With further policy details provided by the central government in 2013, we see 2014 as the year for actual implementation. With the focus now shifted from politics to the economy, we believe that economic growth, forecast at a lower rate than 2013 at 7.5% for 2014, is likely to be more stable given better macro-economic management.
Given the more stable growth rate, we believe that there are reasons to continue staying positive on the China market.
The new government led by President Xi Jinping has set a positive groundwork for reform by communicating growth targets and reiterating the government’s commitment to change. Following the release of comprehensive reform plans after the 3rd Plenum meeting in November 2013, there has been a general uplift in overall sentiment. We feel that this level of transparency has done much to boost the confidence of people and better manage their expectations. We also have more confidence in the government's execution capabilities to push for a wider scale of reforms as power is now more centralised. Not only is Xi Jinping the current president, but he is also Head of China's Communist Party (CPC) and chairman of the country's Central Military Commission.
The latest reported audited local government debt of 17.9tn RMB (end June 2013) is manageable, but has been an overhang for the market. Potential opening up of the municipal bond market will provide the local governments with a new source of long term financing outside of the traditional bank loans. This would help ease market concerns on duration mismatch of debt terms and infrastructure project cash flow generation cycles. Other measures to deleverage such as privatising government owned assets (eg: infrastructure, natural resources mining rights and state owned enterprises) are also positive to drive the improvement of operating efficiency. Lining up the interest of management and shareholders is likely to improve Returns on Equity (ROE) and benefit minority shareholders.
Apart from the traditional investment into roads, railways and ports, we are seeing incremental demand into the city mass transit system, drainage network, gas power plant, hospitals and other environmental protection areas. The process of local government deleveraging may put some pressure on project financing in the short term, however is expected to be mitigated in the longer term. We expect investment into infrastructure to remain stable in 2014.
The Chinese government is looking to aid income redistribution by increasing the number of regions that will have pilot programs privatising the residential land of farmers. Rural residences account for over half of the Chinese population and improving the wealth level of these residences may benefit domestic consumption.
As seen from the chart above, the dispersion between corporate earnings and PE has gone wider over the past three years. Market consensus is between 10-15% of corporate earnings growth in 2014 and we see further potential upside given the more positive business sentiment. The market has potential to rerate and we remain constructive, looking out for potential trading opportunities, as market valuation at below 10x 2014 estimated P/E still looks cheap. Valuation gaps between sector/names have been getting wider with "old economy" names such as China Communication Construction, Weichai Power and banks trading at 5-10x PE; and "new economy" names such as Tencent and Wantwant trading at 20-50x PE range.
The strategy for 2014 is to continue being focused on stock picks in quality growth sectors. The key sectors we favour are Consumer Discretionary, IT, New Energy, Selective industrials and Non-banking Financials. In the past year, we have seen the easing of overcapacity in the industrial sectors which occurred as a result of credit boom post financial crisis. We may start seeing supply cuts in industries such as cement, steel, paper due to a tightening of environmental standards and less capacity expansion in the past 12-18 months as companies had poor profitability. This will help improve the utilisation rate and profitability of cyclical industries especially for industry leaders.
There is likely to be some near term volatility as a result of tackling the accumulating debt risks of local governments and implementation of financial liberalisation amongst other reforms. Recently released PMI data slowed to 50.5 for the month of January 2014, but we feel that this is likely due to the Chinese New Year effect and is better to wait for February data before analysing this in depth.
With China’s reform plan taking shape, we believe that there is long term value to be found. The volatile market sentiment would allow us the opportunity to build up positions in stocks that we have identified as being attractive in the longer term.
Realistically due to the large scale nature of some reform projects, implementation will expectedly take some time. However this is to be expected and from an investment standpoint, we would much rather the government take time to lay the foundations right.
Caroline Maurer, Manager of the Henderson Horizon China Fund