Optimism running high for Chinese shares next year

Current cheap valuations and prospects of market reform boost outlook for A shares

PUBLISHED : Tuesday, 31 December, 2013, 1:36am
UPDATED : Tuesday, 31 December, 2013, 1:36am

Chinese shares may be poised to become an unlikely star of Asian emerging markets next year, outshining India, thanks to cheap valuations and optimism about reforms.

Investors have been underweight mainland China for years.

China-focused equity funds saw some net inflows in November, when the Communist Party announced plans for far-reaching economic and social reforms, and analysts said once the government starts following through on those plans it would trigger a flood of money.

Foreigners have bought a net US$18.8 billion worth of Indian shares this year, according to the market regulator's data.

Official statistics are not published for China, but data from fund tracker EPFR shows a net US$5.5 billion outflows for the year to December 11 for China-focused equity funds.

Chinese equities are just too cheap to be ignored by investors in 2014

At 9.3 times forward 12-month earnings, the MSCI China is trading at a chunky discount to its 10-year median and at its widest gap to the MSCI Asia ex-Japan since the 2008 financial crisis.

And the Chinese market is trading at a 40 per cent discount to MSCI India on a forward price--earnings basis, according to Thomson Reuters I/B/E/S data.

In contrast, benchmark indices in India have hit record highs and valuations are on par with 10-year averages. Besides looking expensive, Indian shares could also be vulnerable to shocks that could come from the US Federal Reserve winding down its stimulus, current account problems, and a general election due by May next year.

At the very least, investors look unwilling to add more Indian risk and will look to make fresh allocations next year in other markets, with China firmly on their radar.

"Overall, we believe Chinese equities are just too cheap to be ignored by investors in 2014," said Desmond Tjiang, Greater China and Hong Kong equities portfolio manager at Pinebridge Investments in Hong Kong.

"Despite reforms and the broad economic slowdown, there are still a lot of industries such as mass consumption, e-commerce and environment-related sectors that should continue to grow exponentially in the coming years."

Beijing last month unveiled a bold reform plan, including pledging to free up markets, in a bid to put the economy on a more stable footing. The plan sparked a rally in mainland stocks that saw H shares gain more than 10 per cent in four sessions, before levelling off.

Some brokers, such as CLSA, said the rally lacked conviction due to an absence of institutional investors, but while some may still be wary of a market that has been in a funk since 2007, there are signs things could be turning around.

In a November 21 report, Goldman Sachs said funds focused on global emerging markets and Asia were underweight China by 290 and 582 basis points, respectively, suggesting a return to equal weighting alone would trigger a powerful rally.

"India may have more upside potential in the short term because markets may rally into the elections due in May, but China represents better value in the middle term," said Angelo Corbetta, Pioneer Investments' head of Asian equities in London.

The MSCI India IT sub-index trades at 21 times earnings forecasts for the year ahead, well above the 12 times for the equivalent index for Asia-Pacific countries excluding Japan. The MSCI health care sub-index is starting to look similarly stretched.

In comparison, China Inc's earnings revision ratio - the pace of earning forecast upgrades against downgrades - has turned around, suggesting investors think Chinese companies' earnings prospects are improving.

"For three years, markets have been betting on a hard landing in China. It is time to unwind some of those bets," said the head of a Asian macro hedge fund in Hong Kong.

For the rally to last beyond early 2014, investors will expect clear steps to be taken to resolve Chinese banks' bad debt problems. They will also want to see how the reform drive will impact corporate margins and earnings, especially for giant state-owned firms.