China Equity Strategy:Why OW Financials?Less NPL,stronger yields and low positioning

1) Improving asset quality: Thanks to the intensifying cyclical recovery andthe surging PPI, banks’ key clients, i.e. non-financial companies, havedelivered a recovery of profitability (higher margins and ROE; Figure1~Figure 2) and a rebuilding of financial strength (richer cash flow andlower leverage; Figure 3~Figure 4; see 1Q results: recovery, rebuilding &resurgence, 5 May); in 1Q17, non-financial EBIT growth leapt to 200% andthe EBIT-to-interest coverage jumped to a 5-year high of 3.2x (Figure 5).

    Against this backdrop, it’s not surprising to find a further slide in NPLformation to 80bps, lowest since 3Q14 (Figure 6), and a lower specialmentionratio (Figure 7). Looking beyond near term, we are not veryworried on the headline debt-to-GDP and think it may rise further giventhe faster-than-GDP deposit growth (Figure 8), and we believe a positivedevelopment has begun to address the skewed debt concentration on thecorporate sector (Figure 9; see Reinforcing the rebalancing of leverage,population and economy, 8 Dec).

    2) Recovering asset yields/NIM: As Chinese companies begin to deploythe financial resources they accumulated in the recent cyclical upturn(Figure 10) to inventory restocking (Figure 11) and capex (Figure 12~Figure13), credit demand increased as evidenced by a historical high ofcorporate medium/long-term loan of Rmb3.2trn in 4M17 (Figure 14~Figure15), together with a higher inflation expectation and recent tighterregulatory scrutiny in shadow banking activity, domestic bond yieldsrebounded, granting banks more credit pricing power. Indeed, we noticethat banks’ NIM yoy contraction has narrowed to -29bps in 1Q17 from ahistorical low of -39bps in 4Q16 (Figure 16); we expect it to improvefurther in the coming quarters, following the close historical correlationbetween corporate bond yield vs. bank NIM (with a 9-month lag; Figure17), and banks’ earnings growth may accelerate further (Figure 18).

    3) Favorable valuations and positioning: Despite recent outperformance,Financials’ YTD returns are lagging behind peers (Figure 19) and investorsgenerally maintain a sizable underweight in the sector (Figure 20), leavingboth MSCI China insurance and banks indices below one std. dev. of theirrespective historical average 12m forward P/B (Figure 21~Figure 23).