Markets likely to head down before a Fall rebound — China’s policy-makers have begun performing the delicate balancing act of reforming the economy and at the same time ensuring growth does not stall says Minggao Shen of Head of Citigroup’s China Research in a new report. He notes that the road to rebalancing growth will be bumpy, borne out by the recent Shibor spike. He therefores expect a choppy 2H13 for the markets within a wide range, darting up on reform hopes and darting down on growth concerns. Amid uncertainties, the markets could fall further before rebounding when clarity on reforms emerges. More from the report focusing on Chinese GDP growth and potential roadblocks along the way.

China Debt GDP Ratio

  • Overweight sectors less sensitive to GDP growth — We recommend sectors that have low leverage ratios, resilient earnings growth and those that stand to gain from reforms. We therefore Overweight consumer staples, low-end discretionary sectors, property, and healthcare. Distressed valuations are another reason to long these sectors, but they could go lower before stabilising. We are Neutral on banks and utilities, and Underweight cyclical sectors – energy, materials and telecoms.
  • Fear triumphs hope for now — Overcapacity, unsustainable local debt and credit dislocation have spooked investors. Come Oct 2013, China’s decision-making ability and policy moves will come under closer scrutiny. The delicate balance between growth and reform may force the government to switch policies between defending growth and boosting reforms. The economy may test 7% growth in the next 12M if China starts de-leveraging and clamping down on shadow banking.
  • Period of adjustment has only just begun — Given the complexity of the coming reforms and the changing global environment (Fed tapering), recent policy and liquidity shocks could just be a prelude to what lies ahead in the reform process. Investment slowdown and local government defaults are major risks alongside possible de-leveraging. Global trends suggest that the investment growth rate could halve once the investment-GDP ratio peaks. China may be near that tipping point.

Citi China Top Picks

China’s GDP growth may test 7% in the coming 12 months, attributable to overcapacity, unsustainable local debts, credit dislocation, and possible missteps and slow responses on the policy front. Structural reforms (such as interest-rate liberalization, a clamp-down on shadow banking and elimination of overcapacity) could be rolled out by the Chinese government in coming months in its bid to rebalance the economy, but the near-term impact on growth could be negative.

China Evolution of Growth Engines

China Grow And Reforms

Slow growth will precede improvements in its quality. The reform package to be rolled out in October 2013, if decisive, could surprise the market and investors could look beyond any near-term economic impact. However, reforms are likely to be gradual and investors will worry about further weakness in the economy and markets before turning positive. The delicate balance between growth and reform may force policy-makers to switch policies from defending growth to boosting reforms. Growth cannot be too slow and reforms too fast. It also remains unclear whether the coming slowdown will trigger more stimulus or reform. Such uncertainties will leave investors battling between hope and fear, as detailed in our 2013 Road Ahead report.

We Now Expect MSCI China To Finish The Year At 60

The recent liquidity crunch has created some overhangs. The policy shock may have hurt the risk appetite in the market, resulting in a higher risk premium, which has stalled the bond market since late June. Given the complexity of the coming reforms and the changing global environment (Fed tapering), such policy and liquidity shocks could just be the start of many more to come for China. Investment slowdown and local government default are two risks. Global experience suggests that the investment growth rate could halve once the investment-GDP ratio peaks.

China may be near that tipping point. The cost of borrowing for local governments may rise as a result of the clampdown on shadow banking. In our China Road Ahead 2013: A Battle between Hope and Fear, we argued that the market could rebound from its 2012 low due to expected economic recovery.

That rebound was cut short by weaker-than-expected growth. We now expect MSCI China to finish the year at 60, plunging to new post-GFC lows before rising again this Fall. We expect its PE to touch around 7x from the current 8.5x if growth slows down in coming years. Nevertheless, it will be a choppy market, in our view, alternating between growth fears and reform hopes in coming years. If the market returns to 0.5SD below the 2010-12 average level with 9% earnings growth in 2013E, our targets for MSCI China, CSI 3000 and Shanghai A index in 2013 would be 60, 2500 and 2300 respectively. For 2014, the targets would be 69, 2900, 2700, assuming 5% earnings growth and average valuations of 2010-12.

Overweight Sectors With Low Leverage Ratios

We overweight sectors with low leverage ratios, resilient earnings growth even in a slow-growth environment, and favourable policies (e.g., channeling more liquidity into the private and consumer sectors, hukou reform, and interest-rate liberalization).

We overweight downstream sectors, including property, consumer staples, selected consumer discretionary (autos and home appliances), IT, clean energy, and healthcare. We are neutral on banks and industrials, and underweight materials, energy and telecoms.

Growth Trends Down

7.5% GDP growth target could be missed

The artificial liquidity crunch in June suggests that the Chinese authorities may attempt to address the core problems in the economy at the cost of slower growth. The Chinese leaders could push for de-leveraging going forward, which may drag down GDP growth further from its recent low last year. China has 7.5% as its GDP growth target for this year, but it could miss it for the first time in the past two decades. In our view, China should be able to defend 7% growth in the near term, barring policy missteps.

Traditional growth drivers are facing new constraints

China’s growth momentum continues to weaken. Its year-to-date growth has been mainly driven by strong infrastructure investment, whose growth rate since 2010 has been the strongest thanks to the launch of new projects since late last year (Figure 1). In line with our expectations, the property tightening measures introduced in March have not been fully implemented, supporting the c.20% investment growth in the sector. Export growth has fallen to its lows since the global financial crisis, consistent with the flat growth in global trade in the first five months of the year. None of these growth drivers can sustain

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