Despite coronavirus, why did China A shares outperform relative to peers?

Despite coronavirus, why did China A shares outperform relative to peers?
Amid the current market turmoil, Chinese onshore equities have managed to outperform. Chris Liu analyzes the fiscal, monetary and structural reasons behind and shares his outlook.

Despite being affected by the coronavirus contagion, the China A-share market was the only major equity market that posted a positive return over the past month (up 2% as of March 11)1. In this Q&A, senior portfolio manager Chris Liu analyzes the market’s performance and trends.

Q1) What do you think are the reasons behind the China A-share market's outperformance over the past few weeks?

China’s economic data in 3Q and 4Q 2019 were quite weak. The market expected that the government would loosen monetary and fiscal policies in 2020 in order to reach its economic target for 2020s of doubling GDP in the last 10 years. That‘s why we saw a pretty strong A share market in Jan before Lunar New Year.

And then the outbreak hit China. The market was down by 8%2 the first trading day after Lunar New Year, but rebounded on expectations of rate cuts and other monetary easing measures. The government later announced cuts in Medium-term Lending Facility (MLF) and Loan Prime Rate (LPR) on Feb. 17 and Feb. 20 respectively, setting the tone of loosening liquidity for 2020.

Looking back at the history of A share market, liquidity is the key factor that determines the market’s direction, at least in the short term. Expectations of abundant liquidity created by loosening monetary policy will certainly boost sentiment.

Meanwhile, the strong performances of mutual funds in 2019 excited investors, we have been seeing huge new funds launching starting 4Q last year. Despite the outbreak of COVID-19, the enthusiasm on new funds launched by star managers did not seem to subside at all. Many onshore mutual funds had to close their subscription windows early as subscription amounts hit the quota quite quickly. These funds have fueled A share market liquidity.

Q2) What have you observed about the China A share market year-to-date?

Small caps have been outperforming large caps year-to-date. Looking back at the history of A share market, small caps normally outperform large caps in an environment that combines weak economic data and loosening liquidity. From 2017 to 2019, small caps underperformed due to rather tight liquidity under the deleveraging backdrop.

China’s deleveraging cycle has come to an end due to economic slowdown in 4Q 2019 and the market expected loosening monetary policy. As a result, small caps finally started to reverse the trend of underperforming large caps and we expect their outperformance to continue before we see real signs of economic growth recovery in China.

Regarding valuations, the benchmark CSI 300’s current PE ratio is 12.18x3 (as of March 11), still well below the historical average, and not expensive if compared with other overseas markets. I believe there will be earnings downgrades especially for those sectors that are hit badly by the COVID-19 in 2020, but much of the earnings downgrades in 2020 are expected to be added back to 2021 earnings forecast as the pent-up demand will come back sooner or later for most sectors.

Q3) The People’s Bank of China has been easing monetary policies, how will these moves impact China’s economy and stock market?

In general, cutting LPR will help the corporates in reducing their financial burden, but the main purpose is to help SMEs go through the period of financial difficulties during the outbreak of COVID-19. Employment stabilization is the key since private companies accounts for 80%4 of employment in China.

Cutting MLF and LPR rates won’t have big direct positive impact on the economic growth, but it has big positive impact on A share market at least in the short term since it’s a liquidity and policy driven market.

In addition to rate cuts, China’s government pre-allocated a special municipal bond quota of 1.29 trillion yuan ahead of its main parliamentary meeting the National People’s Congress5, preparing enough ammunition for possible expansionary fiscal policies, which are more powerful tools to boost the economy.

Q4) Some analysis suggest that the Chinese economy could be hit in 1H 2020 and later stage a strong rebound in 2H. Do you agree with this? What is your near- and longer-term outlook for the China A share market? 

The economy was hit by both a fall in demand and supply disruption in 1Q, and this will significantly affect economy data as we’ve already seen from the poor Feb PMI data.

In 2Q we expect industrial production to recover to close to normal level at least for all provinces except Hubei. However, service industries (such as restaurants, hotels, retail, entertainment, tourism, etc.) might only see some gradual recovery as people might still be cautious, and the outbreak spreading overseas will bring pressure on the external demand. In all, the economy in 2Q could see improvement quarter-on-quarter, but still not recovering back to normal level on a year-on-year basis.  

Going into 2H, we expect the virus to be contained globally. Service industries in China should recover strongly, and pent-up demand for properties, cars, and other durable goods we expect to rebound strongly in 2H. In order for China to meet its 2020 economic goal, we expect accelerated fiscal spending on both traditional infrastructure projects (high speed rail, roads, airports, etc.) and “new infrastructure projects” (5G base stations, healthcare infrastructure, data centers, electric grid, electric-vehicle (EV) infrastructure, etc.). In all, we expect economy data in 2H to rebound strongly. 

Despite recent huge correction of overseas markets possibly rippling across to China’s A share market, we expect the near-term upward momentum to continue before the 1Q results. When heading into the 1Q earnings season, we might see some performance divergence among different sectors and the A share market in general might experience some volatilities. 

In the long term, we remain quite positive on China’s A share market because we think the impact of COVID-19 on the economy is short-lived and will not change the long term trajectory of China’s economy that is driven by innovation and consumption upgrade.

On the liquidity side, even though MSCI might now be taking a pause in including A shares into its global indices after a 20% increase in 2019, we nevertheless think the inclusion factor will go up towards 100% in the next five years. As such, foreign capital should continue to flow into the A share market. Wealth management products in the banking system are facing declining returns with a gradual fading out of implicit guarantees, and we expect a big part of these funds will flow into the A share market.

Q5) In China, 5G network technology has been generating interest for some time. What are your thoughts on the 5G network’s development and what does it mean for the China A-share market?

5G infrastructure is the most important part of the “New infrastructure” that is promoted by the Chinese government. The fast rollout of 5G base stations in China should create huge demand for telecom equipment. At the same time, it’s one of the few sectors that have not been seriously disrupted by the outbreak of COVID-19. The telecom-equipment sector outperforming the benchmark CSI 300 by a huge margin year-to-date as of March 11; the former’s returns was up 20.5% while the benchmark fell by 1.6%6.

While 5G mobile phone sales were negatively affected on both demand and supply side due to outbreak of COVID-19, we expect the supply disruption to recover in 2Q and demand for 5G mobile phones should pick up strongly in 2H. This bodes well for the performance of IT hardware sector, and we think the mobile-phone supply chain stocks in the A share market should benefit.

Q6) In which sectors do you see opportunities?

We like the upstream supply chain of the EV industry in China because:

  • Penetration rate of EVs is rising globally and this should drive expansion of production capacity of lithium ion batteries in the next 3-5 years;
  • The pace of reducing subsidies for EVs in 2020 is expected to be milder after big cuts in the past few years, which bodes well for a recovery of EV industry in China in 2020;
  • Chinese EV equipment makers provide competitive prices, shorter delivery cycles, and better services than overseas rivals; and
  • Chinese EV equipment makers spend a lot of money on R&D.

We also like the drug retail sector in China, because:

  • Drug pricing reform in the past few years has had big negative impact on drug producers, but much lesser impact on the drug retail sector;
  • Hospital reforms on the separation of drug and treatment should benefit the drug retail sector with more prescription drugs allowed to be sold in drug chain stores; and
  • The drug retail sector is fragmented in China and the consolidation potential for large players in China is huge.

Q7) Which sectors are you cautious about?

We are cautious on the media sector especially on the film producing sector. Even though we think the total size of the film market will continue to grow in China, the barriers to entry are very low: a good director with a good script can set up a film production firm on his own and could produce a blockbuster film that competes with large firms. In addition, earnings volatility is too high even for big film producers if they are unable to produce one good movie in a year.

Chris Liu is Senior Portfolio Manager at Invesco focusing on China A shares.

^1 Source: Bloomberg, as of March 11, 2020. Based on CSI 300 index.

^2 Source: Wind, as of Feb. 3, 2020. Based on CSI 300 index.

^3 Source: Wind, as of March 11, 2020.

^4 Source: “China Rebound: Why private SMEs hold the key”, HSBC Global Research, published on March 4, 2020.

^5 “Early approval of 1.29 trillion yuan local debt for 2020 completed,” China Business Network, published Nov. 12, 2019.

^6 Source: Wind, as of March 11, 2020.