Jan 11, 2015

China’s New Normal: Exhilaration in Deceleration?

A tug-of-war between sentiment worries about growth interspersed with bouts of selected easing made for a bumpy ride for China’s equity markets in 2014.

As China enters a “new normal” phase of deliberate growth deceleration, we believe these are bright spots investors will be looking for in 2015.

Operating margins expected to improve

Chinese corporate margin expansion resulting from favorable cost structure will be a bright spot for mid-stream companies, in our view. Chinese companies should see improving margins from:

- Lower costs for raw materials, ranging from agricultural products to hard commodities.
- Lower capital expenditures by state-owned enterprises as a result of a reform to enhance shareholder return.

Interest rate cut could lower financing costs and revive China A-shares

China’s real interest rate remains one of the highest in the world, despite a recent lending rate cut. We believe further room for rate cuts in 2015 could potentially boost Chinese equities by alleviating corporate borrowing costs and indirectly nurturing prosperity in China’s capital markets, particularly for China A-shares.

Further developments on reforms to drive re-rating

During 2014, Chairman Xi Jinping consolidated his political power to facilitate structural reforms, and the pace of reforms was largely on track.

- Revival of the banking sector. We saw concrete developments aimed at reviving the banking sector. China’s debt issues involving the local government financing vehicles — often the foremost concern for global investors in the recent years — are being addressed by the government’s determination to introduce policies and controls to increase transparency surrounding local government and trust products. We are hopeful that the banking sector will be re-rated for Hong Kong-listed Chinese equities.

- Power grid and railway reforms. We expect the reform of China’s monopolized power grid and railway sector to accelerate. The power grid reform involves separating the power transmission and distribution businesses and encouraging private capital to invest in the power distribution sector. Similarly, the railway bureau reform involves allowing the private sector to participate in railway and subway construction to ensure efficiency.

MSCI inclusion of ADRs and China A-shares could potentially boost Chinese equities

Index provider MSCI currently includes only Chinese companies that trade in China’s time zone in its indexes. With the increasing number of Chinese companies listed on US exchanges, MSCI is exploring the possibility of allowing Chinese American depositary receipts (ADRs) to be included in the MSCI China Index.

In addition, the recently launched mutual market access program Shanghai-Hong Kong Stock Connect, as well as the availability of Qualified Foreign Institutional Investors (QFII) and RMB Qualified Foreign Institutional Investors (RQFII) programs, 1 may accelerate inclusion of China A-shares into the MSCI World Index.

In our view, potential inclusion of both ADRs and China A-shares in MSCI indexes could potentially boost Chinese equities, not only by generating positive domestic market sentiment, but also by serving as a wake-up call for global investors to revisit underweight positions in China.

Undervaluation may offer opportunities for long-term investors

Chinese equities are currently undervalued, both on a historical basis and compared with global peers. The MSCI China Index is trading near its trough valuation since 2008 and at an approximately 20% and 40% discount to emerging markets and developed markets, respectively, measured by relative 12- month forward price-to-earnings. 2 We believe this undervaluation may offer opportunities for investors to revisit this “neglected” asset class.

China’s New Normal: What are the Bright Spots for 2015? offers more extensive information about our 2015 outlook for Chinese equities.

1 QFII permits certain licensed international investors to participate in China’s mainland stock exchanges. RQFII permits qualified institutional investors to use renminbi (RMB) funds raised in Hong Kong to invest in the domestic securities market in mainland China.

2 Source: CLSA, Oct. 31, 2014. The MSCI China Index 12-month forward price-earnings ratio relative to the MSCI Emerging Markets Index and MSCI World Index.

Important information

Forward price-to-earnings ratios is a measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation. The P/E ratio, is an equity valuation multiple. It is defined as market price per share divided by annual earnings per share.

The MSCI China Index is an unmanaged index considered representative of Chinese stocks. The MSCI World Index is an unmanaged index considered representative of stocks of developed countries. The MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries. An investment cannot be made in an index.

An ADR is a negotiable certificate issued by a US bank representing a specified number of shares in a foreign stock that is traded on a US exchange.

The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

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