As COVID-19 cases continue to accelerate in Europe and North America and the economies go into lockdown, China is benefitting from being first-in and first-out, with its economy now restarting. Pollution emissions data from China’s top 5 cities, amongst other data, shows a recovery beginning.
Additionally, China's ongoing policy flexibility and relatively closed economy and stock-market provide some protection to the coming global recession. The worse-than-expected -13.5% yoy fall in China’ January-February industrial production and -20.5% in retail sales is both a harsh reminder of the immediate economic impact, but also what is to come internationally.
We expect this local economic recovery, and defensiveness to the coming global recession, to continue to drive Chinese equity outperformance. The country is attractively placed on our country allocation framework, and we highlight three ways to gain exposure for US investors: the largest China ETFs, top 10 China ADRs, and especially US stocks with large China revenue exposure, which have significantly lagged both US and China equity indices.
It remains key to watch the trajectory of China's economic restart, ideally via independent emissions and traffic data, and that local infection rates do not resume alongside this as controls are loosened. Also, further policy actions by the Chinese authorities will likely be required to maintain recovery momentum as developed market economies fall into recession as they face accelerating COVID cases.
Valuations: Chinese equities - MSCI China (MCHI) - trade at a 30% P/E valuation discount to global equities, at 8.8x vs 11.8x. Whilst, China EPS growth expectations, near 3 months after the COVID-19 start, are still +9.1% for 2020e, potentially showing some resilience, after having fallen 4% so far this year. This may still be too high, but likely incorporates more of the local economic impact than, say, US conditions do in US earnings, at this stage.
Tech: The Chinese tech sector has grown dramatically, from a 6% market weight to 24% over the last 20 years. The tech sector has outperformed this correction globally, for first time in 30 years, as business models have changed, with software and internet now dominating: asset light with low leverage, high growth and margins.
Energy: As importantly, Energy is only a small Chinese equity component. Energy is now a similar proportion of market cap as in the US, at 4%, and this is down from 31% in 2005. Additionally, at the macro-economic level, China is the world’s biggest net oil importer, making it a significant beneficiary from the c60% oil price fall year-to-date. Again, this stands in contrast to the world's largest oil producer, the US.
Closed: With the developed world likely to enter an economic recession, with the only question one of how deep and how long, it bears remembering that China is relatively closed. Exports plus Imports as a percentage of China GDP is only 40% (half the level of Korea or Germany), whilst the stock market is amongst the most closed in the world, with overseas revenues representing under 15% of total index revenues. This compares to over 30% in the US, and over 50% in Europe.
Policy: We believe that China’s high 45% savings rate gives the country policy flexibility many other countries do not have. These savings are intermediated through State owned banks, and largely trapped behind capital controls, whilst China's sky-high corporate debt levels are largely in local currency. These high savings rates could also support the equity market, given limited other investment alternatives such as housing (property turnover consistent with limited house price inflation), overseas (capital controls) or bonds (real yields now heavily negative).
China responded to the COVID-19 outbreak with a three-pronged strategy of lockdown, forced quarantine, and selective economic stimulus - combined with some stock market support. It has been a success, so far, with new cases plateauing according to the WHO, and the economy slowly restarting.
We believe the China economic framework has above-average policy flexibility, with a high savings rate, state-owned banks, capital controls, and still positive policy rates. These will continue to be deployed as the economy restarts, and the inevitable global economic slowdown picks up. Latest policy measures have included an RRR cut, additional funding liquidity, and NDRC National Development and Reform Commission (NDRC) consumer support plan.
Beijing’s direct stock market intervention during February’s Chinese market sell-off could also repeated, where the so called ‘national team' of state backed buyers helped dampen local losses. Then the regulator limited short selling, whilst urging mutual funds not to sell shares unless they faced investor redemptions. They also allowed some insurers to surpass the 30% cap on equity investments, turning to well capitalised and long-term mandated insurers to help stabilise the market.
Chinese equities are well-placed on our allocation ‘eye’, in the attractive top-right ‘momentum’ quadrant. This means they are relatively in-favor with investors (measuring relative fund flows, sell-side ratings, and valuation vs history) but seeing positive relative fundamental trends (relative EPS revisions, leverage to easing business cycle, and price momentum). The market is also attractively valued on a composite P/E, P/BV, and P/CF measure versus other global markets.
The 10 largest China ETFs for those wanting broad equity exposure to China’s discounted equity market, with still positive earnings growth. The largest of these is the iShares MSCI China ETF (MCHI). Most offer broad exposure and two a specialist Tech/Internet focus.
The top 10 China ADRs, dominated by internet stocks such as Alibaba (BABA). These have lagged broader Chinese equities, potentially dragged down by their US listings, but also by fundamental concerns around a fall in Chinese consumer spending and payments activity, and still premium valuation levels. The S&P/BNY Mellon China Select ADR Index is down 28% YTD compared to the S&P500 -33%.
We believe these fears are likely now overdone, with the Chinese economy beginning to recover, and these stocks overwhelmingly domestic focused (90%+ of revenue). However, valuations remain at a premium, with Alibaba (BABA) on 22x forward P/E, JD.com (JD) 46x, and Baidu (BIDU) 20x, compared to the US IT sector forward P/E of 19x.
US stocks with significant China revenues seem especially attractive. Our screen of US stocks with the largest China revenue exposures has been especially impacted, with the largest names, not only underperforming Chinese equities, but also in many cases US equities. QUALCOMM (QCOM) is down 32% year to date, Qorvo (QRVO) -42%, IPG Photonics (IPGP) -26%, and Broadcom (AVGO) -44%.
We believe this is a particular opportunity. This basket trades on similar valuations as US technology, at 19x 2020e P/E, despite a third of median revenues coming from China where the growth outlook is recovering, and Chinese technology stocks trade at premium valuations to the US sector. The US companies have also been very quick to reduce there calendar Q1 revenue outlook on COVID uncertainty, unlike the vast majority of the S&P500. They should similarly benefit as China revenue and supply chain issues subside. QUALCOMM cut calendar Q1 revenue outlook to US$4.9-5.7bn (midpoint above analysts forecast of 6% revenue growth), Qorvo cut mid-point revenue guidance by 6%, and IPG Photonics by 16%.
We believe China's position as first-in and first-out of the COVID crisis, along with a restarting economy, further macro-policy flexibility, and cheap equity valuations and good index composition, combine to make Chinese equities the global safer-haven. China market ETFs offer broad market exposure, whilst US-listed China ADRs and China-focused US large caps have both lagged the recent resilience of Chinese equities, given the sell-off in US markets, and offer greater specific opportunity. It remains key to watch the trajectory of China's economic restart, ideally via independent emissions and traffic data. Also, further policy actions by the Chinese authorities to maintain the recovery momentum as developed market economies fall into recession as they deal with accelerating COVID cases.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.