Greater China: The new Europe or the new USA?
Lloyd George Asset Management analyses prospects for Greater China equities in 2007.
Is Greater China a convenient title for three separate Chinese-speaking markets, or is there a bigger picture of rapidly growing integration in which each country contributes to the growth story? Can it be compared to European Union integration or is it closer to the US federal model?
Beijing operates in a similar manner to Brussels (or perhaps more like Singapore), in which there is an abundance of technocratic leadership based on clear plans and detailed reforms. Beijing will do whatever is necessary for integration, including maintaining a relatively soft line on Taiwan. It is also very conscious of social policy and the need to drive down unemployment and a massive market for consumer goods and services.
Hong Kong is ChinaÆs New York or London, especially as the latter is now a very rich city surrounded by efficient industries. It is ChinaÆs pre-eminent services, entertainment and financial hub. Taiwan, on the other hand, looks a bit like ChinaÆs California with technology expertise, great depth of middle and higher management skills and (some) democracy and close association with the West. Indeed a great many Taiwanese now live in California!
While the emergence of ChinaÆs political and economic power has been the most important development in Asia of the past decade, this has not been as fully reflected in its stock markets as one might have expected. Even though Hong Kong has recently hosted the worldÆs biggest IPO (ICBC) and the Hang Seng Index is at an all-time high, performance over the past few years has been eclipsed by others (notably India). Taiwan has lagged most of the region recently for a mixture of political and economic reasons. And mainland ChinaÆs markets have been a roller coaster ride (until this year in a downward direction) wherein a whole raft of problems (liquidity and corporate governance, to name just two) have conspired to obstruct high long-term returns for portfolio investors.
So will this change in 2007? Will we experience a resurgence in the Greater China markets even though we are in the fourth year of this Asian bull market?
Mainland China leadership and the consumer market
The mainland China economy remains robust in spite of widespread ôadministrative tighteningö and central government attempts to pre-empt property and other asset price bubbles. The most obvious signs of decline are in the construction sector in which both more restrictive lending and tighter land acquisition policies have led to a reduction in new housing starts. However, retail sales growth remains buoyant û at around 14% year on year û and will be supported by a 30% pay increase for civil servants, which will help the domestic consumption sectors throughout next year. Inflation has declined to 1% and does not appear threatening, while the slightly stronger RMB exchange rate does not seem to be damaging export growth.
However, much of this is in the price following this yearÆs re-rating so that on a price-to-book value basis (multiple 2.5x) the market is well above its historical average of 1.6x. The price-earnings ratio of just above 13x 2007Æs projected earnings is more reasonable, although even this is 1.8x the growth rate.
There has also been some progress in the issues which affect, and have historically generally deterred, international investors from acquiring stock directly listed on the mainland stock exchanges.
The key to this is the introduction of QFII, which was announced last year and provides set allocations for offshore investors to hold mainland listed ôAö shares. The initial tranche of $10 billion has already been subscribed and there should be another wave of successful applications next year. But the procedures are cumbersome and it will be several years before it is likely to be a smooth process.
We have seen some improvements in corporate governance and have been actively analyzing potential investments since last year with a view to broadening our mainland exposure significantly in 2007.
Hong KongÆs capital
Hong Kong, of course, remains the best ôproxyö play on the China market and is set to experience a third successive year of 6% to 8% GDP growth, which compares quite favourably with the mainland itself. Even after this yearÆs gains, about 28% by late November, we would expect the market next year to be well supported by buoyant growth, perhaps another year above 6%. Domestic consumption boosted by lower unemployment and rising wages will provide a healthy complement to the usual international factors such as tourism, financial services and trade flows which we also expect to be positive.
One such crucial external factor is the direction of US interest rates and the impact on domestic interest rates. Recently abundant liquidity in the banking system has led to a small 0.25% cut in the prime lending rate and the ability to resist three of the last four rises in US rates. With the US Federal Reserve now on ôholdö, this is another benign influence especially since price inflation does not seem to be a problem yet.
This pool of liquidity may remain supportive for a considerable period while RMB appreciation and the pipeline of IPOs continue to sustain it. Mainland Chinese companies will continue to seek dual listings in Hong Kong and China and the success of the ICBC IPO (the worldÆs largest) has served to highlight the importance of Hong Kong as a financial market for mainland companies to gain access to a vast pool of international funds.
We expect 11% corporate earnings growth next year which should underpin current valuations. There is also a considerable gap between the earnings yield on Hong Kong equities and the US 10 year bond yield (a difference currently of 2% per annum). Historically convergence of these two yields has tended to signal a deterioration in liquidity conditions and is an indicator of less attractive market conditions. Hong Kong looks set for continued growth in 2007.
Taiwan û technology, competition and management
The Taiwan stock exchange is still regarded by global fund managers as a technology market, given electronics companies make up 56% of its capitalisation, versus their weighting of 24% in emerging markets overall. The overhang of the tech bubble of the late 1990s, in which excess liquidity chases a stagnant equity base, poses a structural problem for TaiwanÆs market. Its equity supply from IPOs this year is 2% of free float, the second-lowest rate in nine years and less than in China.
Fundamentally the market struggles because the island is a harbour for original equipment manufacturers which compete mostly on cost and which have no direct access to their end users. In addition the kinds of work which US, Japanese and European brands are likely to outsource are capital intensive and cyclical. These include liquid crystal display panel manufacture, commoditised semiconductor products (memory) and semiconductor testing. Given the quality of these industries managements often take advantage of flexible hybrid capital, raising it at the expense of existing equity shareholders.
However, there are opportunities in Taiwan and large capital gains through focused stock selection are readily available. What we look for are companies that have or are developing brand equity or that have a clear leadership in a given technical field.
One long-term theme we are exploiting is the development of cross-strait trade and the shifting of dependence of Taiwan away from the US towards the mainland. The PRC is rapidly developing as a production base to the rest of the world, growing industries that are similar to those in Taiwan; and Taiwanese companies engage with mainland Chinese ones with a better footing than they do with their US peers. Though the mainlandÆs public capital requirements are serviced through Hong Kong, which is developing as a financial centre for Greater China, notably with the listing of Foxconn International Holdings, a subsidiary of the Taiwanese company Hon Hai, Taiwan is still a good source of engineering and management expertise as well as component and unfinished materials.
Many difficulties remain unresolved. Taipei and Beijing still do not have formal diplomatic relations. However, despite unhelpful regulations and diplomacy, economic and social relations have deepened and flourished, and in the long run TaiwanÆs future depends on this.
Conclusions
Greater China remains economically robust and likely to continue to grow strongly in 2007. Hong Kong is benefiting from the services it provides to the mainland and its international pedigree, but the improvements to ChinaÆs capital markets are making steady, if slow, progress. In the eighteen months left before the 2008 Beijing Olympics one must assume that every effort will be made to show China to best effect and that will include competitive stock markets in Shanghai and Shenzhen. But it is also possible that Taiwan, recently the poorest performing market, surprises everyone and achieves the highest returns.
Beijing operates in a similar manner to Brussels (or perhaps more like Singapore), in which there is an abundance of technocratic leadership based on clear plans and detailed reforms. Beijing will do whatever is necessary for integration, including maintaining a relatively soft line on Taiwan. It is also very conscious of social policy and the need to drive down unemployment and a massive market for consumer goods and services.
Hong Kong is ChinaÆs New York or London, especially as the latter is now a very rich city surrounded by efficient industries. It is ChinaÆs pre-eminent services, entertainment and financial hub. Taiwan, on the other hand, looks a bit like ChinaÆs California with technology expertise, great depth of middle and higher management skills and (some) democracy and close association with the West. Indeed a great many Taiwanese now live in California!
While the emergence of ChinaÆs political and economic power has been the most important development in Asia of the past decade, this has not been as fully reflected in its stock markets as one might have expected. Even though Hong Kong has recently hosted the worldÆs biggest IPO (ICBC) and the Hang Seng Index is at an all-time high, performance over the past few years has been eclipsed by others (notably India). Taiwan has lagged most of the region recently for a mixture of political and economic reasons. And mainland ChinaÆs markets have been a roller coaster ride (until this year in a downward direction) wherein a whole raft of problems (liquidity and corporate governance, to name just two) have conspired to obstruct high long-term returns for portfolio investors.
So will this change in 2007? Will we experience a resurgence in the Greater China markets even though we are in the fourth year of this Asian bull market?
Mainland China leadership and the consumer market
The mainland China economy remains robust in spite of widespread ôadministrative tighteningö and central government attempts to pre-empt property and other asset price bubbles. The most obvious signs of decline are in the construction sector in which both more restrictive lending and tighter land acquisition policies have led to a reduction in new housing starts. However, retail sales growth remains buoyant û at around 14% year on year û and will be supported by a 30% pay increase for civil servants, which will help the domestic consumption sectors throughout next year. Inflation has declined to 1% and does not appear threatening, while the slightly stronger RMB exchange rate does not seem to be damaging export growth.
However, much of this is in the price following this yearÆs re-rating so that on a price-to-book value basis (multiple 2.5x) the market is well above its historical average of 1.6x. The price-earnings ratio of just above 13x 2007Æs projected earnings is more reasonable, although even this is 1.8x the growth rate.
There has also been some progress in the issues which affect, and have historically generally deterred, international investors from acquiring stock directly listed on the mainland stock exchanges.
The key to this is the introduction of QFII, which was announced last year and provides set allocations for offshore investors to hold mainland listed ôAö shares. The initial tranche of $10 billion has already been subscribed and there should be another wave of successful applications next year. But the procedures are cumbersome and it will be several years before it is likely to be a smooth process.
We have seen some improvements in corporate governance and have been actively analyzing potential investments since last year with a view to broadening our mainland exposure significantly in 2007.
Hong KongÆs capital
Hong Kong, of course, remains the best ôproxyö play on the China market and is set to experience a third successive year of 6% to 8% GDP growth, which compares quite favourably with the mainland itself. Even after this yearÆs gains, about 28% by late November, we would expect the market next year to be well supported by buoyant growth, perhaps another year above 6%. Domestic consumption boosted by lower unemployment and rising wages will provide a healthy complement to the usual international factors such as tourism, financial services and trade flows which we also expect to be positive.
One such crucial external factor is the direction of US interest rates and the impact on domestic interest rates. Recently abundant liquidity in the banking system has led to a small 0.25% cut in the prime lending rate and the ability to resist three of the last four rises in US rates. With the US Federal Reserve now on ôholdö, this is another benign influence especially since price inflation does not seem to be a problem yet.
This pool of liquidity may remain supportive for a considerable period while RMB appreciation and the pipeline of IPOs continue to sustain it. Mainland Chinese companies will continue to seek dual listings in Hong Kong and China and the success of the ICBC IPO (the worldÆs largest) has served to highlight the importance of Hong Kong as a financial market for mainland companies to gain access to a vast pool of international funds.
We expect 11% corporate earnings growth next year which should underpin current valuations. There is also a considerable gap between the earnings yield on Hong Kong equities and the US 10 year bond yield (a difference currently of 2% per annum). Historically convergence of these two yields has tended to signal a deterioration in liquidity conditions and is an indicator of less attractive market conditions. Hong Kong looks set for continued growth in 2007.
Taiwan û technology, competition and management
The Taiwan stock exchange is still regarded by global fund managers as a technology market, given electronics companies make up 56% of its capitalisation, versus their weighting of 24% in emerging markets overall. The overhang of the tech bubble of the late 1990s, in which excess liquidity chases a stagnant equity base, poses a structural problem for TaiwanÆs market. Its equity supply from IPOs this year is 2% of free float, the second-lowest rate in nine years and less than in China.
Fundamentally the market struggles because the island is a harbour for original equipment manufacturers which compete mostly on cost and which have no direct access to their end users. In addition the kinds of work which US, Japanese and European brands are likely to outsource are capital intensive and cyclical. These include liquid crystal display panel manufacture, commoditised semiconductor products (memory) and semiconductor testing. Given the quality of these industries managements often take advantage of flexible hybrid capital, raising it at the expense of existing equity shareholders.
However, there are opportunities in Taiwan and large capital gains through focused stock selection are readily available. What we look for are companies that have or are developing brand equity or that have a clear leadership in a given technical field.
One long-term theme we are exploiting is the development of cross-strait trade and the shifting of dependence of Taiwan away from the US towards the mainland. The PRC is rapidly developing as a production base to the rest of the world, growing industries that are similar to those in Taiwan; and Taiwanese companies engage with mainland Chinese ones with a better footing than they do with their US peers. Though the mainlandÆs public capital requirements are serviced through Hong Kong, which is developing as a financial centre for Greater China, notably with the listing of Foxconn International Holdings, a subsidiary of the Taiwanese company Hon Hai, Taiwan is still a good source of engineering and management expertise as well as component and unfinished materials.
Many difficulties remain unresolved. Taipei and Beijing still do not have formal diplomatic relations. However, despite unhelpful regulations and diplomacy, economic and social relations have deepened and flourished, and in the long run TaiwanÆs future depends on this.
Conclusions
Greater China remains economically robust and likely to continue to grow strongly in 2007. Hong Kong is benefiting from the services it provides to the mainland and its international pedigree, but the improvements to ChinaÆs capital markets are making steady, if slow, progress. In the eighteen months left before the 2008 Beijing Olympics one must assume that every effort will be made to show China to best effect and that will include competitive stock markets in Shanghai and Shenzhen. But it is also possible that Taiwan, recently the poorest performing market, surprises everyone and achieves the highest returns.
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