NAVIGATING HONG KONG & CHINA
No risk, no return
China’s multi-year P/E de-rating should begin to reverse in 2014 on the back of a modestdecline in the equity risk premium and a stabilization in long-term earnings growth. Balancing structural and social objectives comeswith significant risk but the speed and sequencing of reform is at policy makers’ discretion. Pragmatism suggests that long-term goals will not be pursued at all cost. We expect Chinese equities to rise 20% in 2014 driven by a re-rating in financials (banks and insurance) and selected cyclicals more than offsetting the drag generated by areas subject to deleveraging and consolidation pressure.
Arresting the decline
We expect MSCI China to rise 20% in 2014, driven by 7% earnings growth and a 150bp decline in the equity risk premium, pushing the P/E multiple up from 9.2x to 10.7x forward earnings. Our top-down target is 5% higher than our analysts’ bottom-up driven market cap weighted return. This is a rare occurrence.
Valuation to cushion risk
Unlike most other Asian nations, China has limited exposure to exogenously-driven risks (weaker currency, higher rates, capital flight, politics and policy execution), raising the relative return appeal. Instead, its vulnerabilities lie with endogenously-driven risks but a substantial valuation cushion creates an asymmetric return skew if policy and/or growth disappoint.
High return, high dispersion
Large performance dispersion will again feature in 2014. The majority of China’s value lies in financials, suggesting that a move down the risk curve is needed for higher returns. A rally that is concentrated in reform/structural beneficiaries (i.e. a repeat of 2013) will be the result of a bear-case growth scenario.
We like banks, insurance, selected global and domestically leveraged cyclicals (retail, transport, shipping), and energy (oil & gas). We avoid areas subject to consolidation (capacity attrition), slowing investment, cyclical earnings pressures and those sensitive to rising rates or with high leverage (construction, materials and utilities). Fundamentals remain strong for gamers and autos but they will lose leadership in 2014.