China-US détente eases investor fears

• The meeting between President Trump and President Xi in April removes a cloud hanging over the equity market.
• This comes at a time when fears over debt levels have been well discounted, while growth appears to have stabilised nicely at a relatively high level. Furthermore, corporate earnings are starting to surprise positively.
• As long as the apparent mood of compromise set by Trump and Xi persists, investors are likely to feel increasingly confident.

The results of Donald Trump’s meeting with Xi Jinping in Beijing last April alleviated the worst fears provoked by the protectionist rhetoric and aggressive posturing that characterised the new US president’s election campaign. Just a month later, a 10-point package was announced that was promoted as ‘an early harvest’ from a 100-day plan to reset the trade relationship between China and the US. [1]

Some of China’s concessions, such as its agreement to open its market to US-owned payment processors and credit rating agencies, were dismissed by critics as having been already more-orless settled. However, China’s commitment to resume US beef imports and quicken its approvals of genetically modified crops struck an encouraging note, as did a reciprocal US resolution to encourage exports of liquid natural gas to China, allow imports of cooked poultry from the country, and extend by six months a ‘no action letter’ to the Shanghai Clearing House for failing to register derivatives-related operations with the US authorities. [2]

These indications of co-operation rather than confrontation should encourage investors and help stimulate cross-border direct and portfolio flows between the world’s two largest economies, although it is difficult to identify outright winners and losers from the summit’s pronouncements. President Trump even seemed to endorse President Xi’s ‘One Belt, One Road’ project, usually viewed as a threat to US strategic interests, by sending a delegation to a major summit on the scheme held in Beijing on 13 May.

That the two leaders could have a positive dialogue should also serve to contain the downside risk scenario on the geopolitical front. This is particularly important at a time when North Korea is pushing ahead with its nuclear weapon ambition, and South Korea is responding with the deployment of the US-made THAAD missile system much to China’s displeasure. The Xi-Trump friendliness also struck a good balance to the heightened sense of geopolitical competition between the two superpowers, particularly after the recent ‘pivot towards China’ by President Duterte of the Philippines.

STABILIZED GROWTH OUTLOOK

This comes at a time when investors are beginning to feel less nervous about the Chinese economy. Moody’s downgrade of China’s credit rating from Aa3 to A1 barely registered with Chinese stock prices, as concerns about the country’s shadow banking system and fears over escalating debt levels have already been persistently flagged over the last few years.

Certainly, there are problems in the Chinese economy and international investors face hazards when entering the market, such as governance and transparency issues. There is also uncertainty about the actions of regulators, whose clumsy attempts to stem the market collapse in the summer 2015 are still a disturbing memory.

On the other hand, China has a booming middle class that will continue to grow over the next decade. It remains a high-saving, high-investment economy that is on track to surpassing GDP growth expectation of around 6.5% a year for the second year running. Recent economic data continue to suggest an economy that is firmly on track for a robust soft landing, upon which corporate earnings may yet see upgrades as we progress into the next 12 months.

A CHANGING MARKET

The two largest constituents of the MSCI China Index are now Tencent and Alibaba, which together carried close to 28% weighting (source: Bloomberg, 29 June 2017). In fact, so-called ‘new economy’ stocks already account for close to 40% of the Index. This is a transformational change from five years ago and investors should not continue to view China equities with the same set of risk schemas. The broader and ‘energised’ index, coupled with a shift in policy mindset towards sustainability over the pace of growth, should mean that risk perceptions are likely to moderate when updated.

Despite consensus earnings per share growth of around 12-13% per annum over the next three years, the MSCI China is still trading at 13.5x for 2017, declining to 10.5x in 2019 (source: Bloomberg, 29 June 2017). Such valuation leaves considerable room for the current rally to extend itself driven by both growth and potential re-rating.

International investors have greater opportunity to benefit from China’s continued rise. As long as the apparent mood of compromise set by Trump and Xi persists, investors are likely to feel more confident about raising their allocations to China stocks, and increasing exposure to the country’s new economy sectors.