Encouraging outlook for China’s equity market

China’s equity market was one of the biggest losers during the global equity sell-off in early 2018 as investors became increasingly worried with the country’s deleveraging campaign, as expectations of an  interest-rate hike by the US Federal Reserve increased.

Chinese equities tanked in March due to the intensified concerns over the US-China trade war tensions. Despite that, Chinese equities, as represented by the HSML 100 Index, emerged as the top three performing markets under our coverage as of May 24, 2018.

While everyone is worried and expects a moderation in China’s economic activity in 2018, it’s gross domestic product (GDP) growth figures came in strongly at 6.8% year-on-year (YoY) in the first quarter (1Q), above market expectation for a 6.7% YoY expansion.

The GDP growth figure in 1Q was mainly driven by the robust consumer demand which accounts for almost 80% of the economic growth in 1Q, offsetting the YoY decline in exports.

We believe economic growth in the world’s second-largest economy is likely to moderate in the quarters ahead, given that government officials reaffirmed their stance to reduce risks in the financial system, as well as bring in initiatives to resume its combat against pollution.

The moderation in China’s economic activities in the quarters ahead is not expected to create any material disruptions to growth as the country is focusing on quality of growth.

The inclusion of China A-shares into the MSCI Emerging Market Index last year is fuelling buying interest from global investors.

Bloomberg data shows foreign funds are piling into Chinese stocks conspicuously ahead of the MSCI entry. The average daily buying into mainland stocks via the exchange links in March and April this year were the highest over the past one year period, reversing a net outflow in February.

The initial MSCI inclusion will be completed in a twostage process — on June 1 and Sept 3. The magnitude of the fresh inflows is likely to be small relative to the daily turnover of the equity market. In the future, global fund managers are expecting a full China inclusion by MSCI which could potentially provide the Chinese A-shares an 18% weighting in the index.

The full inclusion process is expected to happen over several years and could amount to more than US$300 billion to US$400 billion (RM1.59 trillion) of foreign inflows into the Chinese A-shares (close to US$1.8 trillion in market cap).

Despite delivering remarkable returns in 2017 and satisfying return so far in 2018, valuation of Chinese equities remains attractive due to prospects of robust earnings growth and valuation expansion.

The Chinese equity market as represented by the HSML 100 was expected to post earnings growth of 17.9% and 12.9%, which would translate into price-earnings (PE) ratio of 9.8 times and 8.7 times for 2018 and 2019 respectively.

The equity market is currently trading at a substantial discount to its fair PE of 13 times, and is expected to deliver a potential annualised return of about 26% over the next two years.

Hence, investors may use any pullbacks as an opportunity to add Chinese equities to positions during volatile periods, to tap into its long-term growth prospects.