Expect China to continue on its upward trajectory despite recent wobbles

Chinese equities had a rough start to the year with domestic equity markets plummeting more than 20 per cent. Offshore Chinese equities fell less, but the MSCI China Index still dropped by 15 per cent. Investor confidence deteriorated on continued macroeconomic weakness, near 2 per cent depreciation of the RMB (CNH broke RMB6.7), and concerns over looming equity supply with the revival of A share IPOs and the temporary ban of major shareholders selling about to expire.

Onshore market weakness was further exacerbated by the circuit breaker system which was officially implemented at the beginning of year. The system, which suspends trading for 15 minutes when markets rise or fall by 5 per cent, followed by complete halt at +/-7 per cent, was triggered twice in January. Initially put in place to manage volatility, the breaker mechanism in fact aggravated market instability. Following the sharp declines, regulators decided to extend the major shareholder lock up for another six months and remove the circuit breaker system all together.

Fourth quarter 2015 GDP growth came in at 6.8 per cent YoY, slightly below expectations of 6.9 per cent YoY, bringing full year 2015 GDP growth to 6.9 per cent, down from 7.3 per cent in 2014. December industrial production growth softened to 5.9 per cent YoY, fixed asset investments dropped to 8.2 per cent YoY, while retail sales growth held flat at 11.1 per cent. External trade improved with December trade surplus rising to more than $60bn, but sceptics raised suspicion on artificial invoicing to participate in CNY/CNH arbitrage opportunities and suggested higher capital outflow pressures based on the strong trade surplus. Naysayers dominated headlines, pointing to China’s economy growing at below target growth and at the slowest pace in 25 years.

Not much attention was given to the fact that the world’s second largest economy has ballooned to over $10tn, and near 7 per cent growth on such a high base is nothing to scoff at. Furthermore, while industrial sector growth slowed to 6 per cent YoY, growth in the more dominant tertiary sector in fact accelerated to 8.3 per cent YoY. The service sector now accounts for more than half of the economy at 50.5 per cent, a full 10 percentage points higher than manufacturing. Economic rebalancing has been achieved with consumption contributing to two-thirds of GDP growth. 

Currency weakening has become consensus, and this adjustment is reasonable following the 20 per cent plus appreciation in adjusted effective exchange rate over the last decade. We are projecting 5-10 per cent depreciation against the dollar for the coming year and a more stable, low single digit decline in effective exchange rate terms. Currency volatility was somewhat front loaded with speculators trying to profit from the discrepancy between CNH and CNY rates, and the People's Bank of China (PBOC) has taken measures such as imposing a standard 17 per cent reserve requirement on CNH deposits with offshore bank in the mainland to tighten CNH liquidity so that CNH/CNY trade more in line with each other.

Moreover, the government is committed to managing the currency against the China Foreign Exchange Trade System trade weighted basket over US dollars which is more reflective of its global economic ties and provides for greater currency stability going forward. Similar to the overreaction last August to the PBOC’s announcement of a tweak to the daily fixing mechanism, global panic over a relatively small depreciation can be blamed on poor communication and lack of transparency on the part of Chinese regulators rather than unexpected deterioration in fundamentals. Which begs the question, when China sneezes, will the world catch pneumonia?

Admittedly, currency weakening increases capital outflows which present added pressures to domestic liquidity as we head into Chinese New Year. To this end, the PBOC has actively engaged in several rounds of injection, providing more than RMB1.2tn (€180bn) short to medium liquidity via reverse repos and lending facilities with plans for net injection of RMB2tn before the long holiday. The government has ample means to resolve liquidity challenges including huge room to cut reserve requirement ratios, which they have yet to do this year.

Chinese authorities may become gun shy after witnessing extreme market reactions to what should be considered relatively small changes in policies. They are in somewhat unchartered territory, managing a much larger and more developed economy in globally linked, open markets. Not unlike parenting teenagers, there is an aspect of learning to loosen the reins and governing by trial and error. We are confident that with a solid base and a strong framework for growth already established, China will emerge to become a leading global economic power despite hiccups along the way. For 2016, the reform focus is on reducing outdated capacity and oversupply, which may lead to some asset deterioration in the banking system. This will not derail its upward trajectory. China will successfully transform from a low labour cost, low value-added manufacturing hub to an upgraded economy with a large and dynamic service sector and state-of-the-art technology and knowhow.

The sharp market pullback this year offers an attractive entry level to equity investors. Valuations are very compelling at over one standard deviation below 10-year averages, with MSCI China Index trading well below 9x forward earnings and CSI300 down to 11.5x2016 earnings. We are preferential to new economy and service sectors with strong secular growth, where we continue to find high double-digit earnings growth even as overall economic growth continues to slow to 6-6.5 per cent. We also see good values in traditional industries, which stand to benefit from structural reform and policy response. We believe expectations in general are overly pessimistic, and returns will surprise on the upside as the cycle turns. And it will turn.

Anthony Cragg, senior portfolio manager of the Wells Fargo China Equity Fund at Wells Fargo Asset Management