Market outlook for 2H July 26, 2018 Abstract: During the first half of 2018, the market experienced significant adjustments in February and June [1]. As of June 29, 2018, the Shanghai Composite Index plunged around 20% from its January high and fell by about 13% in the first half of the year [1. The central bank has cut RRR three times this year and the exchange rate of the RMB against the US dollar depreciated quite rapidly in the middle of the year. Investors are risk averse as they are concerned about a series of market uncertainties. However, as the impact of trade war and the direction for domestic macro policy become clear, there are structural opportunities in both equity and fixed income markets. Index Analysis A-share valuation and long-term buying opportunities In June 2018, A shares went down with RMB accelerated to depreciate against USD. However, it is seen as a good buying opportunity for some overseas investors. Australia's pension fund UniSuper Management Pty is one of the institutions that used the latest sell-off to build a position in China A shares. Their reasoning is that the adjustment of A-shares was caused by tightening US dollar liquidity and fears of a trade war, but the market has been overshoot, in their opinion.[2] A-shares have fallen by 20% in the first half of 2018 from previous year's high point. Shown below is the historical trend of A-shares: Since 2003, there were 1035 times that the FTSE China A50 falls by 10% from the previous year's high point, among which it has recorded positive in the following month, three months, six months and one year for over 50 times. FTSE CHINA A50 Index July 2003-July 2018 after 1-year high 1035 1035 1035 1035 534 565 529 564 51.59% 54.59% 51.11% 54.49% -0.10% 0.04% 0.75% 9.57% Shanghai Composite Index July 2002-July 2018 after 1-year high 1107 1107 1107 1107 587 579 531 597 53.03% 52.30% 47.97% 53.93% -0.33% -0.39% -0.57% 7.08% CSI 300 Index July 2002-July 2018 after 1-year high 981 981 981 981 522 501 483 611 53.21% 51.07% 49.24% 62.28% -0.33% 0.11% 2.06% 12.73% Chart 1 Market trends after A-share indices fell by 20%* after 2-year high 2234 2234 2234 2234 1133 1196 1214 1216 50.72% 53.54% 54.34% 54.43% -0.02% 0.73% 2.91% 15.73% Times of 20% drop after 2-year high Times of 20% drop after 2-year high After 1M After 3M After 6M After 1Y 2375 2375 2375 2361 1228 1194 1225 1190 51.71% 50.27% 51.58% 50.40% 0.03% 0.23% 0.93% 8.31% After 1M After 3M After 6M After 1Y 1951 1951 1951 1942 1080 1063 1100 1169 55.36% 54.48% 56.38% 60.20% 0.41% 1.46% 4.05% 16.59% *Source:Bloomberg,MSCI 1
It s worth noticing that the arithmetic mean return of the indices increased significantly one year after the sharp drop. We got similar result when we extend the data of the Shanghai Composite Index back to 1990. The impact of US-China trade war on A-share indices First, the trade war targets on Made in China 2025 rather than the trade deficit. There are many indications that,the nature of the trade war is not to close the trade deficit but to deal with Made in China 2025 in order to avoid threats that China becomes a nation built on technological innovation. This purpose has been very clear according to the US Statement In June 2018, US Trade Representative Robert Lighthizer announced in a statement from the US Department of Commerce : We must take strong defensive actions to protect America s leadership in technology and innovation against the unprecedented threat posed by China s theft of our intellectual property, the forced transfer of American technology, and its cyber attacks on our computer networks China s government is aggressively working to undermine America s high-tech industries and our economic leadership through unfair trade practices and industrial policies like Made in China 2025. [3] According to the USD 50billions tariff list, it can be found that a large number of product categories are in the sectors involved in Made in China 2025 plan, such as industrial equipment and electronic components. In contrast, those product categories within the low-end manufacturing industry which lead to China s trade surplus are not on the tariff list.[4] The FTSE China A50 may be relatively less affected by the trade war. FTSE China A50 Index put less weight on materials, industrials and healthcare industries when compared with CSI 300 Index and MSCI China A Inclusion Index. If the trade war escalates, Made in China 2025 related sectors would be further impacted and A50 would suffer less from such impact. Chart 2 GICS sector weight distribution of the three major A-share indices (%)* As June 30,2018 CSI 300 FTSE China A50 MSCI China A Inclusion Energy 2.49 2.73 2.46 Materials 7.44 2.35 6.05 Industrials 13.13 4.55 11.86 Consumer Discretionary 12.18 11.03 10.73 Consumer Staples 9.31 13.85 12.77 Health Care 7.42 2.64 7.24 Financials 31.70 49.61 32.22 IT 8.53 5.38 7.61 Telecommunication Services 0.59 0.77 0.10 Utilities 2.64 1.31 3.41 Real Estate 4.55 5.78 5.54 *Source:Bloomberg,MSCI 2
3 Market Outlook from Active Fund Managers Macro economy outlook: expect more active fiscal policies No foundation for a long-term decline in the value of RMB. The RMB depreciated rapidly in July. The CNY depreciated by 1.4% against the USD in the week of July 16 and reached its lowest point in July 2017. The depreciation of RMB was mainly driven by the divergent monetary policy path in China and the US. As we don t see policymakers intention to intervene forex market yet, and that moderate depreciation is favorable to exports, we expect RMB exchange rate to continue to fluctuate within a range of considerably weak levels. Nevertheless, the chance for RMB to break 7 per dollar is quite small, and we expect to see interventions if it happens. We believe there is no foundation for a long-term decline in the value of RMB, from the point of view of purchasing power parity. Meanwhile, the US government has expressed dissatisfaction with a strong dollar. The trade war has shown signs of a transition to a currency war, which limits the room for RMB to continue to depreciate. More proactive fiscal policies are expected. The central bank implemented three RRR cuts in the first half of the year and released 502 billion yuan of MLF on July 23 to maintain market liquidity. We expect that the central bank to further cut RRR in the second half of the year. The expansionary monetary policy after 2008 did not largely boost GDP growth, but increased the leverage and debt burden. Monetary policy needs positive fiscal policy to complement each other. As recent State Council meeting sent out signals for more active fiscal policies and more infrastructures, we expect this will take effect in the 2H. Investment ideas for fixed income and equity assets A-shares are oversold, creating chance for a rebound during earnings season. External factors such as US-China trade war coupled with pressure from deleveraging and the new asset management rules, have hurt A-shares performance during the first half of the year. It seems that many equity fund managers have lowered their equity positions to 50% ---a level that is unlikely to fall further, and are looking for trading opportunities with lots of cash in hand. A-shares are already oversold in terms of valuation, in our opinion. Taking active macro policies into account, we believe that there might be a rebound opportunity as earnings season approaches. The detailed new rules on asset management have been laid out, which are not as strict as expected. Regulators seem to be more tolerant on trading non-standardized assets as well as the implementation arrangement during the transition period, comparing with market expectation. Together with expansionary fiscal policy, investors risk appetite may increase in short term but the room for rebound may be a bit limited. From the perspective of macro policies, strictly avoiding systemic financial risks in the process of deleveraging, and avoiding a sharp economic downturn during trade war, are still the bottom line of policymakers.
4 However, the macro environment has not fundamentally changed despite policy stimulus. Though the market has entered into the bottom area but consolidation may take time. Therefore, we expect the market will seesaw at current low level for a period of time. On the one hand, marginally eased policy doesn t mean that deleveraging is over, so that default cases in credit market may continue to emerge, possibly affecting market sentiment. On the other hand, we need time to observe whether recent market liquidity can substantially boost the real economy. We aim to seize structural opportunities in the 2H, meanwhile carefully controlling downside risks remains to be our priority. As the market gradually corrects itself, the companies with solid fundamentals will show their investment value and bring buying opportunities for mid- or long-term allocation. Hong Kong market: looking for stocks with long-term certainties or cyclical opportunities. As investors are defensive at the moment amid high uncertainties in the market, the investment opportunities lie in sectors with both high certainty in earnings and upside potential in valuation in long term, in our opinion. Private school operators, for example, are less exposed to trade-war and forex risks. In addition, children s education expenses are the priority in the disposable income of many Chinese households despite macro economic changes. Therefore the upside trend for the sector is quite clear in terms of both valuation and earnings. In addition, we also recognized some stocks with attractive valuation in cyclical and consumption sectors. Those with good fundamentals and certainties in earnings in short term are already comparatively safe to invest in. Opportunity in China s high-yield dollar debt Based on our cautiously optimistic outlook for the A-share market in 2H, we are also positive about china s high-yield bonds, which has a high positive correlation with the stock market. Based on our anticipation of the forex movement and observation of the technical indicators of China s high-yield bonds, we prefer China s high-yield US dollar bonds. Trading opportunities for single bonds in some industries have emerged after earlier market correction, especially in real estate, oil and oil service industries. [1] Bloomberg [2]$49 Billion Fund Loads Up on Chinese Shares, Bloomberg https://www.bloomberg.com/news/articles/2018-07-05/shanghai-selloff-sees-49-billion-fund-load-up-on-chineseshares [3] USTR Issues Tariffs on Chinese Products in Response to Unfair Trade Practices https://ustr.gov/about-us/policy-offices/press-office/press-releases/2018/june/ustr-issues-tariffs-chineseproducts [4] World Trade Organization, Department of Commerce, Goldman Sachs Global Investment Research,March 15, 2018
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