With China moving away from the fixed asset investment-led growth towards consumption-driven growth, more traditional sectors like steel-making, materials and coal mining have taken a hit.
Moreover, the new leadership has got tough in its fight against corruption and has been clamping down on conspicuous consumption. This has affected the sales of a wide range of goods and services, from banquet services to high-end luxury goods.
China’s new leaders are aware of an urgent need to rebalance the economy and to promote more inclusive growth. Hence, the bold blueprint outlining a series of reforms for the next decade that was unveiled at the Third Plenum in November.
These reforms will require a high level of support from the local governments and various ministries, as well as Chinese companies. As a result, we believe there will be some inevitable challenges arising in the short term. However, we have faith that once China overcomes these obstacles, it will embark on a new path to growth that is more balanced and sustainable.
Another factor weighing on the recent performance of Chinese stocks is the overall concern about the financial services sector, banks and trust companies in particular. Investors are worried about NPL ratios of banks and the risk of contagion in the shadow banking sector.
In absence of clarity on these issues, the valuations of the financial services sector will remain suppressed, though the current low valuations may have priced in many macro risk factors.
The Chinese government is well aware of the concerns that are weighing on investor sentiment and the People’s Bank of China has begun injecting liquidity into the system through some short-term lending instruments. This should help ease investor concern and restore confidence, at least partly.
The evidence is that the Chinese government will continue to drive its reform agenda forward and this may work as a steady source of positive drivers for the equity market.
For example, the state owned enterprise (SOE) reforms, that were unveiled in November, are expected to increase efficiency and capital deployment within the SOE sector as well as enhance corporate governance and redistribute economic drivers more towards the private sector.
In addition to discouraging the misallocation of resources and capital, these SOE reforms are designed to help accelerate social security reform in China. We also expect the ROE and dividend payout of the overall market to increase over time. As logical investors, we need to take note of the valuations in the market. As of end-December 2013, offshore Chinese equities were trading at levels around one standard deviation cheaper than their historical average and also stood out as attractive on a regional basis.
In 2013 we saw a wide divergence in the performance of Chinese equities at a sector and stock level, unlike risk on/risk off markets we have experienced in previous years. It increasingly looks like China is no longer a beta play but more a stock picker’s market.
While the overall market performance in 2014 will likely be driven by policy and will depend on the balance between reform and growth, there are several pockets of potential interest.
There are investment opportunities in environmental protection-themed stocks, as China's leaders are eager to promote the 'Beautiful China' theme by reducing emissions and increasing the efficiency of energy use. We also see major investment opportunities arising within the new energy sector, namely solar, wind, natural gas as well as hydro power.
We are also positive on the automobile sector, as we believe that strong car sales’ momentum will likely be sustainable in the next few years, as the demand will move from low-end to high-end vehicles.
Within financials, we believe distressed asset managers and brokerage firms that are involved in new kinds of financial innovation may benefit from the reforms implemented by the Chinese government.
Following their rally in the past year, defensives are at extreme valuations, even higher than the levels they scaled in 2008. So we see much better value among cyclical stocks and financials in 2014.
Mandy Chan is head of Chinese equities at HSBC Global Asset Management
