Key points:
·
After falling 20% from the start of the year to a low in Feb, China (MSCI China) has rebounded 8% in the past 4 trading days, paring its ytd loss to 13% (MXAPJ: -8%). We
think the relief/tactical rally may extend, underpinned by a near-term stabilization of key macro factors (China growth, the Rmb, and oil), and an improving risk/reward profile in the equity market given the extent to which risks are being priced.
·
While the tactical case has improved, we believe turning strategically positive on China is premature due to various structural and liquidity headwinds, and policy
constraints. We stay Market-weight on China in a regional context.
·
As such, we advocate a targeted implementation strategy to trade the recovery rally. Ideas include: (1) Most-shorted stocks with reasonable fundamentals; (2) select
ADRs for strategic growth, valuation, and positioning/catalyst reasons; and, (3) options strategies in an uncertain and low-conviction world.
Macro: A near-term stabilization of key macro factors
·
China growth: Reported January macro data have been mixed so far - the trade numbers came
in below expectations, PMIs showed conflicting signals, but the monetary data (new loans, TSF) surprised strongly on the upside. Our read is that underlying demand may still be weak (imports down 19% yoy) now but green shoots are emerging: new loans growth
may slow in Feb due to seasonal normalization but the recent surge, including a significant rise in mid/long-term loans (63% yoy, 25% 3ma yoy), potentially points to continued growth or even acceleration in infrastructure investment and a resilient real estate
market (mortgage loans), notably in higher-tier cities where inventory months have dropped to about 11 months from the peak of 18 months in Oct 2014.
·
The RMB: The topic of Rmb continues to feature prominently in our recent client interactions.
The strengthening of the CNY since Feb (although still down 0.4% vs. the USD ytd) and the narrowing gaps between CNY and CNH have certainly helped sentiment. Bearish positions on CNH, proxied by the CNH open interest on HKEx, have dropped possibly due to concerns
about PBoC’s intervention and a tighter CNH liquidity pool, and the concerns are being reinforced by the recent interview by Governor Zhou, which carried a hawkish tone against sharp devaluation. The CNH volatility profile has been reset, implying a spike
is unlikely in the short term if the central bank is committed to upholding its credibility. On top of these factors, we expect the Fed to stay on hold in its March meeting, which may alleviate downward pressures on the CNY in the near term.
·
Oil prices: Our commodity strategists expect oil prices to remain volatile and oscillate between
$20/bbl and $40/bbl in the near term. They believe the market would not be surprised by spikes to the downside even into the teens as a trendless oil market with significant volatility is now a consensus view with the market positioned as such (particularly
given that realized oil volatility has surged to 100%). This suggests that most of the negative impacts from declining oil prices are likely behind us at this point. Fundamentally, our economists estimate that every US$10/bbl fall of oil prices could lift
China's GDP by 0.1% as China is a net importer of oil, oil demand (volume) is still rising at 6% pace yoy, and falling oil prices should bode well for the trade balance. Direct impact on equities should be manageable as oil/gas companies now represent 3.4%
and 6% of the market's earnings and market cap, although second-order impacts are more dynamic and harder to gauge.
Markets: An improving risk/reward profile
·
Context: At the low end of a 'fat' trading range. We have been flagging this trading pattern
for quite some time and we still think it helps to frame the potential risk/reward tradeoff in a historical context. In short, HSCEI has dropped 40% since 2010 (MXCN: -22%), but has been operating in a big trading range with 14 noticeable/tradable up and down
moves (7 each) during the past 5 years, averaging around 30% in magnitude and 4 months in duration. While technical indicators show that the market is no longer oversold (RSI at 49), cap-weighted valuations are still at the low end of the ranges (more on this
below), and the latest snapback is only 30% of the average historical rallies by magnitude.
·
Earnings have come down but are not collapsing. Earnings downgrades have shown no signs of
abating (17% in past 12 months), driven by the soft underlying activity growth, 40% down in oil prices in the past year, and partly due to the intensifying CNY depreciation expectations (offshore equities are quoted in HKD or USD). However, stripping out the
oil and FX factors, 2016 Rmb-dominated earnings have dropped merely 1% ytd.
·
Valuations are inexpensive: 2 weeks ago, we examined what is being discounted in equity valuations
using different valuation approaches. We still stand by our view that a great deal of macro and sector-specific risk is already being reflected in equity valuations, and select long-term value is emerging if global recession/China hard-landing is not one's
base case. Exhibit 6 compares current market valuations vs. the troughs in 2008 and 2011 on a number of popular valuation metrics. Specifically, on a median stock basis (to address the fact that large-cap banks are trading at low headline valuations given
the embedded NPL risks), MSCI and HSCEI constituents' forward P/E and trailing P/B are close to or even below the stressed levels during the EU sovereign crisis and GFC.
·
Positioning appears light and sentiment stays cautious. Mutual fund positioning data shows
that global, GEM, and Asia funds are Underweight HK/China by 149bps, 206bps, and 318bps relative to their respective benchmarks (cum ADRs); HK/China focused funds have seen US$23bn of net redemption ytd (based on EPFR survey which is only a small subset of
the full universe); short interest is still close to all-time highs; and the 8% rebound appears triggered more by short-covering than real money buying given how the most-shorted stocks in HK have traded.
Upcoming events/catalysts: Neutral to slightly positive
1.
G20 Finance Ministers and Central Bank Governors meeting will be held on Feb 26 and 27 where
we may get statements about closer collaboration among global central banks;
2.
Details on the 13th Five-Year Plan will be unveiled in the upcoming National People's Congress (NPC) meeting in early March, and local government budgets will
be approved at the same time;
3.
Jan-Feb combined activity data (IP, FAI, retail sales) will not be reported until early March
and we think any potentially forceful policy responses (to slowing growth) are more likely to be rolled out after this;
4.
The Fed meeting will be on March 15-16 where our economists expect the Fed to stay pat. Also
in March, our economists expect further monetary easing to be announced in the ECB meeting although they think the hurdle to additional easing by the BoJ could be high;
5.
At the market level, FY15 earnings season will kick off in early March for H shares and we expect an in-line result given lower consensus expectations and a relatively
healthy 1Q-3Q earnings run-rate of 79% vs. full-year consensus;
6.
On May 31, MSCI will implement the second batch of inclusion for 14 ADRs, which may usher in meaningful passive and active allocations to these names.
Implementation ideas
The abovementioned arguments suggest that some of the necessary conditions for a recovery trade are in place and the risk/reward of going tactically long (or paring shorts) looks sensible. But given
the fluidity of global macro factors along the axes of global growth, central banks' policy, oil, and the Rmb, we believe investors need to be specific when expressing this short-term view. We like the following ideas.
·
Heavily shorted stocks with reasonable fundamentals: We screen for a list of HK- and US-listed,
Buy-rated stocks with the highest short-interest to market cap/turnover ratios in Exhibit 8 for potentially more short-covering-driven upside.
·
'New China': ADRs: We think the theme of 'New China', which consists of mainly technology,
healthcare, and select consumer companies, remains the most exciting, and strategically compelling, story in the Chinese stock markets. Particularly, we favor Chinese ADRs because: a) they (proxied by the MXOCN index) have corrected in similar magnitude as
the 'Old China'-dominated HSCEI index (both -15% ytd) which faces various structural challenges; b) valuations have retreated: 24.8x P/E (-0.5.s.d), PEG at 0.7X (HSCEI also at 0.7X); c) the May inclusion is a visible catalyst, and the current price setup is
reminiscent of the 3Q pullback and 4Q recovery ahead of the first-tranche inclusion in Dec 2015; d) our positioning analysis shows that GEM funds are currently underweight China tech sector by 100bps relative to the benchmark, and will be underweight by over
300bps when the May inclusion kicks in; and, e) the recent resurgence of ADR privatization deals should provide a fertile hunting ground for event-driven investors and is arguably sentiment-boosting for the rest of the universe.
·
Options: China ADR call-spreads, HSCEI short-dated calls: We believe buying optionality via
outright calls or call-spreads makes sense given their asymmetric exposure (limited downside risk) against a backdrop where macro/policy uncertainty is high, investors' conviction level is low, and sentiment shifts could be rapid. We highlight 2 ideas: 1)
We like call-spreads on our China ADR basket (GSCBADR4) which contains 14 China ADRs which were included in MSCI in last December. We recommend 4-month (June expiry to capture the ADR catalyst in May) 110-125% call-spreads on GSCBADR4 for indicatively
3.4% premium which offers a max payout of 4.4X; 2) For HSCEI, we prefer buying short-dated outright calls. While short-dated implied vol on HSCEI has risen meaningfully with 1-mo ATM implied vol trading at 36v (vs. 22v at the start of the year), it’s
still trading below realized vol and short-dated call-wing skew doesn’t offer any meaningful cost savings. HSCEI 1-month expiry 8500 strike calls indicatively cost 2.2%. The structure breaks even at 6.2% from current levels and could offer potential returns
of 330% on premium invested if HSCEI reverts to its ytd highs.
Option Risks: Buyers of 8500 strike calls risk losing entire premium if HSCEI stays below 8500 by expiry while buyers of 110-125% call-spreads on China ADRs risk capped upside if the basket rallies
more than 25% by expiry or risk losing premium if it stays below 10% by expiry.
Strategic case unchanged; Stay Market-weight
The tactical case has improved, but we believe turning strategically positive on China is premature. Key reasons are:
·
China is still going through a ‘bumpy growth deceleration’ process which keeps corporate earnings under pressure, especially for stocks in the 'Old China' space.
Our EPS growth of 2% and 7% for 16E/17E for MSCI China is in line with/ 5pp below I/B/E/S consensus;
·
Our base case still calls for the Rmb to moderately weaken vs. the USD by 7% by the end of this year (although only slight depreciation vs. the CFETS basket),
and the Fed to raise rates 3 times this year. As such, pressures relating to the ‘impossible trinity’ suggest that capital outflow remains a challenge and may continue to weigh on investor sentiment;
·
Structural reforms, especially those which are more consequential to equity returns (e.g.
SOE reforms, capital markets liberalization), have been progressing slowly. Macro-wise, the surge in new loans/TSF may boost cyclical growth but make macro deleveraging down the road potentially more difficult and painful;
·
We believe we are still at the early stage of the NPL cycle (our banks team forecasts NPLs potentially reaching 9%) and it may take 5-6 years for banks to absorb
potential losses, thereby constraining strategic upside for Chinese banks, which account for 43% of the HSCEI index cap;
·
China A has performed better than most expected since returning from the Chinese New Year holidays (+3.8%, but still down 18% ytd) but we think concerns about leverage
and liquidity risks, notably the stock collateralized loans (Rmb1.1tn loans, 4% facing margin call risk, assuming LTV ratio at 35%), could resurface when market momentum moderates.
All in all, we stay Market-weight on Chinese equities, and reiterate our end-16 target of 58.5 for MSCI China, implying 13% potential upside from current levels.
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