We advocate staying Overweight in China equities as the country works towards returning to normalcy
Chief Investment Office, Yeang Cheng Ling18 May 2022
- China policymakers have been addressing market overhangs and are working to resolve the situation
- Progress is being made on the Covid situation, e-commerce and tech regulation, ADR delisting issue
- Institutional underweight of China equities relative to benchmark is at a 10Y low.
- We see asymmetric risk-reward in favour of being invested, on the back of returning to normalcy
- We prefer China large SOE banks, platform e-commerce, technology, and insurance companies
China has been addressing market overhangs such as the Covid situation, China real estate developers, platform e-commerce and technology regulations, and American depositary receipt (ADR) delisting issue. We maintain the view that the market will find a bottom at current levels to stage a long-awaited recovery as policymakers have been proactively introducing supportive measures and working to resolve the situation.
Covid cases are falling and should further subside in due course. While there has been headline news on lockdowns and the impact on the economy, the actual number of Covid cases in China is falling (Figure 1), paving the way for reopening. Drawing from the experience in the US and UK, the current Covid outbreaks in various parts of China should eventually subside to pre-omicron levels. In the US and UK, it took approximately six weeks to peak and six weeks to fully subside (Figure 2). If China and Hong Kong follow the same pattern, daily new cases should return to low levels in China towards summer.
Covid impact on EPS being factored in. Consensus on earnings per share (EPS) downward revisions have been largely priced in (Figure 3).
China property market supportive policies. Various local governments have relaxed limitations on property purchases, and banks have lowered borrowing costs for mortgages. Further tightening measures seem unlikely while gradual support to the property market is being administered at a measured pace.
Platform e-commerce and technology. New government regulations continue to be introduced at a faster pace as promised and on a stable and transparent basis. The markets are looking forward to clarity and the end of further tightening.
ADR delisting issue. China regulators are considering allowing the US Public Company Accounting Oversight Board to conduct joint inspections with Chinese regulators on Chinese ADR companies’ auditors. Should this transpire, it may resolve the issue.
Institutional holdings at 10Y low. Global equity funds have greatly underweighted China relative to benchmark weight for the most part of the past 10 years, and aggressively reduced the weights since 4Q18. Currently, the benchmark-relative underweight in China is at 10Y low.
China equities at historical trough valuations. China’s forward PER (price earnings ratio) has dropped to below historical mean while the P/B ratio is below -1 standard deviation, both at the lowest in seven years. Such compelling valuations are adding to the support against downside risk. On a relative basis, China equities are trading at a steep discount to global average.
Risk-reward in favour of being invested. A lot of pessimism has been priced in and expectations set low. On an absolute and relative basis, China equities are inexpensive and being underweighted. We see asymmetric risk-reward in favour of staying invested, on the back of returning to normalcy, progress in removing the market overhangs, and compelling valuations. Sectors we prefer are China large state-owned enterprise banks for their stable yields of 6-7%, platform e-commerce, technology firms, and insurance companies that ride on long-term secular growth trends.