January 21, 2013 11:03 am

Cheap stocks and reform hopes lift China

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Blink and you may have missed it. The rally in mainland Chinese equities has gone so far, so fast, that many investors risk being left behind.

Just a few weeks ago, when Chinese shares in Hong Kong were already flying, mainland stocks were stubbornly grinding lower. Analysts speculated that one of the two markets would have to crack. In the end it was Shanghai that turned.

Since falling to a three-year low in the first week of December, the Shanghai Composite has increased 18.4 per cent to a seven-month high, while trading volumes have spiked to their highest levels since early 2011.

The Hang Seng China Enterprises index of H shares – mainland companies listed in Hong Kong – has gained 34 per cent in a rally that started in August and comes amid a broader move into emerging market equities across the globe. So why did Shanghai, long immune to events elsewhere in the world, finally capitulate?

Perhaps the most common reason given for the rise in Chinese equities is simply that they got too cheap. In late November, the Shanghai Composite index dropped below 2,000 points for the first time in three years, pulling the price to estimated 2013 earnings ratio for the index down to 8.4, compared with a five-year average of 13.9 times. Bank and brokerage stocks, which have been leading the recent rally, were under particular pressure.

“Demand for Chinese equities will come because they are cheap not because there will be some big surprise on earnings,” says Gary Dugan, chief investment officer for Asia and the Middle East at Coutts. “It’s a market that could double, and you could still say that’s reasonable value.”

Those low valuations have helped equities emerge from a year of living in the shadow of wealth management products. Such products – offered by banks and trust companies – typically promise investors 5-7 per cent in interest for an asset seen as risk-free. But, as fears over the trust industry have grown, many wealthy individual investors have been tempted back to the stock market, says Howhow Zhang, head of research at Z-Ben Advisors.

China’s economic outlook has also brightened. Indicators in the manufacturing sector began turning positive during the summer, and improvements in trade data, industrial production and retail sales have followed. In the last quarter of 2012 the Chinese economy finally stopped slowing , data released on Friday showed.

While international investors have been quick to seize on the better data, as shown by the rise in H shares, domestic investors may simply have taken longer to be convinced that the economy is really improving.

The successful leadership transition in Beijing has also played a part, as have efforts by regulators to limit supply and increase demand for stocks. The China Securities Regulatory Commission, led by chairman Guo Shuqing, relaxed restrictions on overseas investment into mainland equities back in June. Mr Guo said last week that foreign investment quotas could be increased tenfold, comments which fuelled a 3.8 per cent one-day jump in share prices.

In late December, the CSRC eased rules on overseas listings, in an attempt to shorten the queue of nearly 900 companies waiting to list on the mainland. The market for initial public offerings in Shanghai and Shenzhen remains closed.

Guo Shuqing is “on a mission to restore confidence... under his rule things will improve”, says Arnout van Rijn, chief investment officer for Asia at Robeco. “Things are afoot so that equity investors... are no longer short-changed.”

However, some analysts are now cautioning that the best of the China rally may already be over. HSBC’s China equity strategist Steven Sun has a target for the Shanghai index of 2,500 by the end of 2013, implying growth of less than 10 per cent from its current level.

And while economic data have improved, there are doubts over how sustainable the recovery will be. Many China analysts believe the economy will once again trend lower during the second half if the government is forced to step in to control inflation or resurgent house prices.

Investors are also concerned about potential downward earnings revisions by Chinese companies, and the risk that equities run aground amid an information vacuum ahead of Chinese New Year and the pending final stage of the power transfer due in late March.

Others warn that significant reforms will be slow in coming. “[With] heightened expectations about the new leadership, markets have high hopes [about reform]. I think they will be disappointed,” says Paul Chan at Invesco. “

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