We expect China’s stock market to face both risks and growing opportunities from late 2018 to the end of 2019. In our view, properly timing the entry will be key for investors.
In late 2017, we expected the global economy would continue its broad-based recovery into 2018. That did not happen. While US economic growth has been supported by factors such as tax cuts and has held up despite the Fed’s interest rate hikes, the Chinese economy failed to continue a recovery which began in 1H16. It has again come under pressure due to a rigorous deleveraging policy and worse-than-expected trade friction between the US and China.
China began to adjust its policies in mid-2018 to support economic growth and may continue to do so until at least 1H19. Subject to constraints such as inflation, housing price and debt, policy support has been relatively mild so far. As the downward pressure on economic growth intensifies, stronger policy support may be needed. In addition to the widely expected cuts to taxes and fees, the government can also adjust monetary policy, fiscal policy and real estate policy.
The CICC macro team expects China’s 2019 GDP growth to slow to about 6.4% in our base-case scenario, with greater pressure expected in 1H19.
We expect A-share companies’ earnings growth to continue slowing in 2019 after peaking in 1H18, partly due to weaker exports and a cooling real estate market. Risks include a sharper than expected export slowdown due to trade friction, while there may be upside found in stronger policy support and greater tax cuts.
Our top-down 2019 earnings growth forecast is 4% for all A-share companies in the base-case scenario (5% for financial firms and 3% for non-financials). We expect earnings growth to pick up as we get further into 2019.
Stock valuations relatively low but likely to rise
Valuations of many sectors are at the bottom of their historical range. The ratio of the total market capitalization of A-shares to the sum of household deposits and bank wealth management products has dropped to 48%, which is close to levels seen at the market bottoms in 2008 and 2014. The implied risk premium of the CSI 300 index has risen to the 80th percentile of the historical range, indicating investors are generally pessimistic.
Nearly half of the sectors are at or close to record low valuations, including finance, real estate, most TMT sectors, and some cyclical and consumer sectors. The valuation of some sectors has been fair relative to earnings growth.
The difference between stock dividend yield and government bond yield has narrowed significantly and sentiment indicators are at a low level. The expected dividend yield of the SSE 50 index has been close to the 10-year government bond yield. The difference between them may narrow further as interest rates fall. Historically, such periods often coincided with good entry points for stocks in the medium term.
A-shares are quite attractive in comparison to their international peers. The A-share market valuation exceeds only those of the South Korean and Italian markets. It is also low compared with its historical range. Recently a large amount of overseas capital has flowed into A-shares through Stock Connect, suggesting international investors recognize the current investment value.
We think an improvement in liquidity may support a slight expansion of market valuation in 2019. The accelerated inflow of overseas capital may provide a stronger support for an expansion in valuation of blue-chip stocks. We also note that bonds are still outperforming stocks, but we expect their relative performance to change along with policy-driven alterations in growth expectations.
Contrarian strategy favoring stocks with solid fundamentals or potential sharp turnaround
From late 2018 to 2019, investors should adopt a contrarian strategy as most pessimistic expectations may have already been priced in. We like stocks with solid fundamentals and low valuations — the percentage of institutional investors is rising while the capital market continues to expand. Meanwhile, investors should also monitor possible turnarounds in stocks sensitive to government policies or those suffering from excessive investor pessimism.
Our sector allocation ideas for the next three to six months
In short, be contrarian. Hold quality names and wait for a turnaround. Many sectors have recorded negative returns for three consecutive years. The overall market valuation has declined significantly and many sectors’ valuations are at historical troughs. There is still downward pressure on economic growth and policy support may gradually increase. On one hand, we would adopt a bottom-up approach to pick individual stocks according to our medium/long-term investment strategy and the match between earnings growth and valuation. On the other hand, we would also track policy and sector changes to watch for investment opportunities in the short to medium term.
Specifically, we think sector allocation and stock picking from now to end-2019 should consider the following factors.
1. The expectations implied by current valuations are largely pessimistic. Although the usefulness of the historical valuation range as a reference is arguable, it is worth noting that the valuations of the market as a whole and many sectors are at the low end of their historical range, which suggests that more pessimistic expectations have been priced in. While we pay attention to risks, we may need to pay even more attention to potential opportunities.
2. There is still downward pressure on economic growth and policy support may gradually increase. Economic growth is still under downward pressure, as exports may continue to slow and the real estate market may cool further. However, the government has adjusted its policies to support growth, though policy support is still relatively moderate so far. Looking ahead, policy support may gradually increase along with the slowdown of economic growth.
3. Increased consumer and industrial spending may continue in the medium to long term. Although the growth of China’s economy is decelerating, the share of the tertiary sector (primarily service and consumer industries) in the economy has exceeded 50% and should continue to increase. Consumer and service industries are still important areas to look for medium- and long-term opportunities.
Taking into account the above factors along with earnings, valuations, and policies and reforms, our sector allocation recommendations for the next three to six months are as follows.
Buy the industry leaders on dips, especially those who benefit from increases in consumer and industrial spending. Although the earnings of consumption-related sectors may still face downward pressure, their valuations have declined significantly and there may be opportunities for bargain hunting. We would now pick quality names from pharmaceutical, home appliance, light industry, and restaurant and tourism sectors and wait for better entry points for other broad consumer sectors such as food and beverage, autos and auto parts, and TMT.
We believe investors should monitor some cyclical sectors with low valuations and bearish expectations that have experienced long declines and that may pick up thanks to policy changes or other factors. These include alternative energy, electrical equipment, defense, securities, and insurance. Macro policies may ease further and real estate policy may be adjusted. The impact on related sectors merits attention.
We recommend being underweight on sectors that would be affected by an economic slowdown and whose valuation risks have not fully dissipated, such as raw material sectors supported by supply-side reforms and export-related cyclical sectors such as ports and shipping.
We advise investors to pay attention to six thematic portfolios:
1) Stocks with high dividend yield.
2) High-quality industry frontrunners.
3) Stocks related to 5G and the development of China’s domestic technologies and industries.
4) Listed companies planning to undertake share buybacks.
5) High-quality SME growth plays
6) Stocks poised to gain from reforms to state-owned enterprises.
For more information, please refer to our report 2019 A-share Outlook: Recovery Likely After Deterioration published in November 2018.