Chinese equities have risen steadily higher in 2017 in a stealth bull markets, despite $700 billion in capital flight last year, a fall in the renminbi to 6.90, periodic liquidity squeezes in the Shanghai money market, draconian credit controls, a 166 per cent corporate credit/GDP ratio and President Xi's consolidation of power over the Beijing Politburo. The world's smart money, stung by horrific losses in Chinese equities in August 2015 and January 2016, is still underweight China. Fund managers in New York, London and Singapore own the lowest holdings of Chinese equities relative to benchmarks since 2006.
The macro bull case for China makes tactical sense. As producer price inflation and industrial commodities prices rise, the cash flows, profits and collateral value of China's state owned enterprises also rises. The National People's Congress rubber stamped Premier Li's 6.5 per cent GDP growth target. The renminbi has stabilized at lower levels. Beijing has achieved a geopolitical rapprochement with Washington after Trump's Taiwan gaffe and threats to launch a trade war. The Yellen Fed's de facto temporary tolerance for US inflation above two per cent at the March FOMC is US dollar bearish and thus bullish for the MSCI emerging market index, which is 27 per cent weighted in China. Chinese bank loan growth and EPS momentum has begun to accelerate Capital controls and PBOC rate hikes have also stabilised the renminbi. No wonder the Chinese large cap index fund is 39 as I write. The Middle Kingdom is making money for investors even as Hong Kong's Hang Seng index broke out above 24,000. As the world's largest crude oil importer, China even benefits from the recent nine per cent fall in Brent and West Texas black gold.
I find the risk reward calculus in Chinese bank shares, the cheapest international lenders in Asia (with good reason) compelling at current levels. China's Big Four banks are on the eve of a multi-year earnings cycle as net interest margins improve and corporate non-performing loan ratios decline, primarily in China's rapidly consolidating industrial sector. As the PBOC tightens monetary policy in response to Fed moves, a steeper yuan money market yield curve will fatten Chinese bank interest rates spreads and weaken "shadow banking" rivals. With minimal dependence on international wholesale funding markets due to its 25,000-plus branch network in the Mainland, a loan/deposit ratio of only 65 per cent and a valuation of less than six times forward earnings makes the Agricultural Bank of China, founded by Great Leap (famine) Forward and Cultural Revolution iconoclast Chairman Mao Tse Tung, a no-brainer.
I agree with Morgan Stanley and Dr Mark Faber's enthusiasm for China Construction Bank, thanks to its cheap valuation (six times earnings, five per cent dividend yield, 0.9 times book value), strong balance sheet above peer 15 per cent returns on equity and vast retail banking network.
Other than banking, Chinese Internet shares offer some of the world's most profitable online media and growth e-commerce franchises. Tencent Holdings (700 Hong Kong) runs the world's biggest mobile messaging and social media platform, with 800 million users (no typo here; 800 million users), WeChat. As in the West, online advertising is migrating from desktop PCs in China to smartphones. Nomura estimates online advertising on social media networks will grow at a 62 per cent compound rate in the next three years. Tencent, with at least a 50 per cent market share of Chinese online ads, is the hyper-growth social media of the zeitgeist, not the overpriced, moronic, overhyped Snap IPO I dissed a month ago that has flamed out on Wall Street.
I was fascinated by Morgan Stanley's comparative valuation of Internet cloud storage firms, given that cloud will be a foundation technology for the human race in the coming decades akin to electricity. I was not surprised to see Morgan Stanley flag Alibaba, given its 50 per cent market share in the Chinese public cloud, now a mere $2 billion or two per cent of the global market, clear evidence that is one of technology's embryonic hypergrowth niches. Alibaba could well grow its public cloud business by 80 per cent per annum in the next five years. Alibaba cloud revenues were $1 billion in 2016 but could rise 10 times in the next four years. Is this scenario remotely priced into Alibaba shares on the NYSE even at $100? Absolutely not. Jack Ma rocks!
The writer is a global equities strategist and fund manager.
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