HSBC: A-shares will rock on to 2010

A-shares may have gone up by 80% year-to-date, but it's still premature to call for a correction. On the contrary, fund managers at HSBC in Shanghai and Hong Kong say the economic fundamentals are likely to support further corporate earnings upside. The A-share market may very well rock into next year.

In particular, George Yan, investment director at HSBC Jintrust, a JV of HSBC Global Asset Management in Shanghai, is debunking a popular theory that says stimulus cash is all that is propping up the show in China. He asserts the same argument against relaxed lending standards by the country's commercial banks, which some commentators have warned will lead to higher non-performing loans later in the year as banks lend to the country's industries already battling excess capacity.

Around 70% of new loans made by the commercial banks have been directed towards government infrastructure projects, with the bulk of the rest going into supporting industries, where valid credit checks are now stringently applied, notes Yan's colleague Richard Wong, investor director at Halbis, part of HSBC Global Asset Management in Hong Kong.

Wasteful lending for the purpose of supporting employment in China is a by-gone practice of the 1990s. Today it is unlikely that the banks' balance sheets will deteriorate overnight, despite the government's push to encourage credit expansion. Most so-called policy banks have since been listed in the domestic and Hong Kong markets, where they are held accountable to shareholders to deliver economically sound business results.

Since the government implemented its regulatory overhaul of the banking sector in 1999, non-performing loan ratios have rarely exceeded 2-3% on an overall basis, Wong says.

Instead, the government is expecting its stimulus plan to work like this:

The first wave of the stimulus cash may well have leaked into Chinese equities and property, but it is in the second wave of cash where the 'wealth effects' will be generated; where improved sentiment for fixed asset investments and consumption will cycle through to boost domestic demand.

The government's Rmb4 trillion stimulus package has effectively taken up the slack from falling corporate fixed-asset investments. Since February 2009, recovery has begun in domestic demand. Overall economic growth has since accelerated, exceeding most forecasts.

Yan says that, although government spending can't cancel out the slump in exports, the importance of exports to China's GDP growth may have been overstated.

Wong takes up this argument by noting that net exports account for just 8.3% of GDP input, but actual growth drivers are found in domestic demand and investment. This is why real incomes in China have grown 12% this year so far. Coupled with new tax incentives, companies in the consumer, discretionary and auto sectors have benefited and their share prices have rebounded.

Quoting JP Morgan's estimates for 2008, Wong says household consumption makes up 34.6% of the country's GDP; government spending 14.8% (discounting the Rmb4 trillion stimulus program); and total investments 42.3%, of which foreign direct investment accounts for less than 10%.

Even against a global slump in demand, Wong points out, China actually recorded positive GDP growth. The strong growth of the stock markets is based on a legitimate mix of good economic fundamentals. There is evidence enough that there is plenty of room for earnings growth at Chinese corporates that may last well into 2010.

For now China's credit expansion is modest compared to the West's. Loan growth is up by just RMB7.4 trillion in the first half of 2009. Most companies are not leveraged like US companies were going into the crisis. China is home to the world's largest pool of household savings and government reserves. The loan-to-savings ratio at banks hovers at about 66%. The banks are more than sufficiently capitalised to finance the next round of lending.

 A-shares have gone up by close to 80% so far this year. But investors could expect more. Yan says with expected earnings growth factored in, A-shares could hardly be called over-valued at this stage.

A further boost to the A-share market is coming from a removal of the supply overhang caused by the unlocking of non-tradable shares. Market reforms have led to the unlocking of non-tradable shares, and during 2007 and 2008, a lot of shares were being converted and dumped into the open market. Now this frenzy has subsided.

Another encouraging factor is the popular support that the re-opened IPO markets have thus far demonstrated. The new supply has not unnerved investors. Instead, IPOs have been well sought after.

Yan and Wong say movement in the Chinese market is now influenced by internal dynamics, not simply because of a correlation in global equities. As long as China's economic fundamentals are strong, stocks will do well. (H-shares, on the other hand, are not isolated from global trends or US market performance.)

Wong favours consumer, auto, discretionary, property, cement, and infrastructure-related stocks. He is neutral on financials, and is underweight exporters. Yan is positioning for the eventual rise of inflation and recommends banking and property stocks, as well as clean energy technology plays.