A Fast-Growing Economy
With gross domestic product of approximately $8 trillion, China is one of the world's fastest-growing economies, with growth rates averaging 9 percent over the past 30 years.
We maintain a view, which is largely the consensus view, that China will experience a gradually slowing economic expansion over the coming years as the government focuses on transitioning its economy from export driven to consumer driven. Even though China’s growth is slowing, its base has gotten so large that it will likely contribute more to global growth this year than when it grew at a double-digit pace 10 years ago.
The Chinese government already lowered growth forecasts from 7.4 to 7.0 percent, but said the 7.0 percent number would be difficult to reach. That’s the slowest growth in 24 years. Analysts are predicting something in the mid-6 percent range. Growth in the area of 6 percent would likely result in more stimulus and lower interest rates.
The second reason we like China is valuations. Emerging markets are trading at steep valuation discounts to the developed world. On a price-to-book value basis, they are trading at only 65 percent of the multiple of developed-world stocks. This 35 percent discount is the deepest in 12 years. As recently as November 2011, they sold at a premium.
Further, the market seems to think that the Federal Reserve has issued a reprieve on rate hikes. Its March meeting left the timing of a first U.S. rate rise dependent on data (which has looked weaker of late), and caused many to push back their forecasts for rising rates. Emerging market stocks have outperformed since the Fed news.
Asia’s economy is looking better, both in comparison to itself over the past couple of years and compared with the rest of the world. Within the region, Southeast Asia appears most attractive, with economies in that part of Asia generally growing faster.
In our opinion, China has the most favorable valuations in Southeast Asia and all of the emerging market.
Its earnings yield stands at 9.0 percent, its 10-year yield is 5.90 percent, with 7.3 percent GDP growth. That translates to a growth-adjusted relative valuation score of 10.4 (earnings yield – 10 year yield) + year-over-year change in real GDP). Only Norway scores higher on a growth-adjusted relative valuation measure. The U.S.’ is 5.3, or roughly half of China’s.
The Significance Of A-Shares
Due to capital and foreign-ownership restrictions, China remains underrepresented among global investors’ portfolios.
When you fully include A-shares capitalization in the emerging market indexes, China’s portion immediately jumps from 20 to 30 percent. MSCI will decide in the next 12 to 18 months whether to include A-shares in its EM indexes. If it does, this will be accomplished over a number of years, probably in 5 percentage point to 10 percentage point increments.
If so, this represents a huge, steady and growing passive demand for Chinese shares.
There are 50 or so companies listed in H-shares in Hong Kong and A-shares in mainland China. The A-shares of these companies sell at a 30 percent premium to H-shares. The premium has gone as high as 40 percent, and the lower end is 10 to 15 percent.
We think the key to thinking about this is that H-shares are undervalued, and if you believe in the China story, the H-shares look like good value, even though relaxing the foreign-ownership restrictions mostly benefits the A-shares.