Market Snapshot:2H17A-share market outlook
A shares’ “slow bear” to continue A shares underperformed global stock marketssignificantly in 1H17. The Shanghai Composite Index has grown just 4.1% YTD, much weakerthan the MSCI Emerging Market Index (18.2%) or MSCI World Index (10.1%). Looking ahead,the GF A-shares research team expects the “slow bear” market trend to continue into 2H17given the following reasons. 1) Corporate earnings growth peaked in 1Q17 and is likely toslow gradually in the upcoming quarters given that: i) the property sector has entered adown cycle after sales growth peaked in April 2016 as property tightening measures havestarted to cause slowdowns in home sales and housing starts in recent months; ii) commodityprices have entered a down cycle, with crude oil, coal and iron ore prices dropping 20%-30%from the peak in 1Q17, suggesting that materials sector earnings might have also droppedsubstantially; iii) A-share earnings typically follow a three-year cycle, and they are now movinginto a down cycle following a one-year up cycle since 2Q16.
2) Interest rate up cycle continues, though rising less rapidly The Chinese governmenthas shifted its policy priority to reducing financial leverage and containing asset bubbles since3Q16. The PBoC raised the reverse repo, MLF and SLF rates in the open market in Feb andMarch this year, delivering a very clear signal that the central bank wishes to tighten monetarypolicy, as has been reflected by the China 10-year government bond yield which rose from3.06% to 3.70% during 1H17. Looking ahead, interest rates are likely to maintain an upwardtrend, but with a flatter slope for two reasons. First, given that the negative impact of economicand financial deleveraging on economic growth is relatively mild, monetary policy is likely tomaintain a tightening bias for the time being; second, US-led interest rate normalization is likelyto exert pressure on interest rate levels in China.
3) Risk premium Reform and economic restructuring expectations have typically been a majorfactor driving A-share investors’ risk appetite. During 2013-2015, the acceleration in structuralreform significantly enhanced risk appetite subsequent to the CPC’s 18th National Congress.
Looking into 3Q17, the PBoC’s recent liquidity stabilization measures will likely ease after theend of 2Q17, while government-led regulatory supervision for financial deleveraging will belaunched in July-Aug following banks’ self-checks, which might lead to significant challengesto market liquidity. Market sentiment is likely to be sensitive until relevant regulatory details areannounced. A turning point might not appear until the 19th CPC National Congress when themarket will likely refocus on reform expectations.
Relative valuation attractions Since the beginning of this year, investors have favored sectorleadingstocks with stable earnings, high ROEs and low valuations. In particular, leadingconsumer stocks have outperformed the overall market. However, the valuation of the sectorhas reached its historical average (P/B ~5.2x), while its valuation premium over the market(relative P/B 2.66x) is climbing towards its historical peak level (>3x), making the sectorexpensive. We believe banks, auto and property names offer a better balance betweenvaluations and fundamentals, while airports and toll roads have additional attractions from theirstrong cash positions on hand and relatively high dividend yields. In addition, airlines and newenergy vehicles are also worth considering because of ongoing industry recoveries andrelatively low institutional investor holdings.
Long-term structural allocation With the ongoing earnings growth slowdown and prevailinginterest rate up cycle, stock selection will become increasingly important. That said, based onoverseas experience, we like the Chinese home appliance sector due to its competitive edgein the global market, as well as high-end baijiu and healthcare leaders whose peers haveshown consistent share price strength in global markets such as the US, Japan and Korea. Inaddition, auto and semiconductors (import substitution), rail and construction machinery(manufacturing globalization), branded apparel (consumption upgrade), and non-bankfinancials and airlines (service industry) will also be key sectors that are likely to outperform inthe long run.
Risks A-share companies reporting worse-than-expected earnings growth; stronger- andearlier-than-expected participation of foreign investors before the official inclusion of A sharesinto the MSCI Index.
