By Ken Peng
Head - Asia Investment Strategy
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Investment opportunities in the second term of Xi
The market is abuzz about what China’s 19th Party Congress, due to start on 18 October, might bring. Some observers believe that recent economic momentum has been driven by a deliberate policy of boosting the economy with stimulus ahead of flagship political events. Once the meetings conclude, they fear that the stimulus will fade and that growth will falter.
The problem with this theory, however, is that it ignores major improvements in China’s economy and investment outlook, in our view. President Xi’s second five-year term in office is actually starting off on a much stronger footing than his first term in 2012. We expect next month’s Congress to reinforce his position as core leader, bolstering Chinese political stability from the point of view of foreign investors.
China has also made major progress in cutting industrial overcapacity. Significant excess production in industries like crude steel has been reduced, with further production cutbacks underway. Also, the highly indebted Chinese corporate sector is deleveraging somewhat, while the amount of non-performing loans in the banking sector has begun to fall.
The other major improvement compared to 2012 is that the Chinese yuan is no longer overvalued. Capital that was previously flowing out of China is now flowing back. As a result, the authorities are now in a position to further liberalize the exchange rate regime, and potentially ease capital controls.
Admittedly, there could be near-term volatility as investors get accustomed to this new environment. However, it would be a welcome development if China’s markets become more accessible for global investors.
The implications of this for China’s currency could be significant. We expect the yuan may strengthen to below 6 per dollar in the coming three years. The opening of equity and bond markets to foreign investors, with more liberalized foreign exchange hedging and capital controls, is likely to encourage investor inflows. A potentially weaker US dollar would also support yuan appreciation, without significantly hurting China’s competitiveness, as other currencies are likely to strengthen against the dollar as well.
Chinese equities have already been experiencing an earnings recovery this year, with upward revisions to forecasts by analysts helping China to outperform this year. We expect further upgrades to earnings forecasts, helped by steady producer price inflation and limited real exchange rate appreciation. At the same time, we continue to see Chinese equity valuations as low, which strengthens our conviction in our overweight recommendation. In fixed income, we also favour yuan denominated bonds, including those issued outside of China. We believe they may see a revival alongside a strengthening of the Chinese currency.
Overall, we think that China’s recent growth is more than just a short-term cyclical bounce or politically-driven spurt. We believe the country is laying the foundations of a sustainable model of economic development. Global investors – even those focused on emerging markets – remain underweight China. Both Chinese companies and the yuan are thus underappreciated and undervalued. As a result, we think investors have an opportunity to pick up Chinese equities and fixed income, with potential currency upside when the gains are converted into US dollars.