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China bulls determined even as sentiment sours

When the direct trading link between stock markets in Shenzhen and Hong Kong opened this month, local dignitaries were easy to spot at the launch events. Less conspicuous were international investors ready to take advantage of what was billed as a big opportunity to buy into Chinese equities.

The link offers foreign investors greater access to shares on the Shenzhen Stock Exchange, home to some of China’s up and coming technology companies. However, flows into the newly available market reached just a fifth of their daily limit on its debut and have failed to match that since. 

Judged by the money, international interest in Chinese stocks remains anaemic. However, talk to strategists focused on the country and many think the world’s second-largest capital market could be on the brink of another bull run. 

“China is a market we still like,” says Andrew Swan, head of Asian Equities at BlackRock. “There’s incredible dispersion in this market and a lot of change, whether it is driven by regulation or reform, but also change driven by technology and within that we can find some fantastic opportunities.” 

The scepticism of international investors is understandable. It has been more than a year since Chinese stock markets were synonymous with anything other than headaches. The last big bull market in early 2015 was eye-popping in scale. The bust that followed in June 2015 was brutal, and investors whose money was trapped when about half of the shares listed in China were suspended still bear the scars.

Since then, angst about China’s currency policy has triggered two more episodes of global market turmoil and, as the year ends, worries about further depreciation of the renminbi are growing. 

Small wonder that Chinese companies listed in Hong Kong — still the broadest means of gaining exposure to the country’s equities — are trading on a soggy eight times expected earnings, compared with a ratio of 15 times for the broader MSCI Asia-Pacific.

Yet strategists at Morgan Stanley have upgraded China to “overweight” for the first time in 18 months, looking for a rally led by renewed earnings growth. Others are focused on a potential misunderstanding by western investors of changes unfolding in China. Jason Sun, chief China strategist at Citi, describes his view as “non-consensus positive” and argues there are three main sources of confusion. 

“The first is we think clients are overly concerned about the financial systemic risk for the whole banking system, the second is that we think clients are overly concerned about the property tightening-related downside risk next year,” Mr Sun says. “And, thirdly, we think clients underestimate the China reform process.” 

The country’s debt pile is a particularly long-running concern for China watchers. Overall debt has risen to more than 250 per cent of gross domestic product from about 150 per cent 10 years ago — a dizzying increase. 

However, bulls argue this may be peaking, and in key areas, beginning to ease. 

“We acknowledge that the overall gearing level is high, [but] we do not believe there is an imminent risk of a short-term crisis,” says Mike Shiao, Invesco’s chief investment officer for Asia ex-Japan, who points to the locally funded nature of most Chinese debt as well as banks’ efforts to diversify from corporate lending into lower-risk household loans. 

Mr Sun, who recommends investors go overweight on banks and insurers, thinks the peak of corporate lending has already passed with the increase of debt in troubled sectors such as steel and coal slipping below economic growth rates. 

“There is too much risk priced in,” he says. “What we think the consensus may miss about China is that this data are just too lagging [and] they’re not able to capture very recent credit controls.” 

One of the biggest risks for China, however, may be outside its control — namely the course Donald Trump takes once he assumes the US presidency next month. The president-elect has threatened to label China a currency manipulator and impose 45 per cent tariffs on the country’s imports. 

Analysts acknowledge the danger — which could lop more than a percentage point off Chinese growth by some estimates — but think the likelihood of Mr Trump making good on his threats is slim since it would hit the US too. Prices of everyday items would rise and potentially, the costs of high-value US exports such as aircraft if China retaliated. 

“One, you’ll hurt American companies, and second you’ll hurt US consumers,” says Francis Cheung, head of China and HK strategy for CLSA, who believes the US might instead target certain sectors, with steel, aluminium, cars and solar-related products among the most likely candidates. 

“Maybe [Mr Trump’s]’s angle is to try and get better access for US companies,” he said. “That’s the only way any of this makes sense.” 

This year the Shanghai Composite and its Shenzhen counterpart are down 12 per cent and 15 per cent respectively in local currency terms. Crucially, neither has broken below its average valuation of the past five years, according to Morgan Stanley, implying sentiment has not been so thoroughly crushed as it was in the four-year bear market that ran until 2014. 

“Overall, we expect a more extended and subdued A-share bull market period than last time,” says Jonathan Garner, chief Asia and emerging markets equity strategist for Morgan Stanley. “Lessons have been learnt by the regulator in relation to margin trading and futures trading and policing IPO activity.” 

China bulls will be counting on it.

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