China: What to Expect in the Year of the Dog

China has finished the Year of the Rooster on a strong note. The Hang Seng China Enterprise Index (HSCEI) was one of the best performing markets in the world in January up over 15%. The Hang Seng Index also performed strongly up 10%. While the global market volatility in early February did claw back some of these returns, the HSCEI is still up 5% in 2018, outperforming the ASX 200 by approximately 8%. But can this strong performance continue? Below Ellerston Asian Investments outlines what to expect from China in the Year of the Dog. Gong Xi Fa Cai!

Strong Macro Outlook & Attractive Valuations

China’s GDP growth continues at an impressive pace, rising 6.8% in the last quarter of 2017. All the fearmongering about a hard landing in China has clearly been wrong. Similarly, the Chinese renminbi (RMB) is at 6.3 to the US dollar, having appreciated approximately 8% in the last year. Again, China doomsdayers like George Soros, Kyle Bass and Crispin Odey, who shorted the Chinese currency in 2017 hoping to benefit from its demise, have been spectacularly incorrect. Supply side reforms are working and the government’s efforts to decelerating the growth of leverage are also bearing fruit.

This strong macro outlook is not yet reflected in valuations. The Hang Seng China Enterprise Index is trading at an inexpensive PE of only 8x with expected EPS growth of 22% this year. The ASX 200 by contrast, is trading at 16x PE with expected EPS growth of less than 7%. The HSCEI PEG ratio (PE divided by growth) is 0.4x versus the Australian market at 2.3x, so the Australian market is almost 7x more expensive than China on a growth adjusted basis.

In terms of Price to Book valuations, despite the rally in January, the HSCEI is still trading below book value (0.9x) with an ROE of 12%. The ASX 200 also has an ROE of 12% but is trading at more than double the Price to Book multiple (1.9x). This valuation gap between China and Australia and other developed markets will close over time.

Catalysts: A Share Inclusion and Southbound Flows

China is not one homogeneous equity market but consists of three very different markets: (1) A shares, Chinese companies that trade in Shanghai or Shenzhen; (2) H shares, Chinese companies that trade in Hong Kong; and (3) ADRs, Chinese stocks that trade in the US. Each of these markets has different drivers in the Year of the Dog.

In June of this year, Chinese A shares will be included in MSCI Indices for the first time. This is a major step forward for domestic capital markets in China. We have identified six A share stocks that are going to be foreign favourites upon A share inclusion: Moutai, Midea, Qingdao Haier, Wuliangye, Hikvision and Yili. We currently own four of these six stocks and aim to increase exposure prior to June.  

Performance of H shares is increasingly a function of Southbound flows. Southbound refers to funds flow from the mainland into Hong Kong via the Stock Connect Program. We expect Southbound strength to continue this year and like Hong Kong Exchange as a stock that benefits from increased activity via Stock Connect.

Chinese ADRs are primarily in the technology sector and these stocks sold off in late November and early February in line with the NASDAQ and FAANG stocks. Chinese ADRs are now very attractively priced. Alibaba is one of our top China ADR positions and we also hold Baidu and JD. 

Risks in the Year of the Dog

We see two mains risks in the China this year. The first is that a trade war breaks out between the US and China. The US has already imposed higher tariffs on washing machines and solar products. These products are not material to the Chinese economy but the policy does send the signal that the US is unhappy with the WTO framework and increasingly wants to take matters into its own hands. We are watching the NAFTA renegotiations closely.

Secondly, there is key man risk in President Xi. Following the 19th Party Congress last year, Xi cemented his control over the Party apparatus and took the unprecedented step of not appointing a potential successor to the Standing Committee. It is often the case that the more concentrated the political power, the higher the risk of policy error. There are two important political meetings in China in March, and we are watching closely for any change of key policy personnel.

Conclusion

Ellerston Asian Investments (EAI) remains positive on the outlook for the China’s economy and markets in the coming year. Approximately 48% of the fund is invested in Hong Kong/China and six of our Top 10 positions are Chinese companies (Tencent, Alibaba, China Construction Bank, ICBC, China Life and Ping An). We look forward to an exciting and profitable Year of the Dog.

About Ellerston Asian Investments (ASX:EAI)

Ellerston Asian Investments (ASX:EAI) is a concentrated large cap portfolio based on high conviction best ideas which is benchmark independent. Providing investors access to high growth opportunities throughout Asia via a highly experienced and specialised team.