Regular readers of The Switzer Report will know that Hong Kong listed Chinese equities (“H-Shares”) have been our most significant single bet in terms of geographic positioning for the past 12-months and that H-shares currently comprise around 45% of the AIM Global High Conviction Fund. Given we have just returned from a week in Beijing, it’s timely to recap some high-level thoughts on the state of the Chinese economy and equities markets.
During our visit to China, we met with 20+ corporates, macro advisers, and Chinese government officials. It would be hard to describe the mood in Beijing as anything other than buoyant. The Chinese economy is enjoying its best period of growth in six years.
One measure that does a decent job of tracking the state of the Chinese economy is the Li Keqiang index. Named after Chinese Premier Li, this index tracks the year-on-year change in bank lending, rail freight, and electricity consumption. This simple dataset is much easier to assess in real time, and therefore less prone to “manipulation” than official Chinese GDP data. In the chart below we have plotted China’s official GDP growth (in Red) versus the Li Keqiang Index (in Blue). While official GDP data has shown steady growth of 7-8% pa over the six years, the Li Keqiang index tells a different story. It shows a distinct cycle of very poor growth in 2014/2015 followed by a very healthy expansion over the past 18 months. While many expect this growth to moderate next year, we believe the economic environment will continue to be positive, particularly given the likely strength of the export sector adding another leg to China’s growth story.
Source: Bloomberg
The Li Keqiang Index (above) also supports the trend in Chinese Industrial profits – a fall in aggregate profits in 2014/2015 followed by a sharp rebound in 2016 and 2017. We have plotted the year-on-year change in industrial profits (the bars in the chart below) against the H-Share Index of Chinese corporates listed in Hong Kong (the black line). This shows that the H-share market enjoyed an enormous rally in early 2015, built on hype around stock market reform, at the exact time that Industrial profits were falling off a cliff. A very poor foundation for a share rally! The market sell-off that ensued and the turnaround in the economy in early 2016, set the foundations for the stellar rally that H-shares have enjoyed over the past 18 months (+46% from the lows). As depicted in the chart below, this rally has a much sturdier footing than the 2015 exuberance.
Source: Bloomberg
We also continue to think that money flowing out of mainland China into H-shares, known as “Southbound flow”, is a significant catalyst that can drive valuations higher in Hong Kong. The prevailing foreign exchange controls make it difficult for residents of mainland China to diversify their investments overseas. As a result, mainland residents currently allocate less than 1% of their total assets to overseas investments. The introduction of the stock connect program has significantly increased access to the Hong Kong market for mainland investors. In the past 18 months, an average of almost RMB1.0 billion of net southbound capital has flowed into the Hong Kong stock market daily. This has accounted for about 8% of the turnover on the Hong Kong stock market – it’s little surprise that this has helped drive the market higher. The chart below shows net Southbound flow as a percentage of total daily turnover on the Hong Kong stock market.
Source: Bloomberg
Finally, we look to the commentary of global businesses operating in China for an independent view on the economy. Last week alone, as Q3 reporting season gets underway, we have seen numerous supportive comments from a broad range of corporates, some of which we provide below:
“China continues to be a bright spot and a surprise to the upside…. primarily due to higher end-user demand for construction equipment. Our current estimate for 2017 is for the 10-ton-and-above excavator industry in China to more than double versus last year.” Brad Halverson, CFO of Caterpillar. Q3 results call 24 October 2017
“In Asia Pacific, the highly positive purchasing trends by local clientele were further confirmed. Mainland China, but also Hong Kong, Macau, Singapore, Korea, and now Taiwan, achieved strong double-digit rises…In Mainland China, it’s worth noting that momentum is spreading to all tier cities,” Jean-Marc Duplaix, CFO Kering Group (owner of luxury brands such as Gucci, Bottega Venetta and Balenciaga). Q3 results call 24 October 24
“China is a fast-growing economy. You would probably realize that China is driving the growth across the whole of Asia, not just in insurance, but all part of the economy. Let me remind you…we estimate there will be a total 225 million middle-class customers [in China] by 2030. This is equal to the total population of the world’s fifth largest country today.” Garth Jones CFO AIA Group. 20 October 2017
We continue to believe that Chinese equities are cheap and our rigorous bottom-up research continues to identify plenty of interesting investment opportunities in predominantly consumer-facing sectors, such as tourism, diversified financial services, technology and healthcare.
What’s good for China is good for Australia and it is no coincidence that Australian equities are breaking out of their moribund trading range as the Chinese economy shows clear evidence of strong growth.
I remain of the view that the emergence of the Chinese economy is the biggest economic development of our lifetime. All investors need more direct exposure to China in their portfolios.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.