2019 midyear outlook—Greater China equities

After greater China equity markets recovered in the first quarter of 2019, the escalation of trade tensions between the United States and China in May once again dominated market sentiment. Although higher tariffs and the surrounding boisterous rhetoric drew the most market attention, we believe the real story for investors is the Chinese government’s strategic support for its own economy, both over the short term and long term, to aid its transition to a consumer-based, value-added economy.

Overall, equities in China have held up relatively well in recent months, primarily due to Chinese government monetary and fiscal policies. The People’s Bank of China has adopted an accommodative policy stance, cutting the reserve rate requirement for banks and maintained ample liquidity amid volatile markets. The government has also progressively unpacked its fiscal policy toolbox to make it less expensive for companies to conduct business and for consumers to retain more of their income. Indeed, businesses benefited from numerous policies, including the three-percentage-point cut in the value-added tax (VAT) at the highest tranche and a reduced pension contribution rate for employers³ that will lessen the cost of doing business in China. The country’s property⁴ and infrastructure⁵ sectors have also benefited from preferential government policies.

At the same time, the Chinese economy has benefited from ongoing economic restructuring and structural reforms through alleviating pollution in cities and improving the health of industries plagued by overcapacity. In addition, some enterprises have strengthened their ability to pay down debt, which in turn has bolstered the financial system, enabling the banking industry to record the lowest problem-loan ratios in five years.⁶ In our view, these measures have put China’s economic fundamentals on better footing than they were just a year ago.

These improved fundamentals were reflected in corporate earnings. During the first quarter, insurance and consumer staples companies delivered better-than-expected results, and we believe that the insurance sector is bottoming out after a sharp slowdown in 2018. Many insurers have sold more protection policies, resulting in strong VNB growth (value of new business growth, which measures the value of an insurer based on the level of new business achieved over the past year) and improving margins, and that momentum should continue for the rest of the year. Some consumer staples companies are seeing gross margins improve as material costs drop.

After the release of first-quarter corporate results, markets began revising up estimates. The market was originally expecting double-digit earnings growth for FY2019. Although tariffs are likely to shave two to three percentage points off earnings in 2019 and 2020,⁷ respectively, we believe corporate China’s bottom line will hold up over the short term. We believe that in the second half of the year, government measures to help mitigate the economic impact from China-U.S. trade tensions will provide support to Greater China equities, although we anticipate continued market volatility.

While focusing on short-term developments can be important, following daily market gyrations closely and the volatility of the bilateral trade talks can obscure the bigger picture. Amid the recent volatility, we held on to our long-term belief that many attractive opportunities exist in China’s transition to a more consumer-based, value-added economy.

Indeed, even before bilateral trade tensions escalated, we were already planning for “the day after tomorrow” and we selected three long-term investment themes that we believe will benefit from China’s gradual economic transition:

• Research and development (R&D)/innovation—China’s government and corporations have put increasing emphasis on R&D and innovation to improve competitiveness. This shift isn’t new: Companies have increased R&D investment under the 13th 5-year plan (2015–2010),⁸ but the emphasis has clearly accelerated as trade tensions have led to the United States to ban Chinese imports of certain intermediate goods, changing global supply chains. We believe Chinese companies will continue to invest more in this critical area, particularly basic research, as a means to move up the value chain. We’re constructive on upstream technology, industrial applications, and the country’s burgeoning healthcare sector.
• Policy driven—China’s government has identified several key policy areas as targets for fiscal spending over the long term. Environmental protection, which includes supply-side reform, natural gas, waste-to-energy, and wastewater treatment, are key areas that will continue to receive government support. As the government unveils further measures, we’ll remain vigilant to identifying the next key beneficiaries of government support.

With these themes in mind, we view protracted China-U.S. trade tensions (in some form) as a structural feature of the market landscape moving forward. The implications of recent trade policies, particularly the decision to restrict Chinese technology companies’ access to U.S. suppliers, have injected greater uncertainty into the Chinese investment landscape. Even if the trade sanctions are ultimately removed, we believe the bifurcation of global technological supply chains into two camps—the United States and China—is a real possibility that may potentially bring about short-term pain, but also serve as a long-term catalyst for Chinese companies to boost their competitiveness on a more urgent timeline.

When the fog of uncertainty stemming from U.S. policies finally dissipates, we expect significant opportunities to emerge for investors, and when they do, we believe they’ll fall into the themes we’ve already identified.

1 Bloomberg, June 14, 2019. 2 A market correction is generally defined as a decline of 10% or greater in the price of equities from its most recent peak. 3 “China is plugging pension hole by tapping into US$25 trillion in equity in state-owned enterprises,” South China Morning Post, May 21, 2019. 4 “New home prices rise in almost all Chinese cities as lower mortgage rates, lighter restrictions spur demand,” South China Morning Post, May 16, 2019. 5 “China infrastructure stocks climb as Beijing offers support,” Financial Times, June 11, 2019. 6 China Banking and Insurance Regulatory Commission, May 10, 2019. Problem loans are defined as special mention loans and nonperforming loans. 7 Morgan Stanley, May 14, 2019. 8 The 13^th 5-Year Plan (2015–2020) set a goal of R&D expenditure reaching 2.5% of GDP by 2020. In 2018, R&D expenditure accelerated to 2.18% of GDP, according to the National Bureau of Statistics of China, as of February 28, 2019.