With the Federal Reserve’s (Fed) rate cut expectations heating up, the current market environment is starting to benefit emerging market equities, including the China A-share market. Starting from 6 February, the A-share market continued to rebound, from the 2600-point range to the 3100-point mark. On 5 March, the Report of the Work fo the Government basically continued the policy tone set by the Central Economic Work Conference last December, restating an "around 5%" economic growth target for 2024.
In this article, Thomas Fang, Head of China Global Markets at UBS, and James Wang, Head of China Equity Strategy Research at UBS, shared insights about the outlook of the Chinese stock market and how to build a portfolio while market stabilizes.
Q1: After the short-term rebound, does the A-share market still need fundamental and policy support?
Thomas: The sharp fluctuation of the A-share market early this year was less correlated with fundamentals. With solid A-share earnings and decent overall industrial profit growth in the fourth quarter of last year, as well as a supportive policy tone, the sharp fluctuation of the A-share market early this year was more due to liquidity disruptions.
Taking into account of the active regulatory interventions before and after the Spring Festival, the A-share market’s overall liquidity has improved significantly. Coupled with overseas investors’ extremely underweight position in China and the historically low valuation of A-shares, UBS believes that the A-share market is likely to continue to rebound in the short-term.
Northbound funds recovered sharply, with a net inflow of over RMB40bn in February, rarely seen in nearly a year. Prior to the Chinese New Year, the tighter control of securities lending, the restriction of DMA quota, and the continuous purchases of ETFs by Central Huijin, China Securities Finance Corp (CSFC) and the State Administration of Foreign Exchange’s (SAFE) investment platforms have stabilized the market and attracted more retail fund inflows. According to UBS’s estimate, the Year-to-date net inflow in the A-share market through ETF purchases by Central Huijin, CSFC and the SAFE's investment platforms may have exceeded RMB410bn billion, of which CSI 300-linked ETFs accounted for about three-quarters.
We note that since February, Northbound funds have reversed a net outflow trend, accumulating a net inflow of about USD7bn so far, but the majority of funds came from trading funds and index-tracking investors; the medium and long term active funds are unlikely to reverse course in the short-term, given large losses and pressure from holding Chinese equities in the past 1-2 years, geopolitics and the appeal of other regions.
However, the medium- to long-term development of the stock market still requires the continued stability of China's economy and further policy support. In addition, the confidence of local medium- and long-term investors in particular, needs to be solidified in order to usher in a long-term bull market. In my view, the market’s ups and downs are normal, and China's capital market should stick to self-improvement, demonstrate steadfastness in management, respect market rules and regulations, and strengthen the protection of the legitimate interests of all types of domestic and foreign investors, so that the world's second-largest capital market can play a critical role in the effective allocation of resources and the price discovery of high-quality enterprises.
Q2: Under this circumstance, how would you advise investors to construct a "barbell” portfolio that is not only defensive but also offensive?
James: We believe Chinese equities’ risk-reward is skewed to the upside as MSCI China is currently trading at a historically low valuation and investor holdings are light.
In the short-term, given some macro uncertainties, UBS previously preferred a high dividend yield portfolio, as they should benefit from potential fund inflows from insurers and the national team. The previous focus on the "valuation system with Chinese characteristics" has also been related to this.
Within high dividend yield stocks, we include companies that have some earnings growth. In the past this strategy outperformed a pure, defensive high dividend yield strategy.
In addition to the defensiveness, as UBS remains bullish on the medium-term outlook of the market, I am optimistic about two approaches that constitute the portfolio’s offensiveness. Firstly, is property-related sectors, including state-owned developers, property management and home appliance companies, because these companies themselves are still relatively good despite the subdued property sector. In addition, if the entire stock market is to experience a fundamentals-driven rebound, a prerequisite is that the property sector needs to stabilize, and property-related sectors should be among the first batch of beneficiaries.
Secondly, UBS is also bullish on a basket of leading companies in various industries, the so-called "core assets". UBS chose 20 sector leaders. We find that the average return-on-equity (ROE) of these companies would be around 20%, and each company has positive cash flow. So theoretically, these companies should outperform the broader market every year. Indeed, this portfolio has outperformed MSCI China every year in the past decade. Of course, this portfolio outperformed more notably when the market flourished, while delivering largely in-line or slightly better performance when the market weakened. This is because this portfolio contains high-dividend-yield sector leaders such as those in the commodities and power sectors, most of which also generated high growth.
Overall, this portfolio has complementary components catering to different market environments. When the market declines, it has some defensiveness, and can significantly outperform when the market trends up. If we look at the price-to-earning (P/E) valuation of this portfolio relative to MSCI China’s historical valuation trough, from a portfolio perspective, we feel that this portfolio as an offensive option has great value for money.
Q3: What is medium to long term focus on fundamentals and value for money of the valuation?
James: In the longer term, UBS is focusing more on sector fundamentals and value for money of the valuation over the next 12 months.
UBS remains most bullish on the internet sector. We have recently seen internet companies' margins start to pick up as regulation normalizes. Companies themselves are also very motivated to boost shareholder returns, for instance by raising dividends and buying back shares. These moves will boost their long-term ROE. Regulatory pressure has also eased recently. As a proxy of the private sector, internet companies should also benefit from some policy tailwinds for the private sector.
In addition, on a 12-month horizon, selected consumer sectors are also the focus of UBS. "The main reason is that consumption remains an important driver of economic growth in the medium to long term, and some companies are still resilient, such as automobiles and film box office, most of which have seen their valuations fall to historical lows.
UBS believes consumption would slow somewhat this year. Given an undeserved valuation slump plus a resilient, slow recovery in consumption, UBS is also bullish on companies whose share prices fell excessively last year, such as food and beverages, beer, sportswear and restaurants.
Meanwhile, UBS is also bullish on the outlook of after school tutoring (AST). After the rectification in 2021, the industry is becoming more regulated. Meanwhile, AST demand from residents remains strong. Moreover, the related industry is less correlated with the macro cycle. Although relevant companies gained a lot last year, in the medium- to long-term, UBS remains bullish in the industry’s prospects.
