What's next after the sell-off? Hong Kong and China equities update

Despite the coronavirus outbreak and the oil price slump, offshore Hong Kong and China equities have been resilient, with the MSCI China Index outperforming the MSCI World Index by over 12 percentage points. Furthermore, the Shenzhen Stock Exchange Composite Index is one of the world’s most resilient indexes this year.¹ In light of the changing investment backdrop, we’ll share our views on some of the investment themes that have been affected by the recent uncertainty, such as consumption, and provide an update on our secular long-term themes. 

In an early effort to contain the virus, the Chinese government extended the Lunar New Year holiday, introduced quarantine measures, and imposed travel restrictions. As a result, factory production and new orders in the country collapsed to record lows in February;² therefore, it won’t be a surprise if the first-quarter earnings of China’s corporates are negatively affected. It’s now mid-March, and we can already see a gradual and orderly resumption of industrial production in 90% of the country’s provinces (excluding Hubei).³ In addition, supportive policies from the government—such as lowering benchmark lending rates, suspending corporates’ Social Security payments, and the potential for further fiscal stimulus with new infrastructure projects—imply that the impact of COVID-19 on China’s economy should be relatively limited this year.

As the COVID-19 outbreak has now spread across the globe, earnings forecasts for Chinese equities have declined to 8%.⁴ Nevertheless, investors should continue to see investment opportunities in companies that have the potential to deliver solid earnings growth over the next two to three years. 

Seasoned investors used the recent sell-off as an opportunity to reinforce high-conviction ideas and avoid names that could be exposed to more downside risks. In view of the global COVID-19 outbreak, investors should fine-tune their focus within the consumption sector with a cautious view of travel- and tourism-related names and a positive view of firms in the domestically driven consumption services space. We believe there may be more negative surprises from travel-related sectors in the first quarter and the remainder of the first half of this year, as restrictions on movement are being extended globally and are expected to remain in place for the next few months.

The recent commodity market tumble has fanned the flames of an already volatile stock market. U.S. Brent crude oil collapsed by as much as 34% on March 9, after Saudi Arabia shocked the market by launching a price war against Russia.⁵

We believe investors should maintain a defensive approach to the energy sector:⁶

• From a tactical perspective, it makes sense to be cautious in the upstream energy sector, particularly oil companies.
• Avoid petrochemical-related commodities.
• Remain selective in indirect investments in downstream utilities, such as domestic gas distributors, which are expected to be net beneficiaries of the lower gas prices, which, in turn, may boost consumption.

Despite this uncertain backdrop, we believe the key secular trends that form the basis of our three investment themes remain unchanged. 

1. Consumers’ consumption upgrade
   
   We believe the current market volatility presents a good buying opportunity in the following sectors: education, property management, and other omnichannel-driven e-commerce names. For example, growth in the penetration rate of online education hit its highest level in more than a year due to school closures. Leading providers are exhibiting clear competitive advantages by merging offline learning with online sessions. This is largely due to scale, an ability to ramp up online content in a timely manner, and high execution capabilities. We don’t believe these structural changes in consumer behavior will be reversed when the overall situation normalizes. Property management service is another area where structural growth should persist. The gross floor area for properties under management in the residential and commercial space is expected to increase by 10.1% and 16.0%, respectively.⁷ This will translate into robust demand for quality property services, and we believe that top-tier property managers with good execution capabilities will gain market share in the medium term.
   
   
2. Research and development 
   
   There’s been talk of an approved COVID-19-related vaccination within the healthcare space, but we think that speculative opportunities such as this will be short-lived.
   We acknowledge that while governments need to speed up the approval process for vaccines and virus-related drugs, the approval of other medications (e.g., cancer drugs) may be delayed. Nevertheless, the investment case for healthcare remains solid; the sector is supported by an aging population and unmet medical needs. Investors should continue to focus on biotech and medical equipment companies, where import substitution, favorable government policies, and industry consolidation will allow high-quality winners to surface. Outsourced research service providers (contract research organizations) that don’t bear the financial risks of the research, but could enjoy the ongoing growth in demand for biotech research and development projects, could also be appealing. 
   
   
3. Technology
   
   Our interest in companies that will benefit from the rollout of 5G services remains in place, as we believe that 5G ecosystems will be a prominent theme in Chinese equities. Investors should continue to capture this thematic opportunity from multiple fronts, including upstream equipment, semiconductors, downstream handset components, big data analytics, and cloud services. Close attention will also be paid to valuation levels along the entire supply chain, and we’ll be on the lookout for quality firms that might have borne the brunt of indiscriminate selling in the broad-based market sell-off. 

The COVID-19 outbreak is undoubtedly causing a great deal of uncertainty among investors that’s translating into heightened market volatility. However, by remaining calm and looking through the near-term disruption, we can see that current events may not necessarily weigh on China’s economic and earnings growth. As such, investors should focus on the longer-term investment themes that are designed to provide stable and secular growth.

1 Bloomberg, as of March 16, 2020. Year-to-date index price returns in local currency: MSCI China Index: –15.11%; MSCI World Index: –27.80%; Shenzhen Stock Exchange Composite Index: –0.63%. 2 Caixin/Markit Manufacturing Purchasing Managers’ Index, February 2020. 3 Hong Kong Economic Journal, March 17, 2020. 4 Bloomberg, March 17, 2020. In this instance, China equities refer to the component companies of the MSCI China Index. 5 Bloomberg, March 10, 2020. 6 Manulife Investment Management, March 10, 2020. 7 Estimated compound annual growth rate from 2018 to 2023, sourced from CNInsights, China Property Management Association, January 2019.