Data on mobile-phone usage can track China's tourism industry. The credit card and online sales data we see from China c
GLOBAL EQUITY OUTLOOK • FEBRUARY 2017
Warming up to China Global investors have been wary of embracing China on concerns of an increasing debt load, persistent capital outflows and a potential trade war with the U.S. Yet today there are powerful structural and cyclical forces in play that make China’s equities attractive, we believe. An overly cautious approach may mean missing out on fresh returns from the world’s second-largest economy.
Highlights Kate Moore Chief Equity Strategist, BlackRock Investment Institute
• We expect global reflation and a domestic cyclical upswing, as reflected in the BlackRock GPS, to support Chinese equities. Progress on domestic structural reforms and undemanding valuations add to China’s attractions. • Making money in Chinese stocks requires dropping one’s preconceptions, paying close attention to policy priorities and using new data sources to generate ideas. We believe big data can help supplement traditional fundamental analysis.
Gerardo Rodriguez Portfolio Manager, Emerging Markets Rui Zhao Portfolio Manager, Asia-Pacific and China Equities Helen Zhu Head of China Equities, Active Equity Group
• The biggest near-term risk to China’s stocks is a breakdown in trade triggered by U.S. protectionism. Yet trade is a smaller growth driver than in the past, and China is strengthening ties within Asia and making its economy more consumer-driven.
Performance conundrum Chinese equity returns have trailed the nation’s spectacular growth since 2000, underperforming other emerging markets such as India. China H-shares – listed on foreign exchanges such as Hong Kong – have fared better than A-shares – which are listed on onshore exchanges. See the chart below. Structural problems (resulting from the 2009 stimulus) and declining multiples have weighed on equity returns since the financial crisis. Earnings growth has been solid, but high levels of investment left less free cash flow to distribute to shareholders. We see these dynamics changing as policy makers press ahead with reforms, domestic and offshore valuations converge and China is admitted to global equity indexes.
When investors aren’t fully rewarded Global equity performance versus real GDP growth, 2000-2016
Sources: BlackRock Investment Institute, MSCI, Thomson Reuters and Haver Analytics, February 2017. Notes: Annualized, dollar-denominated equity returns are based on MSCI national indexes; annualized GDP growth percentages are based on the countries’ national accounts.
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Changing mix Domestic investors – primarily retail – buy shares in China’s onshore markets while international investors access China through offshore H-shares. Both indexes are made up of companies with low direct foreign sales, we estimate, with 10% of A-share company revenue coming from abroad and a slightly higher level for H-shares.
Hopes for margin turnaround Capital expenditures vs. profits
Onshore shares are often driven by momentum and have been subject to dramatic speculative booms and busts in recent years. Foreign institutional investors have historically been confined mostly to investing in offshore markets. The different investor bases – and level of sophistication – explain much of the valuation differential between the two markets. Dual-listed large mainland Chinese companies currently trade at a near 20% premium on onshore markets versus their offshore counterparts, according to Thomson Reuters data. This premium has roughly halved in the past year. We expect it to erode further as programs allow mutual market access for investors between mainland and Hong Kong exchanges. The makeup of China’s equity market is undergoing a transformation as the country rebalances its economy. “New economy” companies in consumption-driven sectors such as technology and services accounted for half of the IPOs in the A-share market in 2016, according to Gildata and BlackRock data. And new-economy stocks now make up more than half of China H-shares – roughly the same breakdown as the developed-market MSCI World index. See the chart below. “Old economy” sectors such as materials, industrials and financials are still overrepresented in the domestic A-share market. Yet the picture is fast changing. Financials, meanwhile, now make up around 25% of the onshore and offshore market, according to MSCI data, after peaking at more than 40% in 2015. Foreign investors leery of owning shares in banks grappling with an increase in nonperforming loans, or highly leveraged state-controlled companies in old-economy industries, have alternatives.
New economy’s equity stake Stock market sector composition, February 2017
Sources: BlackRock Investment Institute, MSCI and Thomson Reuters, February 2017. Notes: New economy is defined as consumption-driven sectors, including technology, health care and the consumer. .
Sources: BlackRock Investment Institute, China's National Bureau of Statistics and Thomson Reuters, February 2017. Notes: The blue line is the two-year moving average of gross capital formation as a percentage of GDP, pushed forward by four years. The light-blue line is an estimate. The green line shows the two-year moving average for earnings before interest and taxes (ex-financials).
Overcapacity fatigue The eventual inclusion of domestic A-shares in indexes should expand the representation of China in global capital markets and attract a broader group of investors. China may eventually make up more than 40% of the market cap of the MSCI EM Index, up from around 25% today, MSCI estimates. China’s onshore and offshore markets are set to converge, attracting a more stable and less speculative investor base. This begs the question: Are Chinese equities investible? And where are the greatest opportunities today? It may be tempting for investors to focus exclusively on “new economy” stocks given the high indebtedness and mature growth rates of some industrial and manufacturing companies. Yet we also see opportunities as the programs to reduce capacity and improve profitability in overbuilt heavy industries are expanded over the coming years. Initial supply-side reforms already bore fruit in 2016: steel and coal prices sharply rebounded, breaking out of a four-year downtrend – and producers were able to engineer a huge turnaround in profitability. This marked improvement was not lost on equity investors as downstream materials stocks outperformed other sectors. We expect this is just the tip of the iceberg when it comes to the government-driven cleanup of inefficient industry. We see more attractive opportunities emerging as policy makers pursue a multi-year and multi-sector suite of reforms to reduce excess capacity and leverage. Our analysis shows that cuts in capital expenditure can lead to a sustained improvement in margins over subsequent years. See the chart above. While profitability has declined for both H-share and A-share indexes from lofty levels over the past five years, the return on equity for China’s indexes is on par with the U.S. and above non-U.S. developed markets. More efficient use of capital should pave the way for a broad and sustained improvement in profit margins, we believe.
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Data alternatives Investors need not depend solely on China’s government data when making investment decisions. Big data culled from satellite imagery, mobile phone usage and text mining of filings from companies doing business in China may give investors an edge, we believe. •
Satellite data available from vendors can identify sectors of China’s economy that are experiencing the highest level of growth. Images taken from space, for example, can monitor the amount of materials going into a construction site and help determine whether a project is being completed on time.
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As the appetite of China’s consumers keeps growing, insight into how people spend can assist in predicting corporate growth. Credit card data can provide a sense of which brands are growing in popularity in China. Online search terms can be used as a leading indicator for e-commerce purchases. Data on mobile-phone usage can track China’s tourism industry. The credit card and online sales data we see from China can also help to forecast sales of many global companies, we believe.
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Mining the text of conference calls conducted by companies doing business in China, which BlackRock’s Scientific Active Equity team tracks, can provide insights. After declines in 2014 and 2015, global executives began speaking more positively about China last year. See the chart below. Even as government data raise questions, official newspapers can help identify the potential beneficiaries of policies. Tallying the number of articles on a subject in newspapers such as the People’s Daily, published by China’s Communist Party, can give investors a sense of the direction authorities are taking. By our measure, we have seen a growing emphasis on the government’s supply-side reform campaign.
Sizing up China Global companies with positive views on China, 2012-2017
Disproportionate foreign exposure Foreign share of corporate revenues by sector, 2016
Sources: BlackRock Investment Institute and Bloomberg, February 2017. Notes: The bars show foreign sales as a percentage of total revenue for MSCI China-A companies based on data from their most recent fiscal years.
Trumped on exports? The biggest immediate risk to Chinese equity markets is a breakdown in global trade. U.S. President Donald Trump has threatened to raise the tariff on imported goods from China to 45% (from about 3% at present) in an attempt to bring home manufacturing jobs. China has become less dependent on exports to the U.S. than in the past, and net exports’ contribution to GDP has also declined. Yet any curbs on Chinese exports could hurt China’s technology and energy industries, which draw about one-fourth of their revenue from overseas. Other sectors such as consumer staples and utilities are less dependent on foreign sales. See the chart above. Another threat is a U.S. congressional proposal to impose a 20% border adjustment on imported products and components. China, meanwhile, is far from passive. Well before the U.S. election in November, China’s leadership began to lay the groundwork for deeper ties with Asian trade partners through the Asian Infrastructure Investment Bank and the One Belt, One Road development program. President Xi Jinping reaffirmed a commitment to trade when he said in January at the World Economic Forum in Davos, Switzerland, that “no one will emerge as a winner in a trade war.”
Sources: BlackRock Investment Institute and Factset, February 2017. Notes: The line shows the percentage of global companies expressing a positive view on China. Sentiment is measured through BlackRock's proprietary text-mining of corporate managers’ conference calls.
Bottom line: We see Chinese stocks supported by an accommodative and flexible policy that aims to stabilize growth ahead of the 19th Party Congress this fall. The nearterm upside may be capped by trade tensions and the pace of structural reforms. There is also China’s ever-growing debt pile to monitor. But over the medium term, we believe Chinese equities are an attractive – and under-owned – asset. Many of China's challenges are discounted in market valuations, and profitability is improving thanks to supplyside reforms. Further, the ongoing liberalization of the financial system will gradually increase opportunities for foreign investors to participate directly in China’s markets.
BlackRock Investment Institute The BlackRock Investment Institute (BII) provides connectivity between BlackRock’s portfolio managers, originates market research and publishes insights. Our goals are to help our fund managers become better investors and to produce thoughtprovoking content for clients and policymakers. B L AC K R O C K V I C E C H AI R M A N Philipp Hildebrand
H E AD O F E C O N O M I C AN D M AR K E T S R E S E AR C H Jean Boivin
G L O B AL C H I E F I N V E S T M E N T S T R AT E G I S T Richard Turnill
EXECUTIVE EDITOR Jack Reerink
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