According to a December 7th report from HSBC Global Research, China is likely to bounce back in 2016. HSBC Head of HK/China Equity & China Equity Strategy Research Steven Sun argues for “slower but higher quality growth” in 2016. He says that China will probably manage to balance near-term demand-side stimulus with supply-side reforms to begin to unlock its long-term growth potential as it transitions to the “new economy”

Sun summarizes his perspective in the introduction to the report: “We look for 20%+ upside in H-shares, driven by mean reversion of valuation. Growth stabilization, fresh reform momentum, and a lower risk free-rate will lead to a re-rating. Foreign fund inflows may resume, aided by clarity on the US Fed’s fund rates, China’s capital account liberalization and the cheapest valuation globally.”

Highlights of HSBC report on China stocks in 2016

The HSBC report emphasizes that from a macroeconomic perspective, the transformation in China’s economy is on the fast track. Sun says that balanced demand-side stimulus and supply-side structural reforms planned for the 13th Five-year Plan (2016-20) will lead China stocks and the Chinese economy forward.

He also argues that “new” economy China stocks will probably outperform in 2016, and notes that HSBC is currently overweight on the financial, IT, healthcare, and selected consumers and investments sectors.

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Sun highlights the four Chinese policy priorities of reducing over-capacity, lower business cost, shrinking property inventories and minimizing financial risk. Keep in mind that HSBC reduced its China GDP forecasts to 6.7% from 7.2% for year end  2016 and 2017 respectively due to slow fiscal expansion and weak external demand. The HSBC team is also calling for a 50 bp rate cuts and 400 bp RRR cuts by the end of 2016

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Of note, although current earnings forecasts for Chinese firms for 2016 and 2017 are relatively positive, Sun argues that they will probably be revised downward due to the impact of the banks, energy and materials sectors. The downward revisions, however, “should be moderate after the 12-15% cut y-t-d. We think H-share EPS growth may be largely flat for 2016e and around 5% for 2017e. Similarly, MSCI China’s EPS growth should be around 5% and 10%, respectively for both years.”

Sun is calling for a 20%+ move up in Chinese H-shares, largely “driven by mean reversion of valuation.” He also argues that growth stabilization, new momentum towards important economic reforms and a lower risk free-rate will all add up to a re-rating for the country. Moreover, foreign fund inflows may even pick up again given increased insight into Fed fund rates, China’s capital account liberalization and a relatively cheap global valuation.

Last but not least, Sun also notes that sentiment has improved and volatility is dropping in Chinese H shares. He argues that value stocks and large caps are likely to come back into favor in the current economic climate.

That said, he also notes the temporary banning of major shareholders from selling shares will expire next month, which could well lead to selling pressure for small cap Chinese stocks, particularly given IPO registration reform will probably be launched in 2016 and the Shenzhen-Hong Kong Stock Connect could be operational as soon as the first quarter of 2016.

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The December 7th report also introduces HSBC’s 2016 China stocks index targets: MSCI China 72, SHCOMP 3,900, CSI300 4,200, HSCEI 12,000, HSCCI 4,600, and HSI 24,500. Sun points out that these targets suggest a potential upside of between 9% and 20% for Chinese equities in 2016.

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