China continues the shift towards rebalancing its economy
China’s announcement Tuesday that it was increasing its one-year lending and deposit rates by a quarter point suggests the start of an overt shift towards the rebalancing of its domestic economy. In addition, it should help China manage the large scale inflows that have begun in anticipation of the next round of US quantitative easing (QE2). While risks have indeed risen with the announcement, cyclically low valuations, reasonable earnings expectations, and continuing strength in the renminbi suggest that the risk-return profile of Chinese equities remains attractive.
Many may choose to interpret Tuesday’s surprise move as a threat to the growth momentum of the Chinese economy. Though headline reports will focus on the equal increase in both the one-year lending and deposit rates, of more interest is what has occurred in longer-term deposit and lending rates. Here, the margin has narrowed. In other words, yields on deposits have risen by more than yields on lending, effectively increasing the income of savers, creating a disincentive at the margin to shift savings into more speculative investments such as a equities or property.
While such a move may be helpful as China attempts to divert a greater portion of the large pool of savings towards consumption rather than speculative investments, China’s announcement may also help its efforts to combat the impact of large capital inflows on its economy.
Thus, yesterday’s move may represent China’s initial response to the issue of accelerating capital inflows. In other words, in addition to helping to achieve the more permanent policy objective of economic re-balancing, the increase in rates in China may also serve to mitigate the potential inflationary impact of excessive capital flows by channelling a portion of them into longer-term savings and averting the large bubbles in real estate and equities seen in previous cycles.
Chinese equities remain underpinned
For Chinese equities, Tuesday’s tightening may limit the potential for a large rise in price-to-earnings (PE) multiples, as seen in 2006-07 following the original floating of the renminbi. However, investors should not solely focus on the impact on valuations. It is also important to consider Chinese domestic policy and global liquidity trends, as well as valuation and earnings, when determining the outlook for Chinese equities through 2011.
Indeed, as highlighted in a previous Daily Theme, the underperformance and absolute declines in Chinese A-shares through the first half of 2010, despite strong economic growth, can largely be attributed to the combination of aggressive domestic tightening and incrementally tighter global liquidity (with the end of US quantitative easing in March), as well as rich valuations and overly optimistic earnings expectations.
With growth having moderated significantly from late-2009/early-2010 levels, we believe the case for another round of aggressive Chinese tightening remains weak. Moreover, valuations are still sitting near cyclical lows, in contrast with the cyclical peaks of late 2009, leaving limited scope for a significant compression in price-earnings (PE) ratios in our view. Moreover, with modest consensus earnings expectations now in place for 2011, the risk of disappointment likewise appears limited.
Investment Outlook
The key risk to our supportive outlook for Chinese equities is that our positive view on liquidity conditions proves overly optimistic, and earnings multiples compress rather than stabilise around current levels. While this risk has admittedly increased after China’s announcement yesterday, on balance, even with a less supportive domestic liquidity environment than expected, we continue to believe that the risk-return profile of Chinese equities remains attractive looking into 2011.
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