Remaining bullish on China

We were bullish on China all last year and through to May of this year, but became cautious as the rally progressed, and cut our exposure closer to neutral late in the second quarter. Little had come from the promising reforms outlined in the Third Party Plenum in late 2013. The economy continued to grow but only due to increasing levels of debt. And furthermore, the government’s plan to recapitalise the banks and state-owned enterprises – by issuing shares to foreigners who would be driven into the A-share market after its inclusion in the MSCI Emerging Markets Index – seemed to have stalled.

The robustness of the vendor-financing scheme called ‘One Belt One Road’, intended to create new outlets for China’s old industries like steel and aluminium to countries across Eurasia, the Middle East, Africa and south-east Asia, had come under question. China’s targeted transition to a market economy is still possible, but with every passing quarter this becomes more difficult to achieve as debt levels and industrial overcapacity increase. It is concerning that the recent volatility in Chinese equities, which provided an early test of the government’s resolve to liberalise markets, spurred an official intervention preventing the market from determining reasonable valuations. Such action, though understandable and not unprecedented, looks misguided and casts doubt on China’s ability to embed reforms.

Diverging perspectives

From a top-down view, therefore, China looks very risky. And yet, from a bottom-up perspective, we are finding compelling stocks to own. And not all of the top-down conditions are bad. Financial deregulation, to name one important reform, continues apace, with important reforms to local government financing and the market is being allowed to play a greater role in setting both lending and (very recently) deposit rates. China’s new exchange-rate policy, in which the value of the renminbi will be fixed each day based on the previous closing spot rate, is a significant step towards liberalising the currency. It is a necessary move, too, as a rigid dollar peg is not a long-term solution for the world’s second-largest economy.

From a bottom-up perspective even if the market is overvalued – and this point, we believe, is arguable – there are individual companies with good long-term growth prospects that remain undervalued. The dispersion of valuations between the Hang Seng China Enterprises Index (Hong Kong-listed mainland companies, mainly state-owned), the ChiNext (small-cap, early stage, fast-growth companies), the Shenzhen Stock Exchange (more mature, but mainly ‘new economy’ stocks) and the Shanghai Stock Exchange Composite Index (a combination of SOEs and private companies) is enormous, from 15x to 70x. In addition, the sheer size of the Shanghai market, with more than 1100 companies, along with the Shenzhen bourse and its 1,700 names, gives plenty of scope for stock picking.

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