, unequal distribution of income, social tension and pollution on a scale unprecedented in human history. Many of these ills were brought about, directly or indirectly, by China's past reliance on investment to deliver growth,' wrote David Cui, a Bank of America Merrill Lynch strategist in a 2011 report.

This view holds that policymakers must move the country away from investment-led growth with low returns, or exactly the kind of industrialisation that has dominated the mainland economy since the launch of Deng Xiaoping's market reforms.

In October 2010, the State Council said it wanted to focus on seven strategic industries, promoting the development of renewable energy, energy efficiency and environmental protection, next-generation information technology, biotechnology, high-end manufacturing and new materials.

Economists expect that, if the government unveils large stimulus packages, it will be targeted at the above sectors. Investors wanting to play that angle could look at China High Speed Transmission Equipment, for example, which makes transmissions for both trains and wind turbines (therefore acting as a play on two focal areas of government support: rail and renewable energy).

BYD is another obvious pick. The firm has attracted investment from Warren Buffett, and it makes electric vehicles. It is just the mix officials favour: clean energy, technology and high-value manufacturing.

Cui's report identifies dozens of small mainland firms that fall within the seven official pillar industries. Most investors will never have heard about these firms, as many are A-share listed and, therefore, unavailable to Hongkongers.

For example, Cui points to the Shanghai-listed Chongqing Jiulong Electric Power, which specialises in clean energy. Closer to home there is the Hong Kong listed CMMB Vision, which develops video for mobile devices.

Investors might have a hard time getting excited about such stocks, if only because they are so obscure. But the message from economists and strategists is that such firms represent the future of China if policymakers get their way.

Beijing will not sacrifice its goal of rebalancing the mainland economy for the sake of short-term growth. For example, the government has been notably reluctant to pull back on controls on the property sector, even though property is a large contributor of jobs and growth, and is easy to stimulate.

Economists expect property tightening will continue until the National People's Congress next March. Investors may be sceptical that much will come from the government's 'seven pillar industries scheme', and may struggle to identify potential winners among these industries at this early stage. The message at this point is more negative: don't expect the government to use a big stimulus if it risks channelling investment to old industries, away from its seven targeted sectors.

'The government needs to balance growth with its economic restructuring reforms, and it won't sacrifice one for the other,' says Zhu.

 

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