Now that the US and China have agreed to begin easing trade tensions, the fog over China’s markets is starting to lift. Investors should consider Chinese equity opportunities that have been overlooked because of tariff fears.
While the trade war is far from over, the Phase One trade deal reached on December 13 represents an important truce between the US and China after 18 months of escalation. Full details haven’t been officially confirmed, but it was widely reported that under the agreement, the US won’t impose 15% tariffs on $160 billion worth of Chinese goods that were scheduled to take effect this week. China also agreed to cancel tariffs it had planned for US imports. US tariffs on another $120 billion of Chinese goods will be cut in half to 7.5%. US tariffs of 25% on another $250 billion of Chinese goods are unchanged and will be the subject of trade talks next year.
According to the deal, China will buy more American agricultural products in exchange for a reduction of tariffs. However, there is still no change to the US ban of major Chinese technology groups such as Huawei and ZTE. While agreement was reached on technology transfer protocols between the US and China, we believe tensions over the use of technology between the two economic powers are likely to persist.
The truce doesn’t resolve some of the deeper structural problems between the two countries, such as intellectual property protections. Friction over these issues is likely to persist regardless of who is in the White House after the 2020 election. Still, we think this new interim deal is an important step forward. It removes some uncertainty over trade, avoids a near-term escalation of the US-China trade dispute and could mark the start of a path towards some short-term easing of tariffs.
What Does It Mean for China?
Even after removal of some trade hurdles, China’s economy still faces major challenges. China’s GDP is expected to grow by about 6% in 2020, a slowdown from an estimated 6.2% in 2019. The deceleration in China will likely continue, especially in the context of a broader global macroeconomic slowdown.
In this environment, China’s government will probably continue to implement countercyclical policies. These include mild, ongoing monetary-policy easing as well as fiscal stimulus support, especially in areas such as local infrastructure.
Government support for the domestic Chinese technology industry will also continue, in our view. Given the US crackdown on Huawei and other tech sanctions, China can be expected to press ahead with efforts to wean itself from American-made components by promoting the development of domestic technology suppliers. So even in the context of a trade truce, we believe China’s push to localize tech components will continue.
What About the Stock Market?
Chinese stocks have performed well this year, despite the uncertainty that prevailed before the truce. The MSCI China A onshore index rose by 30% in local-currency terms through November 30.
Decelerating economic growth hasn’t spoiled Chinese corporate earnings. For listed companies on the domestic A-shares market, earnings are expected to grow by 16.7% over the next 12 months—3.3 points higher than emerging-market earnings growth and more than double the pace in developed markets—according to consensus estimates. Profit growth is particularly strong in sectors such as consumer staples, communication services, technology and real estate.
But market valuations—particularly for A shares—have been suppressed by investor pessimism about the prospects for a trade resolution. The price/forward earnings ratio of the China A market was 12.0x before the deal was announced. That’s slightly cheaper than the MSCI Emerging Markets Index trading at 12.2x P/FE and a 28% discount to the MSCI World Index of developed-market stocks.
Attractive valuations and a supportive policy backdrop underpin the China equity opportunity. In the vast onshore market—with more than 3,000 stocks worth a combined $7.8 trillion—we believe investors can find solid sources of return potential by applying deep fundamental research to uncover undervalued high quality companies with strong earnings momentum. These include companies that were largely unaffected by the trade war yet whose shares were discounted because of a general aversion to Chinese stocks amid the tensions. Some companies that were directly in the trade crossfire also deserve attention because their business dynamics may improve as the truce begins to take hold and tariffs are lifted. Good candidates can be found in in industries such as:
- Technology and Telecom—Global and Chinese efforts to upgrade networks to 5G technology have been rattled by Huawei’s travails, as the company is a major manufacturer of 5G telecom equipment. But Chinese manufacturers of printed circuit board (PCB) materials and optical components are racing to fill the supply gap left by the US ban. Shengyi Technology is the largest supplier of copper clad laminate, a key material for PCBs, and is working closely with Huawei. Accelink Technologies and Zhongji Innolight are suppliers of optical components that may also stand to benefit from the localization trend.
- Construction Machinery—Even amid the Chinese slowdown, strong demand for construction machinery persists. The industry is being supported by replacement demand, increasing infrastructure spending driven by fiscal stimulus and compulsory regulatory upgrades to emission standards for new machinery from 2020. Sany Heavy Industry, a leading excavator manufacturer, and Zoomlion, one of the largest crane and concrete equipment producers, both have large and growing market shares in China and globally, as well as high margin businesses driven by their large-scale businesses and effective cost control.
- Animal proteins—China’s meat industry is in turmoil amid an outbreak of African swine fever. That started in August 2018. The disease has led to the culling of 200 million hogs, about 40% of the country’s swine herd. As a result, wholesale pork prices have more than doubled this year. And the impact has been global, with US hog future prices jumping since the summer because of reduced supply in China, the world’s largest consumer and producer of pig meat. Higher pork prices are boosting the profitability of some pork suppliers such as Wens Foodstuff Group and New Hope Liuhe. Meanwhile, the shift to other animal protein sources has benefited Chinese chicken producers such as Fujian Sunner Development.
- Home appliances—Chinese home appliance makers, buttressed by the vast domestic market and greater efficiency after a decade of intense competition and consolidation, are the largest in the world today. As leaders in white goods—from washing machines to refrigerators to air conditioners—these companies have aggressively expanded in international markets, often through acquisitions of celebrated brands in developed markets. While white goods still face US tariffs of 25%, if the truce ultimately leads to more reductions in US tariffs, we believe these companies will capture more international market share. For example, Haier Smart Home will be able to leverage its vast global supply chain to improve efficiency at the acquired GE Appliances businesses in the US.
- Textiles—Many global companies have moved textile manufacturing away from China to cheaper markets such as Vietnam and Indonesia. Higher tariffs accelerated this trend. While some of this shift is structural, reduced tariffs may help some Chinese textile companies to keep more business from moving to other competing markets.
In recent years, China’s A-shares market has been opening to foreign investors. Major international indices such as MSCI are adding more Chinese stocks. Progress toward partial resolution of the trade tensions should help international investors regain confidence to increase positions in Chinese stocks with positive business dynamics and clear cash-flow drivers.
- John Lin
- Portfolio Manager—China Equities
- Stuart Rae
- Chief Investment Officer—Asia Pacific Value Equities
John Lin is Portfolio Manager of China Equities at AllianceBernstein (AB).
Stuart Rae is Chief Investment Officer of Asia-Pacific Value Equities at AllianceBernstein (AB).