As forecast earlier in the year, China’s economic growth seems to be stabilising due to better macroeconomic management. The gross domestic product (GDP) growth in Q1 and Q2 was 7.4% and 7.5% year-on-year, respectively. The central government remains confident that annual GDP growth will stabilise at 7.5% for 2014, with the expectation that Q3 growth will exceed 7.5% since it is a critical quarter for economic activities. To achieve that objective, the monetary policy must remain accommodative and fiscal spending must stay robust.
We believe the following three themes will also have a significant impact on China’s short to medium term growth:
Realisation of the Shanghai-Hong Kong connectivity
The Shanghai–Hong Kong stock connectivity scheme was initially announced on 10 April and the official launch is expected to happen in October this year. The scheme allows investors mutual access to the Hong Kong and Shanghai stock exchanges subject to a quota restriction, although we believe this quota will be increased overtime. We expect fund flows will flourish for both markets as a result benefiting stock exchanges and brokers on both sides. Companies with unique market positioning that are listed on only one exchange currently, such as Tencent and Kweichow Moutai, will surely attract investors on the other side.
Continued progress in SOE reforms
State-Owned Enterprises (SOEs) in China contributed significantly to the country’s investment-driven economic growth in the past three decades. At the same time, such economic structure has also led to issues such as misallocation of limited financial capital, excessive management focus on scale instead of return on asset, and insufficient incentive to innovate. As growth momentum slows, these embedded problems are becoming more evident. We believe the SOEs with improved operating efficiency can help offset some of the short-term negative impact and contribute to China’s economic growth. More importantly, over the long term, these reforms should invigorate private sector investment and help revitalise the economy by creating a fairer business environment.
Year to date, SOEs that made positive progress in restructuring, such as Sinopec, Datang Power and Sinotrans Limited, have outperformed the overall market. As more SOEs go through various phases of restructuring, we expect to see further divergence in performance across sectors and stocks. Although it is difficult to quantify the net impact of SOE reforms, we expect any marginal improvement to surprise on the upside since investors are generally sceptical about the potential benefits.
Cost savings from anti-corruption measures
The anti-corruption campaign thus far has hurt discretionary spending, especially high-end goods and catering services. Fortunately mass market consumption, supported by stable employment conditions and wage increases, has helped partially offset the negative impact. Therefore, the anti-corruption measures will likely improve investor returns in the medium term as SOEs reduce cost and improve efficiency through the process
We believe the following companies are poised to benefit from these themes:
- Sinopec is looking to sell 30% of its marketing division to private investors by the end of Q3. Perceived as a pioneer SOE reformer, this asset sale will serve as a showcase for mixed ownership programmes. We expect the company to make material progress on this front in Q3 and Q4, and the current stock price does not seem to fully reflect the upside potential.
- Hong Kong Exchange is a major beneficiary of cross border trading. The much anticipated mutual connectivity between Hong Kong and Shanghai exchanges will likely result in increased trading activity in the Hong Kong market if the quotas are expanded. If the connectivity proves successful, we expect to see a significant boost in the company’s earnings for 2015 and 2016.
- Baidu seems well positioned to profit from the trend of Chinese users increasingly relying on their mobile devices for internet searches. The mobile division’s share of total revenue continues to rise, helping to drive robust top-line growth. We expect the company’s profit margin to bottom out this year after spending heavily on sales and marketing. The stock valuation is cheaper than peers such as Tencent.
Looking ahead
We believe the short-term bias toward accommodative monetary and credit conditions along with continued government spending on infrastructure — especially railways and public housing — will help support the growth outlook for this year. On the backdrop of a stabilising macro environment and positive reform momentum, we believe Chinese equities are positioned for a rebound in the remainder of the year because they are undervalued on various metrics.
Opinion column by Caroline Maurer, Fund Manager, Henderson Horizon China Fund
Note: References to individual companies or stocks should not be construed as a recommendation to buy or sell the same
