China / Hong Kong Market Focus
Market Strategy
HSI: 19,002
Recommendation highlights
Sector Recommended stocks
Financials (+) ICBC, CCB, Ping An, COLI
Energy (O) Shenhua, Sinopec
Telecom / Tech (O) China Telecom, Comba
Utilities / Infra. (-) CK Infrastructure
Cyclicals (-) CNBM
Consumer (N) Golden Eagle, Luk Fook
Sustainable re-rating if fiscal policies persist
• Market has been de-rated by a FAI-driven growth model and easy credit which have, ironically, led to slower money circulation and cash flow problems for some industries
• After 4-years of de-rating, there is now limited downside for the China/HK market; we expect the HSI and HSCEI to gain 13% and 17% by end-2012
• Rerating would be sustainable only if the government continues with proactive fiscal policies while pursuing selective credit easing
• Strategy: Corporate earnings growth will be slow in 2012 in tandem with the GDP growth. Buy consolidation leaders and economic growth proxies that are undervalued. Overweight Financials and Telecom. Avoid high growth-high PE stocks
RRR cuts without increasing loan quota is not easing.
Growth concerns and slower hot money inflows justify the latest RRR cut. Expect a cumulative 300 bp cut in the RRR by end-2012, but this is merely operational and not a sign of broad-base easing. FAI will only slow down gradually to ease corporate pains. Flexible credit allocation should help transition to a service-oriented economy.
Lower property prices will help consumption.
During periods of rapidly rising property prices, potential homebuyers would have to save more, which means consuming less. Hence, the government’s restrictive property policies should eventually promote consumption. And fiscal measures to promote IT, new industries, logistics, services and SMEs should ensure broad-base economic growth.
Municipal bonds: killing three birds with one stone.
If the program succeeds, it will resolve revenue expenditure mismatch in local government projects, provide a source of income for households, and improve the vitality of the banking system. Long-term positive.
Investment summary
China / HK had been one of the worst performing major markets over the last 12-18 months. We forecast a re-rating next year, but that would be sustainable only if the government continues with proactive fiscal policies while pursuing selective credit easing. When consumption starts to fuel economic growth rather than investments in FAI and properties, market PE should be re-rated to where it was when FAI share of GDP was much lower. For now, the market will remain range-bound, although the current low valuations suggest the major indices should trade at higher levels by end- 2012. We expect the Hang Seng Index to end 2012 at about 21,500, which translates into 13% upside from here. Our target for the HSCEI is 12,030, 17% above current levels.
RRR cuts may not be followed by rate cuts
Despite the latest RRR cut, we do not expect the central bank to cut interest rates next year as real deposit rates will remain negative even if the CPI drops below 4%. Going into 2012, we expect the overall liquidity situation to be able to support 24% urban FAI growth. On the other hand, a smaller trade balance could slow the rate of Rmb appreciation, which should help Chinese businesses to adjust to a slower growth path.
Besides broad-base monetary tools, the government will likely use fiscal incentives and encourage bank lending to support the IT, logistics, transportation and other domestic- oriented services industries. Job creation in the services industry coupled with better social care benefits will reduce the need for precautionary savings, and encourage households to spend more.
Money in circulation fell in a FAI-driven economy
The FAI-driven growth model has not only reduced industry returns on assets, but also money in circulation in the banking system. The Rmb4tn stimulus package in 2009/10 has weakened the link between credit growth and economic growth, which contributed to the sharp de-rating of the market relative to the rest of Asia since late 2010. The global market sell-off in 2H11 has pushed down China/Hong Kong shares to their lowest PE multiples in 10 years, based on consensus forward PE estimates.
Long term gains, short term pains
The central government has shifted its focus, and is promoting the domestic services industry using primarily fiscal incentives rather than broad monetary tools. In the transition towards a consumption-led economy, wages are expected to rise faster than revenue growth, which means profit growth would be slower than GDP growth. Thus, there is no meaningful rerating catalyst for the market in the near term.
Recent targeted easing measures suggest that the Chinese government is fine-tuning its macro-policy for small- and medium-size enterprises (SMEs) to reduce their pains in the economic adjustment. If the adjustment is successful, the Chinese economy will become more diversified, more serviceoriented, and less credit-driven. In the medium term, the market should trade at much higher valuation multiples, and the resulting valuation gain should more than offset the impact of lower nominal growth.
Reality check
We have lowered China’s 2012 forecast GDP growth to 8.5% from 9.0%. Slower GDP growth, especially in nominal terms, would have implications for market earnings. Before deciding on individual sector weightings, we had to first determine whether market forecasts for sales, margins, and returns on investments, are realistic given changes to the macro environment. Comparatively high revenue forecasts for the Auto, Software/Internet, China Properties, Pharmaceuticals and Gaming sectors are worth special attention. The earnings and valuation risks (both upside and downside) are important factors to consider when judging whether these sectors merit an overweight, neutral or underweight in a typical fund manager’s portfolio. A summary of the consensus sales and earnings forecasts is found on page 11.
China properties; cheap, but be selective
18 months after implementation, the restrictive property policy is starting to work. Price corrections and lower sales volumes should enable individual cities to set their own mortgage credit terms, to support purchases by genuine homebuyers. However, we believe most of the anti-speculation restrictions will remain for another six months. And to promote further industry consolidation, credit allocation should remain relatively tight for property developers. Current valuations have priced in most of the negatives, although lower ROA outlook would remain an overhang for some counters in this sector. We recommend investors keep a neutral position in Chinese Properties, and limit exposure to SOE developers like COLI, which offer steady earnings growth and stable ROA. We also like Country Garden for larger exposure to Tier III and Tier IV cities.
Transport & Industrials: Underweight
Given the uncertain global market outlook, cyclical sectors, including Industrials and Transportation, could see further profit downgrades. We recommend to heavily underweight Shipping, Steel and Industrials. Cement is the only overweight call among the cyclicals. Improved demand-supply balance and pricing discipline should enable cement companies to enjoy healthy margins. Margins should drop in 1H12, but improve from 2H and volume growth becomes the key earnings driver. Top pick: China National Building Material.
Like F&B & Retailers; but cautious about autos & gaming We recommend a neutral position in Consumer & Healthcare. In Consumer, we like F&B companies, which could see improving margins and secured earnings streams. Sugar, soybean, and certain packaging materials recorded the largest price declines in Nov11, which is positive for beverage companies and edible oil players. We are concerned some retailers may be unable to sustain high growth rates in 2012, but remain comfortable with sector majors like Golden Eagle and Luk Fook. We are cautious about China auto companies in the near term. High-growth gaming stocks that are still trading at high PE multiples could be more vulnerable to profit downgrades. There will be more attractive entry points for these stocks in 1H12. Buy on weakness: Galaxy and Sands China.
Buy Chinese Banks, Telcos and coal producers
We would overweight the Telco sector, especially China Telecom in anticipation of solid growth and reasonable valuations. We are positive on Chinese banks given strong preprovision profit growth. We see limited downside risks in Chinese banks because the shortfall in collateral values is wellprotected by low loan-to-valuation ratios for property developer loans and mortgages (c.50%). Their high loan loss reserve coverage should also mitigate the impact of rising NPLs. We are Neutral on Energy/Commodity stocks, but would overweight coal stocks. Our top pick here is China Shenhua, the vertically-integrated coal/power/transport company. Increase exposure in Insurance, cut HK Utilities and Chinese Power
We also shift weighting from HK Utilities and Chinese IPP to Chinese Insurance for more exposure to Chinese financials. Lower investment yields and the sharp drop in top-line growth have suppressed the performance of the Chinese Insurance since late 2010. Ping An, which is ahead of the competition in terms of distribution, is our favourite in the sector.
Explaining the myth: more loans, less liquidity
China’s inflation (CPI) has finally slowed to 5.5% from a peak of 6.5% in July. The continued drop in inflation has led the market to expect credit loosening and an increase in loan quota. Given the payment difficulties observed in the construction and some manufacturing industries, the public’s call for a general easing is understandable. But in many cases, the tightness reflects the mismatch of cash flows of recent years’ investments rather than the government’s macro-policy. This situation can only be alleviated, not resolved, by more lending.
The results of China’s credit-led growth model were encouraging in the early 2000s. However, the link between credit growth and GDP was weakened since 2006. A higher amount of finance was required to generate similar GDP growth between 2007 and 2010. Most of the Rmb4tn stimulus in 2009/10 went into infrastructure and construction sectors, which did boost the economy by expanding its investment share of GDP. However, many of these projects appear to have a lower multiplier effect on domestic GDP compared to infrastructure spending in the early 2000s.
Higher import content and milder second-round impact
The sharp rise in the cost of imported raw materials partly explains the lower GDP multiplier. The other is lower secondround effect of fixed asset investments, which reflects underutilization of the new facilities, be it a toll road or regional airport. For low payback projects with multi-year negative cash flows before reaching breakeven, investments in the second, third or even fourth years still require significant loan inputs before construction is completed. As a result, money in circulation in the banking system has dropped, even though money supply and outstanding loans are growing rapidly.
The next chart shows the 1-year lagged effect of credit creation on nominal GDP growth. For example in 2000, the Rmb564bn increase in net loans contributed to Rmb1.04tn nominal GDP growth in the following year, translating into high effective return of 132%. But after peaking in 2001 at 185%, returns dropped to only 64% in 2009, when the Rmb9.6tn increase in net loans only resulted in a Rmb6.03tn rise in nominal GDP in 2010.
The Rmb4tn stimulus package in 2009/10 has created structural imbalances by weakening the link between credit growth and economic growth. This partly explains the China/Hong Kong market de-rating since late November 2010, when Korea and most other ASEAN markets remained buoyant even though the outlook was the same for the entire region. The global market sell-off since June 2011 has finally pushed down China/Hong Kong shares to their lowest PE multiples in 10 years, based on market consensus forward PE estimates.
Fiscal incentives rather than monetary loosening
We think it is premature to expect the central government to provide additional liquidity to support the financial market. An analysis of the previous easing cycle shows that a broad base easing is not imminent. Credit tightening was usually maintained until the CPI dropped below one-year deposit rate, currently at 3.5%. The notable exception was in 2008, when exports tumbled in the aftermath of the collapse of Lehman Brothers.
Note that despite the recent deceleration in the money supply to 13% currently, which is slightly below the long-term average, total social financing, including lending facility, created by the issuance of wealth management products, is still growing at 15% YoY. Thus, the system’s credit supply is not tight. Industry-specific liquidity issues must be tackled by the borrowers, though the government has favoured the use of selective easing actions to support SMEs by encouraging banks to lend to smaller companies. On the fiscal front, the VAT threshold was also reduced to assist the transportation and services sectors.
Going forward, we believe the government may use a preferential tax policy rather than broad base monetary easing to promote the priority industries mentioned in the 12th Five Year Plan, such as IT, environmental protection, and high-end manufacturing.
And unless the EU debt crisis develops into a full-blown financial crisis, the government will continue to emphasize the use of fiscal measures to fine-tune its macro-policy. Targeted fiscal measures have two advantages over monetary easing. First, a cut in interest rates would increase the risk of igniting another bout of general or property asset inflation. Second, broad monetary easing will help underperforming industries such as steel, but that would perpetuate the over-capacity problems instead of encourage industry rationalisation.
RRR should be viewed as an operational tool
We forecast a 3 ppt cut in the required reserve ratio (RRR) between December 2011 and end-2012, but that does not mean an aggressive easing.
The reserve requirement is one of the tools the central bank uses to mop up liquidity that is flooding the mainland’s financial system through trade surplus and other capital inflows, including hot money. The current 21.5% RRR is high by historical standards, being 4 ppt above the level a year ago and 6 ppt higher than two years ago. Looking into 2012, a shrinking trade balance and likely reduction in hot money inflows should lead to slower industry customer deposits growth. This would pave the way for a cut in the RRR, and
lower the portion of deposits banks have to place with the central bank.
But as long as loan growth remains the same as the original target, the RRR cut should not be seen as a general easing measure for the economy, although it would help banks by reducing the portion of lower yielding reserves.
Lower property prices will help consumption
18 months after implementation, the restrictive property policy is starting to work. A reduction in property transaction volume has had an impact on fixed asset investment (FAI) growth, and there are increasing signs that the weaker property prices are beginning to be felt in sales of discretionary items such as autos.
Making properties more affordable has always been a hot media topic. Most comments, including some brokerage reports, focus on the government’s social objectives – to address social discontent or wealth inequality issues. Our analysis, which is based on economic data, suggests an economic logic behind the property tightening in China. By bringing down property prices to more affordable levels, the saving rate should drop and consumption should increase. However, it could take several years for the economic adjustment to be completed.
To understand the relationship between real estate prices and consumption, one has to first look at the historical correlation between household savings ratio and real estate prices.
Although income growth in China had accelerated in recent years, the high cost of living and even larger increases in property prices are causing public discontent. If we believe happiness is correlated to consumption, then it would not be difficult to see why most people are unhappy.
Save more as property prices inflate and interest rates stay low Household savings is defined as the difference between household income and consumption. The household savings ratio is total household savings expressed as a percentage of disposable income. During periods of rapidly rising property prices, an average middle income household which aspires to buy commodity housing would have no choice but to increase its savings ratio every year, which means consuming less. And the aggregate behaviour of households who wish to buy (or upgrade) properties would inhibit consumption growth in the economy.
The decline in real interest rates also contributed to an increase in savings since 2010. Assuming a household’s savings is below target, it may end up having to save more and as a result, consume less.
Once property prices have deflated to manageable levels, possibly by 10-20%, we believe the property measures will be gradually relaxed. However, the anti-speculation measures will likely remain in place for now, and a stable market would make it easier for households to meet their savings targets. Over the long term, it would require a comprehensive financial sector reform, including expanding the domestic bond market and increasing social spending, to reduce the household savings ratio.
Negative wealth effect should be temporary
A by-product of the current economic restructuring process is a reduction in property-related wealth for home-owners. However, homeowners are predominantly those in the upper income bracket. They would have enjoyed above average income growth in recent years, and with that expected to continue, the dampening effect of negative property wealth may only have a temporary impact on consumption.
That said, the consumer discretionary sector could see more earnings downgrades as competitive marketing strategies for certain items such as cars, could pressure profits further when sales volumes slow down.
Municipal bonds: killing three birds with one stone
Most local governments are keen to boost infrastructure in their respective jurisdictions. But cash flow mismatch arising from massive long-term investments has inhibited their ability to borrow more, which has led to fears of a system-wide increase in non-performing loans.
Matching long-term funding needs
To address these financing needs, the central government has allowed trial bond issuance programs for four local governments, namely Shanghai, Zhejiang, Guangzhou and Shenzhen. For municipals with low outstanding borrowings relative to their GDP, debts can be sold in the market and issued based on their own credit standings rather than relying on the central government’s implicit guarantee or other forms of support.
The central government is leading the formulation of a longterm debt issuance strategy. In addition to coordinating the issuance timetable, the central government could assign preferential tax incentives to certain types of bonds. Fiscal incentives, when used appropriately and in conjunction with central bank monetary operations, could be used to give an initial boost to market development. For instance, market development could accelerate once a market-sensitive benchmark yield curve is reached, based on the highest quality local government instruments. The initial scale of the issuance, while tiny compared to the total outstanding LGFV, should be seen as the first step of a long term plan to rationalise local governments’ financing.
Help households to find savings instruments
A successful development of the domestic bond market also requires financial intermediaries to educate the public about the comparative merits and risks of various bond instruments. The enormous scale of underground lending (estimated at RMB3-4tn in Jun 2011) and the popularity of wealth management products until the recent clamp down, suggest that demand for income-generating savings products is huge. Currently, most households believe there are few “safe” alternatives other than cash deposits or investing in physical properties.
Banks: more room to grow, trade at higher multiples
From an investor’s perspective, we hope to see more initiatives in this area as the asset quality of commercial banks is tied to the speed at which their exposure to LGFVs can be reduced. If the local municipals’ bond issuance is successful, more banking system loans can be diverted to support the manufacturing and service industries, and enhance the commercial orientation of the system.
In summary, the successful development of the domestic bond market would enable China to address three issues: (i) revenueexpenditure mismatch of local government’s infrastructure projects, (ii) provide a source of income for general households, and (iii) improve the vitality of the banking system by removing riskier lending so that banks can redirect lending to more commercial activities. In other words, China would be able to kill three birds with one stone.
Easing SME lending would help transition into a consumption Economy
In anticipation of diminishing returns on FAI over the longer term, it makes sense for the government to gradually shift spending from investment to social spending, and increase the role of private consumption. Based on the policy adjustments discussed above, China will be able to shift from an investment or property-led growth model to a domestic, consumptiondriven economy.
From the perspectives of long term savings-investment balance, the recent easing for selected SMEs should reduce the number of individuals and small enterprises that are facing credit constraints. And this should reduce the need for precautionary savings for medical care and other household needs.
Screening for outliers amid slower growth
The successful sales of local government bonds in Shanghai, Zhejiang and Guangdong recently have important implications for the entire system. Repayment of loans by LGFVs to banks would enable them to relend to other areas. The slower trade growth would reduce foreign capital inflow and justify the latest RRR cut. Coupled with recent fiscal measures to support SMEs, these should ease corporates’ financial burden and reduce risks of bankruptcies. Assuming the loan quota is maintained at about Rmb8tn, banks should be able to grow their loans by 14-15% in 2012.
We also lowered China’s 2012 forecast GDP growth to 8.5% from 9.0%. Before deciding on individual sector weightings, we had to first determine whether market forecasts for sales, margins, and returns on investments, are realistic given changes to the macro environment. We looked at consensus estimates for total revenue, EBIDTA margins, net earnings and ROAs. If we exclude forecasts for the oil & gas and banking sectors, the derived 13.7% topline growth for 2012 is consistent with our nominal GDP growth projection. This is premised on the assumption that corporate asset turnover does not deteriorate. This may be applicable to most sectors, but there would be some risks in certain sectors.
Aggressive growth forecasts for Brilliance and ZhengTong Sales in the Auto sector, including distributors and parts suppliers, are forecast to grow 25.7%. This seems aggressive given that industry sales volume growth is likely to be only single digit next year, at 7-8%. But most of the growth reflects the market’s bullish view on Brilliance and the positive outlook for auto distributors as they grow their operations aggressively through acquisitions. Market forecasts for China ZhengTong and Brilliance are especially aggressive relative to ours.
Using 2012 data, expectations for four other sectors are also comparatively high: Software/Internet (sales +30%, net profit earnings +26%), China Properties (+29%, +24%), Pharmaceuticals (+28%, +25%), and Gaming (+20%, +27%). Slowdown in China property sales may only be apparent in 2013 (+23%) as 30-50% of 2012 sales were booked in 2011.
Pharmaceuticals: key issue is working capital
Pharmaceuticals should continue to register strong revenue growth. The major obstacles here would be drug pricing pressure and tight cash flow at some customers at provincial levels. These could result in cash flow uncertainty and increased need for working capital financing.
Gaming: uncertainty
Gaming has a relatively short listing history in HK/China, implying limited visibility of the determinants of gross gaming revenue. Nevertheless, experiences in other markets suggest we could see a sudden drop in gaming revenues amidst the current slowdown in China’s economic growth.
Retailers: forecasts are realistic
Surprisingly, sales expectations for retailers are only moderately high, at 17% for each of 2012 and 2013. These growth rates are achievable given China’s wage increases, and they are similar to our top-down retail sales forecast for 2012. Market concerns of a hard landing for China may be somewhat exaggerated; there will be negative wealth effect on high-end consumption in the near-term as property prices start to drop, but consumption should grow over the longer term along with wage increases.
The latest same-store sales growth (SSSG) performance of selected retailers signals a gradual normalization, from extremely high levels in earlier months. For example, Luk Fook saw >30% SSSG in Hong Kong for the rest of Oct 2011 after >50% SSSG during October Golden Week. Results of other surveys are shown on the retail sector appendix page 35-36. Overall, sales trends are within our expectations. Maintain overweight for Retailers. Top picks are Golden Eagle and Luk Fook.
IPPs, Coal, Oil and other cyclicals
NDRC reforms: news is out, take profit on IPPs
The National Development and Reform Commission (NDRC) announced on Nov 30 the long-awaited tariff hike and temporary interference in spot coal prices to stabilise coal supply to the power industry in winter. First, the on-grid power price will increase by Rmb0.026 /kwh. Second, the NDRC will cap Qinhuangdao (QHD) price at RMB800/t (5500 kcal). Third, contract prices would be allowed to increase by 5%. The latter two will have little overall impact on coal producers’ ASP. China IPPs will be the direct beneficiaries of the potential hike in power tariff, but we believe this has been priced in by the market. We recommend taking profit on IPPs after the announcement. Underweight Chinese IPPs.
Coal and Energy: Buy Shenhua and Sinopec
The latest NDRC reforms do not change our positive view on China Shenhua. With its unique vertically-integrated model that include rail and port infrastructure, Shenhua has a significant advantage over other pure plays. Its power assets will also benefit from the tariff hike and geographical proximity to its own coal mines. Hence, Shenhua offers the best quality earnings in a sector that is known for volatile earnings. A lower spot price exposure (50% vs 70-80% for Yangzhou Coal) will cap earnings volatility in an economic slowdown.
Among the oil majors, we continue to like Sinopec. As long as Brent oil prices stay at USD95-115, the stock offers the best risk-adjusted reward as swings in oil price would lead to higher earnings, either through higher E&P profits or lower refinery losses. Despite the uncertain global economic outlook, oil remains a relatively safe bet. We recommend a neutral
weighting in this sector.
Other cyclicals: prefer Cement
We have an underweight call for global cyclicals like shipping. Despite the cut in RRR, it is too early to buy domestic cyclical since railway investments are only expected to rebound slightly and property-related FAI could slowdown further in 2012. Among the cyclicals, we prefer cement for the ongoing consolidation in the sector. With double-digit volume growth,
China National Building Material (CNBM) offers strong earnings and margin upside in the medium term as it consolidates local players in Sichuan, Yunnan and Guizhou.
Comparatively, the Chinese steel sector historically demonstrates less discipline in capacity management than cement. Chinese steel companies are trading at very cheap valuations based on P/BV or replacement cost metrics. Despite this, we cannot make a positive call on the sector because of overcapacity. The lack of product quality differentiation (unlike Korean firms) also means that any short-term margin improvements would be unsustainable.
Properties: minimal downside to 2012F/13F margins
The property curbs have had some effect, with large-scale price cuts in the major cities. Still, Chinese developers were able to maintain strong volume growth and high profitability this year, and some have even locked in 40-50% of their 2012 profits. Thus, from an investor’s perspective, the trend to watch is analysts’ forecast profit margins and ROA for 2013.
The average EBITDA margin of Chinese developers in our universe would drop from an estimated 32.9% in 2011, to 31.9% in 2012 and 30.3% in 2013, based on consensus estimates. And using a conservative set of assumptions, we estimate EBITDA margin would average 29%, slightly above the 28.4% recorded during the Global Financial Crisis in 2008. These suggest possible further downside to analysts’ forecasts, but the magnitude would be limited.
We believe most of the anti-speculation restrictions will remain for another year. And to promote further industry consolidation, credit allocation should remain relatively tight for property developers. However, this would be balanced by selective relaxation of home mortgages by individual cities, which should ease the progression of credit transfer from developers to the household sector.
Current valuations have priced in most of the negatives. There is still meaningful upside, albeit lower than during the previous rebound cycle given the lower longer-term ROA outlook (5.6% based on consensus) compared to 2006-07 period (7-8%). Depending on how long property and land prices can sustain at current levels, potential land bank write-downs would be another overhang for companies that had been less-disciplined in accumulating landbank near the peak of the cycle.
Strong companies: COLI and Country Garden
We recommend investors keep a neutral position in China’s Property sector, and gain exposure only through COLI which offers steady earnings growth and stable ROA. We also like mass market developer Country Garden. With prudent cash flow management and disciplined acquisition, it should continue to outperform in 2012 due to larger exposure to Tier III and Tier IV cities.
Overweight Chinese banks
We expect Chinese banks to perform well in 2012 under most policy scenarios. We believe current valuations have discounted a sharp jump in NPL, which is inconsistent with our soft landing scenario. For banks, the current mix of selective credit easing and fiscal support for SMEs and local governments are already sufficient to ensure a soft landing, which would result in small and manageable increases in NPL.
For most corporates and SMEs, the current policy mix should help to lift some burden, but the current loan growth target may not be sufficient to help industrial and construction firms resolve payment problems and other working capital funding issues. Although both banks and cyclical sectors are trading at depressed valuations, the market does not seem to realise that there is a much higher certainty of banks achieving their operating profit targets than most other cyclical sectors.
NPLs can be absorbed by strong pre-provision profits Chinese banks recently saw increases in NPLs and special mention loans, which reflects deteriorations in SME and real estate lending. However, profitability remains strong with preprovision profits equal to 3-3.8% of average gross loans. Such high profitability would enable banks to absorb a possible jump in credit costs without reporting losses or raising new capital. We prefer large banks like Industrial and Commercial Bank of China (ICBC) and China Construction Bank (CCB), which face little constraints to grow loans due to their low loan-to-deposit ratios (LDR) and strong deposit franchises. We recommend buying these counters now, despite potentially higher credit costs. Even without further easing, these banks are forecast to have solid pre-provision profit and ROA/ROE.
HK banks: concerns over rising HKD LTD ratios In comparison, we are less excited about Hong Kong banks. Our 2.0% GDP growth forecasts for Hong Kong for 2012 is premised on a mild recession in Europe and slow growth in the US (c.2%) and our 8.5% forecast for China GDP growth. Hong Kong’s economy will be hurt by sluggish trade growth, with real goods and services projected to grow 2.1% and 2.2%, respectively, next year. Private consumption will be hit by weak local consumer confidence. Chinese tourist spending will eventually decline as the mainland’s economic growth decelerates.
Meanwhile, a rising loan-to-deposit ratio (LTD) for HKD assets and liabilities has raised concerns among regulators and bankers. From an investors’ perspective, we think the relevant issues are management of NIM and growth outlook of listed banks. While the HKD funding mismatch is itself an issue, there are some mitigating factors
First, consider a deceleration in the Chinese economy. This would eventually reduce Chinese corporate borrowings through Hong Kong. And coupled with weaker domestic loan demand in Hong Kong, total HKD loan demand would eventually decline. China’s slower growth rate would also change expectations that the RMB/HKD is a one way bet, and the amount of HK dollar savings converting into RMB deposits should also decrease. Thus, the uptrend in the HKD LTD ratio may not be sustainable, and may be eventually stabilized as the markets adjust to a slower growth environment.
Underweight HK banks: real issue is lack of growth
Funding cost is rising because of upward pressure on deposit rates, in some cases even exceeding home mortgage rates. In a decelerating economy, bad debt could rise rapidly, especially those in the SME sector. Although many of the negatives have been priced in and valuations seem cheap, Hong Kong banks lack a positive catalyst for sustained performance. Underweight. Gain exposure through large banks with liquid balance sheets, such as BOCHK.
Insurance: Neutral
Assuming China's benchmark interest rate stays at the current high levels, we are neutral on insurance. Over the long-term, agency force should be the key premiums growth driver. But near-term, solvency concerns and volatile equity markets are major risk factors. Within the sector, we prefer Ping An, which is in a better position to benefit from the channel transition in both the life and non-life sectors.
Hang Seng Index: Forecast to reach 21,500 by end-2012
We expect the HSI to end 2012 at the 21,500 level, which translates into 13% upside from current levels. Our new target is equivalent to 10.7x 2012 earnings. China/HK market earnings should bottom out in 2012 with 6.9% growth, followed by an 11% increase in 2013 (Bloomberg’s HIS consensus estimate could be more volatile than ours, as the former includes revaluation gains/losses). Our market earnings are premised on several economic assumptions, including a cumulative 300 bps cut in the RRR between now and Dec 2012, and the official interest rates remaining at current levels.
Although the HSI reacted positively to the first RRR cut by gaining more than 1,000 points, it is unlikely to be a sustained rally beyond 20,500 in the near term. The main downside risks we should be worried about, especially in 1H2012, include possibility of a deepening Europe recession and potential loan repatriation by European banks under de-leveraging exercises. For the HSCEI, our target is 12,030 based on 8.9x PE which is slightly above the current 8.2x. Our end-2012 target represents 17% upside from current levels.
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