“Outperformance from China is likely to continue”

Market Overview:

Equities:

The latest set of economic data shows that China’s recovery has gained momentum as COVID-19-related curbs are gradually rolled back, adding to the positive sentiment for Chinese equities amid global volatility. We think Chinese equities should continue to outperform compared to Europe or the US.

After three months of contraction, China’s economic activities have sprung back in June. Shanghai opened up from its two-month long lockdown and Beijing and other cities are relaxing its mobility restrictions to curb Covid-19 spread.

The official manufacturing purchasing managers’ index rose to 50.2, and the non-manufacturing PMI came in strongly at 54.7. Both indicators are above the 50 mark that separates growth from contraction for the first time since February. The Caixin/Markit manufacturing PMI also posted the largest expansion in 13 months to reach 51.7, above market expectations.

Figure 1: China Caixin Manufacturing PMI (Source: Trading Economics)

Following the release of the official data on 30 June the markets reacted positively, with the CSI 300 Index closing the day 1.4% higher, bringing the overall gain in June to 9.6%. Until the 4th of July, the CSI 300 held these gains, however, since then it has seen a slight pull back. The MSCI China index also performed higher in June, ending the month 5.7% higher, while global stocks dropped 8.6% over the month.

However, despite recent strong performance, Chinese equities are likely to stand out in the second half of the year compared to global equities. We maintain the most favorable rating for China among Asian equities as well.

Inflation remains a minor issue for China.

Majority of the economy is battling with inflation, the US CPI hit its 40-year high of 8.6% in May, and Eurozone inflation set a record of 8.6% in June. However, China disclosed its CPI of only 2.1% for May, in addition with the Core CPI of 0.9%. The producer price index was much higher, at 6.4% in May, dropping slightly to 6.1% in June. The PPI has come off from a peak of over 10% in 4Q21. We expect inflation to ease further in the next six months due to base effects.

Figure 2: China’s Consumer Price Index
Figure 3: China’s Producer Price Index

Because inflation is not a problem, China has breathing room to ease monetary and fiscal policies. While the rest of the world tightens, Beijing can remain accommodative in its monetary and fiscal policies. To revitalize the on-shore economic activity and lift employment following a very challenging April due to COVID-19-related lockdowns, the Chinese government has been cutting the reserve requirement ratio (RRR), medium-term lending facility rates, loan prime rates, and taxes and fees. It has also ramped up spending on infrastructure, directed banks to lend more to small and medium-sized businesses, and front-loaded the issuance of local government bonds. We see an additional 1–2 cuts to the RRR alongside more credit easing in the next six months.

Chinese equities are recovering; however, the progress might be bumpy.

China appears to be improving as the regulatory clampdown has seemingly ended and the real estate market may have bottomed with tail wins such as the backdrop of low inflation, easing of mobility curbs, and improving supply chain constraints. With valuations still at attractive discounts relative to the US market, we expect there is room for Chinese equities to catch up in the months ahead. However, we are expecting volatility caused by continuing lockdowns, and potential negative headlines relating to ADR de-listings.

Europe:

Eurozone PPI eases slightly in May. Eurozone industrial producer prices rose somewhat less than expected in May due to slightly lower energy costs. The producer price index (PPI) for the 27 Eurozone economies rose 0.7% month-on-month in May, following a 1.2% m/m increase in the previous month, according to Eurostat data published on Monday. Economists polled by The Wall Street Journal had forecast a 1.2% rise. While the latest Eurozone PPI may indicate a slight moderation in upstream inflation pressure, recent headline inflation from the Eurozone, which reached a record 8.6% in June, has done little to reassure investors that the threat of entrenched price rises has passed.

Our view: We believe a consistent decline in both headline and core inflation readings still remains a long way off, and that the ECB continues to face a significant challenge to bring inflation back under control. Following its recent hawkish rhetoric, we expect a first 25bps interest rate hike in July, a 50bps hike in September, and a 25bps at both the October and December meetings. With inflation likely to remain high for some time yet, and GDP growth continuing to slow, we think investors are well advised to shore up their portfolios by focusing on the defensive parts of the equity market, such as healthcare. Value sectors have historically also outperformed in periods of inflation above 3%.

ETF Connect another move to deepen financial integration. Investors in Hong Kong and mainland China gained access to some exchange-traded funds (ETFs) in each other’s market for the first time on Monday, via the newly activated ETF Connect program. The cross-border investment scheme has been long anticipated, with regulators agreeing in principle in 2016. Due to strict initial qualification rules, only four Hong Kong-listed ETFs were included, compared with 83 products from the much larger ETF market in Shanghai and Shenzhen.

Our view: The rules governing qualification include sufficient fund size and local-weightings, which is why only four Hong Kong ETFs made the initial inclusion. Still, of the 87 ETF Connect products in total, three of the top four by daily liquidity are in Hong Kong. We expect investors from the north to focus more heavily on the tech-oriented ETFs, which allow for indirect exposure to several of the larger tech names that are currently ineligible for single-stock Connect, while the same dynamic with indirect exposure may benefit select northbound ETFs. Over time, significant offshore volumes into Hong Kong’s index tracking ETFs may begin to influence liquidity and risk sentiment of the broader offshore market more directly. Chinese equities remain most preferred within our Asia strategy, and we favor cyclical/value sectors and reopening beneficiaries in the near term.

Trading Strategies:

We reiterate, in line with our views in the previous update over the past month, that it is crucial for China to reopen its economy in the summer (i.e., June/July period) as that would help ease some of the cost-pushed inflation that we have previously mentioned a few months ago. We warned of the risk of a re-tightening of measures exists should sudden spikes in infections occur and that seems like the case currently. However, all is not lost as the jury is still out and major lockdowns across China hasn’t emerge. In the nearer term, we believe the consensus view of 75bps rate hike in July is almost certain. What’s not is the US inflation data that will be released tomorrow, Wednesday and that will set the tone for global equities market.

Amid and despite what we believe as the two most pressing macro-overhang on Global Equities investors currently face (i.e., the renewed risks of lockdowns in China and runaway inflationary risks in the US and globally), the Equities market, China/HK market in particular, remains a bright spot among major asset classes. As reiterated in our previous investment meetings, we currently favour HK/China Equities while we see value emerging in the US should inflation numbers come under control.

Major near- and longer-term themes to focus: (i) to continue to monitor the progress of Chinese economy reopening; (ii)further policy support to achieve full year 5.5 GDP growth target; These includes infrastructure buildout across the nation, subsidies on auto sales for individual buyers, cooped up domestic demand for consumer spending, domestic travel:

1. Overall, continue to favour Value over Growth stocks against a backdrop of uncertainty over the Fed’s control of inflationary risks and rate hikes, developments in US-Sino relations as talks progresses as well as the on-going developments of the Russian-Ukraine war;

2. Despite the recent rally in certain sectors, we maintain mid-longer-term overweight in Banks (Singapore banks) on longer term rate hike cycle theme; Chinese Telcos (defensive with dividend), Chinese Autos (in particular EV related themes) and Chinese Healthcare. These sectors are fundamentally attractive over the longer term and may consider accumulating on major pullbacks; Unless inflation shows signs of abating in the US, ie. take cue from US July inflation data, we remain Neutral on US equities overall with a cautious view on US Technology sector on valuation grounds. Should inflation data show positive signs of abating, we believe investors can then consider to allocate a little more to US equities;

3. Overall, continue to employ more tactical short-term trades in order to capture opportunities arising out of ongoing market volatility; put on partial hedges as well as hold a sufficient level of cash in the portfolio (no less than 15%) to remain defensive and to stay nimble amid continued market volatility.