Buy on China skepticism

Widespread skepticism about the power of monetary policy at the outset of easing cycles can provide great investment opportunities. Despite clear lessons about the effects of central bank activism in the US in 2009, Japan in 2012 and Europe in 2014, international investors still doubt the quality of the bull run in China’s onshore stock markets ignited by the People’s Bank of China.

As a result, even though the Shanghai A-share market has climbed 66% in six months, repeatedly setting new sevenyear highs on elevated turnover, the H-shares of Chinese companies listed in Hong Kong have failed to keep up, rising a comparatively meagre 29% as foreigners have held back from the market.

International investors do not question the potential for a sustainable rerating of Chinese assets because they doubt the PBOC’s commitment to reflation. It’s just that most think they can afford to wait. In recent years, the knee-jerk response to aggressive central bank easing has been currency depreciation, which initially at least has offset the contribution of any stock market rally in international benchmarks.

Although Chinese A-shares are not included in benchmark indexes, the same attitude has prevailed. So far, investors have decided to bide their time, expecting a renminbi depreciation.

However, as we have argued before, devaluation is not in China’s interests. Beijing needs exchange rate stability both to advance its international financial agenda and to preserve domestic financial stability. With China’s leaders pressing for the inclusion of the renminbi in the International Monetary Fund’s Special Drawing Rights basket this October, the central bank is highly unlikely to countenance any significant currency depreciation against the US dollar over the coming months.

With a closely managed exchange rate, unlike most other emerging markets, China has the tools to counter the potential tightening effects of any capital outflows by easing domestic policy without letting go of its currency. And with both nominal and real interest rates well above zero, China has plenty of room for effective easing unconstrained by the zero lower bound, and without the threat of falling into a liquidity trap.

More importantly, if they are combined with further structural reforms, the central bank’s easing measures could help to channel credit flows towards productive investments.

While the jury is still out on this, one of our preferred indicators, which tracks the relative performance of the listed private sector versus listed state sector companies, is showing encouraging signs.

After a worrying underperformance in 4Q14, which could imply capital funneled into the wrong hands, privatelyowned enterprises are attracting renewed investor interest this year after delivering solid profit growth in 2014.

The risk for international investors is that when they wake up to the resilience of the renminbi and of private sector earnings, they will find themselves forced to pay a much higher price for Chinese stocks. The valuation gap between the onshore and offshore markets is still wide, with mainland listed A-shares trading at a premium of almost 30%.

But with Beijing allowing more mainland funds to enter the Hong Kong market, the gap can close very quickly. Indeed, with Hong Kong’s H-share index of locally listed mainland companies up an impressive 4.5% last week, wallflower investors who continue to hang back may soon be in danger of missing the party.