What next for China and its equity markets?

It’s the big question on most investor’s minds as President Trump ratchets up the trade war and Chinese equities sell-off. Analysts at French bank SocGen have busy weighing in on the big debates with their star strategist Albert Edwards suggesting that a further depreciation for the Remnimbi is on the cards – whereas his Asian equity analysis colleagues reckon that the equity sell-off is overdone.

Here’s Albert on the “weak” yuan”….

After June saw the largest monthly fall in the Chinese renminbi against the US dollar on record, the Chinese central bank (PBoC) stepped in with some soothing words to reassure the markets. Comparisons are being made with the situation at the end of 2015 and most of 2016, when the markets were continually anxious about Chinese currency policy. Despite the reassuring words from the PBoC, it is difficult to see how, if Chinese interest rates are being slashed, the renminbi can do anything other than fall sharply.

Two weeks ago, we highlighted on these pages the accelerated pace of the slowdown in the Chinese real economy data. We pondered whether a weakening renminbi would be part of the policy armoury deployed to counter the dramatic slowdown in China’s economic growth. We had not expected the renminbi to fall quite so quickly.

After May’s shockingly weak Chinese retail sales, fixed asset investment and credit growth, the PBoC had to be seen to be doing something, especially since US tariffs of 25% on $34bn of Chinese goods will come into effect on 6 July. Our economists estimate the drag on the Chinese economy could be close to 1% of GDP and cost 3-4m Chinese jobs, while for the US, the drag on GDP would be more modest at just 0.1-0.2%.

Hence it was no surprise that the PBoC cut the by 50bp RRR for the largest banks to 15.5% (effective July 5) for the third time this year. With the economy looking increasingly vulnerable it simply has no choice but to ease aggressively. And with the Fed heading decisively in the opposite direction, is it any wonder the renminbi slumped in June?

Clearly, the fear is that the Chinese authorities are using the weak renminbi as a stick to beat the US with over the trade war, but let’s put things into perspective. To quote Kit Juckes on the war of words over the yuan: “the chart shows its trend in real effective terms over the last 18 years. The 2015/16 policy of letting it weaken has been abandoned and the recent fall should be seen within the context of the bounce in real trade-weighted terms that we saw in recent months. It’s not clear that we will have a trend from here.” Not yet anyway!

I suspect that on this score, Albert Edwards has a point. A steadily weakening currency scores lots of strategic points against Trump.

Chinese equities now oversold

The potentially good news is that SG’s Asia equity analysts reckon that the equity market correction has gone too far – they believe a lot of the bad news is in the price. In a note from the previous week they suggested that their “risk premium model signalled zero onshore market growth in 2019. To match the summer 2015 bear market, earnings would not only have to be flat this year (consensus is for 15% growth) but not grow at all until 2020. Possible for sure, but unlikely given how little China’s listed equities are exposed to exports.”

That’s seems to be the crucial point – most Chinese equities aren’t especially export dependent.

“We observe this lower dependency at both the macro – the contribution of exports to GDP growth is dwindling, with a rebalancing toward consumption- and micro levels. On the latter, we estimate that more than 90% of CSI 300 components by weighting generate their sales domestically.”

So, if Chinese equities aren’t THAT vulnerable to a trade war, what should investor’s be buying into?

You guessed it – Chinese consumer stocks.

“real income growth is steady, the middle class is expanding and wealth effects remain positive (essentially housing). However, the recent equity market correction saw all sectors bar Health Care decline by 10% or more. This has opened up investment opportunities in sectors sensitive to domestic consumption whose earnings growth is somewhat less exposed to the trade war and the negative effects of deleveraging. We propose gaining exposure to consumption growth through two channels: indirectly through China tourist stocks in Asia and directly through a basket of China onshore consumption stocks. We already focused on China tourism in early May and designed a basket of 43 Asia stocks”.

The SG analysts helpfully propose a new

“China onshore consumer basket, designed to track the performance of stocks exposed to household consumption. We focus on domestic consumer Blue Chips which screen as reasonably valued and profitable on a consensus basis. The basket includes stocks which are: (i) MSCI China A and Northbound Connect eligible; (ii) in the Discretionary, Staples and Health Care sectors; (iii) generate more than 80% of their sales in China; (iv) trade on a consensus Price-Earnings-to-Growth ratio equal to or below 1; (v) have a debt-to-equity ratio below 1; and (vi) offer a ROE greater than 10%. The result is a basket of 15 stocks well diversified across the various segments of China household consumption and evenly balanced between Shenzhen and Shanghai stocks and between privately held and State-owned enterprises.”

What struck me was that many of the stocks listed in the basket above trade at PE ratios of well below 20.

I counted the following in the list:

  • Beijing Dabeino (a forward PE ratio of 11.7)a Food producer,
  • Wuhu Shunrong (11.8) auto components,
  • Hangzhou Robam (15) household goods,
  • Tongwei (9.4) food products,
  • Shanghai Pharma (15.6) healthcare,
  • Gree Electric (9.9) household goods.

 Are Indian equities due another surge?

After a bullish start to the year, many Asian markets reversed their gains in recent weeks and months. In fact, Asian markets have just posted their worst half-year fall in 5 years!  Although India was one of the few BRIC markets to show small gains in local currency terms (the other one was Russia), the Rupee’s recent weakness against the US$ and GB£ created small losses for foreign investors in the Indian market.

A note out last week from researchers at Lalcap suggests that these lacklustre numbers for India hide a much more positive macroeconomic picture.

The note observes that:

  • “The Nikkei Manufacturing Purchasing Managers’ Index, compiled by IHS Markit, rose to 53.1 in June from May’s 51.2, the highest since December. Orders from international markets rose at the strongest pace since February. Manufacturing firms in June increased hiring at the fastest pace since December;
  • India’s factory activity grew at its fastest pace this year in June on higher output driven by strong demand. That points to continued strong economic activity in the quarter that ended in June. India’s economy grew at 7.7% in the January-March quarter, its quickest pace in nearly two years”
  • The bad news was “the Indian Rupee fell to an all-time intra-day low when it touched Rs 69.06 on 28 June vs the US $. It has since bounced back to around Rs 68.83 on intervention by the Central Bank. Dependence on oil imports has exposed the economy to risks of higher crude prices. India imports about 80% of its oil needs. Brent crude is up 14% this year, and prices could flare up further;

Lalcap now reckons that the Indian Rupee “may well fall below the psychologically important level of 70 vs the US$ in the next few weeks if oil prices surge, foreign investors, sell more bonds and equities and repatriate capital”.