Cheap valuation is not enough for a China rally

Shanghai/Singapore: The last time China’s stocks were this cheap in 2008, the benchmark index rose 83 per cent in a year.

Now is different as policymakers struggle to reverse the worst economic slowdown in more than a decade, the most-accurate strategists say.

While the Shanghai Composite Index trades at 11.4 times the earnings of China’s biggest companies, the lowest level since at least 1997, economists predict the world’s second-largest economy will grow at its slowest annual pace in 13 years.

Investors anticipate the government will lack focus on the slowdown as the Communist Party prepares for a once-in-a-decade leadership transition.

Haitong Securities strategist Chen Ruiming, who correctly predicted on August 1 the index would fall below the 2,000 level, says the measure is poised to drop a further 14 per cent to 1,800 this year.

China’s stocks will end down for a third year, according to Bank of Communications’s Hao Hong, the only forecaster among 13 strategists surveyed by Bloomberg at the start of the year to predict declines for equities in 2012.

Falling interest rates and increasing copper prices — which foreshadowed the rally in 2009 — aren’t predictive this time around, David Cui, chief China strategist at Bank of America Corp, said. He sees more losses for the index after saying on February 22 that it would slump to 2,100 by year-end. The measure dropped 0.8 per cent to 2,069.74 at 1.59pm local time.

“These signals are only indicative of a market turnaround if and when there are signs of a genuine turnaround in economic growth and the prospect of sustained improvement in corporate earnings,” Shanghai-based Cui wrote in emailed comments on September 25.

“Right now, things appear to be still heading downhill and the market cannot figure out where the bottom is.”

The Shanghai Composite tumbled 34 per cent from its November 2010 high to 2,086.17 on September 28, the most among benchmark equity gauges in 21 developing nations tracked by Bloomberg. China’s financial markets were closed for holidays last week, when the MSCI All-Country World Index advanced 1.6 per cent.

The Shanghai gauge’s price-to-earnings ratio has dropped to 11.4 from an average 24 during the past decade and a 2007 high of 46, according to data compiled by Bloomberg. The MSCI Emerging Markets Index is valued at 12.6 times profit, while the Bovespa index in Brazil, the second-biggest emerging market after China, trades for 18.8 times.

Jonathan Garner, chief strategist for Asia and emerging markets at Morgan Stanley in Hong Kong, sees “significant undervaluation” in China and recommends material, energy and consumer discretionary stocks that will benefit from the largest economies in the world easing monetary policies.

Goldman Sachs Group’s Jim O’Neill says Chinese stocks are the most attractive among the so-called Bric nations that include Brazil, Russia and India as China’s leaders foster changes to boost consumption and reduce the economy’s reliance on exports. MSCI Inc’s Index of the largest emerging market economies will rise as much as 20 per cent next year, O’Neill said.

“Going forward, the Chinese authorities are really going to ensure that the broader-income consumer, the broader middle-income groups in China are the ones that are really going to benefit most,” O’Neill, who oversees about $700 billion (Dh2.57 trillion) as chairman of Goldman Sachs Asset Management, said in a phone interview from London on Friday. Consumer stocks as opposed to commodity shares will benefit most from the Chinese economic growth next year, he said.

Bears say the new government won’t change policy soon enough to make shares attractive.

Data for the past two months point to a deepening slowdown after manufacturing contracted in September, imports unexpectedly fell in August, industrial output expanded at its weakest pace since May 2009 and industrial companies’ profits dropped for a fifth month. Policy makers cut their expansion target to 7.5 percent from the 8 percent goal in place since 2005, Premier Wen Jiabao said on March 5.

China’s economy may grow at a 7.7 percent pace this year, according to the median forecast of 45 economists in a Bloomberg survey, which would be the slowest rate since 1999. The GDP report is scheduled to be released Oct. 18.

“The economy will still be down,” Haitong’s Chen said in a phone interview from Shanghai on Sept. 25. “The only way for the market to improve is to allow a natural adjustment within industries - allow for companies to restructure, be acquired or go bankrupt.”

Trading Accounts

The People’s Bank of China reiterated last month it will pursue a “prudent” monetary policy, scotching speculation of interest-rate cuts, while the official Xinhua News Agency said on September 12 “massive stimulus” would be detrimental to growth.

The central bank has refrained from easing monetary policy since rate cuts in June and July and a May reduction in banks’ reserve requirements. The government has been reluctant to lower rates further amid concern inflation will quicken and more liquidity will re-flate the property bubble.

Since 1996, the Shanghai Composite has advanced nine times out of 13 in the three months after the central bank lowered borrowing costs. The index jumped 17 percent in the three months after a December 2008 rate cut.

This time, the Shanghai Composite has fallen 9 per cent since June 7, when the government announced the first of two rate reductions. The combined drop in deposit and lending rates is 56 basis points.

A third year of equity losses has spurred local investors to empty trading accounts.

The number of Chinese stock accounts containing funds dropped by 1.1 million to 56.1 million in the year to September 21, the most for a 12-month period.

Leadership change

“The whole market is very pessimistic,” Shi Weixiang, strategist at Shanghai-based Guotai Junan Securities, the nation’s third-biggest brokerage by revenue, said in an e-mailed interview on September 21.

At current valuations, “there’s more opportunity for the market to gain,” said Shi. Guotai Junan predicted the slump in China’s stocks in 2010 and 2011 before turning bullish this year.

Delegates from the Communist Party will gather in Beijing starting November 8, when they are forecast to anoint Vice-President Xi Jinping, 59, and Vice-Premier Li Keqiang, 57, as the so- called fifth generation in charge, to replace President Hu Jintao and Premier Wen.

“China’s equity market is now trading much closer to prior trough valuations and should exhibit better performance after the leadership transition and as growth picks up next year,” said Morgan Stanley’s Garner.

Sany Heavy

The Shanghai Composite’s price-earnings ratio fell to as low as 11.8 in November 2008. The gauge rallied 83 per cent during the next 12 months as the government announced a $585 billion stimulus package, reduced borrowing costs by 216 basis points in three months and cut the amount of reserves banks must set aside to 15.5 per cent to bolster the economy as the global financial crisis curbed demand for exports. Gross domestic product recovered from a 6.2 per cent expansion in the first quarter of 2009 to a 9.2 per cent pace for the full year.

A gauge tracking industrial companies on the CSI 300 Index rallied 72 per cent in the two years to 2010 amid an unprecedented credit expansion that boosted infrastructure spending. The measure has slumped 13 per cent this year, the second-worst performer among the 10 industry groups.

Sany Heavy Industry, China’s biggest construction equipment maker, has plunged 23 per cent in 2012 after rallying 163 per cent in 2009.

The stock traded at 7.9 times reported earnings last month, the lowest on record.

Tax Cuts

A rebound in copper prices hasn’t foreshadowed gains for stocks this time around because China, the world’s largest consumer of metals, isn’t buying as much as in the past, Hong, BoCom’s managing director for research, said on Sept. 21.

In 2009, copper prices surged 140 per cent in London, while the Shanghai index had an 80 per cent advance.

Last quarter, copper prices jumped 6.8 per cent, while the stocks gauge dropped 6.3 per cent.

“Investors had expected the economy to stabilise in the first half and rebound in the second half and this didn’t happen,” Chen Li, UBS AG’s head of China equity strategy, said in a phone interview on September 27. “From the third quarter, it’s obvious the economy is still deteriorating. The economy’s slowdown is much worse than expected.”

For stocks to rise, the government needs to take more fiscal measures because monetary policy steps such as interest- rate cuts haven’t been effective, Hong said.

“Tax cuts would be great and any form of genuine tax relief would be welcomed by the market big time,” he said.

BofA’s Cui said investors need to see the government tackle the fundamental issues facing China’s growth, including reforming state-owned enterprises and the tax system.

“I don’t think stimulus or loosening is the path to investors’ heart,” Cui said.

“Reform is.”