For Chinese Stocks, It's Back to Basics

 | Feb 09, 2017 | 10:00 AM EST
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The reform of China's bloated state-owned enterprises will be a key factor to watch in 2017, equity strategists say. It may cause short-term problems over credit and jobs, but should lead to long-term economic stability.

The sea change throws up several stock plays in the basic materials sector that are met with new-found enthusiasm among equity strategists. Reforms and the promise of greater government spending have caused both Barings and CLSA's equity strategist, Chris Wood, to become bullish in those areas.

Wood, in his look-ahead for 2017 given this week, notes that he recently moved to overweight on Chinese H shares, Chinese companies trading in Hong Kong, having traditionally been underweight China stocks. His key reason for optimism is that growth in China's domestic production, as measured by its producer-price index (PPI), has turned positive for the first time in years. 

China's PPI accelerated from 3.3% growth, year on year in November to 5.5% in December. That's the highest level since September 2011, and marks four months of straight gains. There's a very strong correlation between growth in producer prices and growth in the overall economy.

China's gross domestic product will get a boost because the government will be spending on infrastructure projects in the year ahead, Barings believes. Fresh stimulus, government bonds and public-private partnerships should all drive economic growth, particularly in the first half of the year.

Supply-side reforms and that kind of fiscal spending should be good news for the coal, steel and cement industries. The new infrastructure projects also cause re-stocking in areas such as construction materials and heavy machinery.

Wood includes companies in those industries in his long-only thematic stock portfolio for Asia ex-Japan. Among Chinese coal producers, he highlights the country's largest coal producer, China Shenhua Energy (CSUAY) , which also generates thermal power and transports coal.

China Communications Construction (CCCGY) , which builds ports, roads, bridges and railways, is his favorite play in the infrastructure sector. He turns to Maanshan Iron & Steel HK:0323 for exposure to the steel industry. Its metal products are used in construction, home appliances and automobiles.

For tech stocks, he includes Sunny Optical Technology  (SOTGY) , which produces optical products and scientific instruments, and mobile-gaming giant Tencent (TCEHY) as his favorite Chinese Internet play.

Barings shares Wood's enthusiasm for companies producing raw metals and products used in infrastructure and construction.

"If the success of supply-side reforms is more long term, there is every chance that the long-term growth prospects of these companies would receive a significant boost," it states in its Investment Insights for the new Chinese lunar year. "And this is why we are more constructive on the cyclical industries and materials sectors than we have been in some time."

It remains to be seen, though, whether that momentum can continue into the second half of the year, when external pressures may take a toll. The new U.S. president's tough stance over China continues.

Donald Trump has yet to share a telephone call with Chinese counterpart Xi Jinping. Trump sent Xi a letter saying he wanted "to develop a constructive relationship that benefits both the United States and China." He then wished him a happy Year of the Rooster -- two weeks too late.

Is the China criticism bluster? Probably.

"I've been assuming that Donald Trump's talk about protectionism is more threat than reality -- he likes to negotiate," Wood says. "Are these hard-ball negotiating tactics or protectionism? Right now, it's not clear. But it's not discounted in current financial markets if he is protectionist."

Barings is taking a "wait-and-see" approach on Trump, despite the new president's ostensible antagonism towards China. The uncertainty over the new administration's stance on trade, currencies and domestic fiscal policy will create opportunities for bottom-up stock pickers, the fund manager believes. 

"In the Year of the Rooster, deft investors up with the dawn will find a wealth of long-term growth prospects in Chinese equities," Barings says.

There has been plenty of concern over China's current account and the decline in its foreign-currency reserves, which have dipped below "only" $3 trillion for the first time in nearly six years. In response, Beijing has been introducing new capital controls, and the central People's Bank of China has been tightening monetary policy.

That's a potential negative for Chinese equities -- but is outweighed. "I'm looking at the PPI going positive as a bigger positive than the negative PBOC tightening," Wood says.

The production cuts in industries like coal and steel, as part of the state-owned enterprise reform, mean the stresses in China's banking system are reducing, not increasing, Wood continues. Several senior government officials have been upbraided for failing to meet steel-production targets, showing a high level of policy support for reforms. The pickup in commodity prices has added more wind to the sails for those industries.

Chinese stocks are showing volatility, reflecting the various whims that take Trump and his administration. The MSCI China index fell 7.1% in the fourth quarter amid doubts over Trump's approach, but has since rebounded 8.8%.

The largest China-focused ETF, the iShares China Large-Cap ETF (FXI) , has underperformed, up 7.5% year-to-date. But the iShares MSCI China ETF (MCHI) has actually outperformed, up 9.7%, similar to the SPDR S&P China ETF (GXC) , up 9.4%.

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