China still on top, but not everyone's a fan

More fund managers polled by HSBC have turned bullish on Greater China equities in the first quarter of 2009. That doesn't come as a surprise because many fund managers with Asian portfolios have been shifting their focus to China since the latter part of the year, notably after the mainland announced its Rmb4 trillion ($586 billion) stimulus plan in November. Not all fund houses are convinced, however, and Aberdeen Asset Management is among those with serious concerns over the prospects of growth in China.

Around 67% of the fund managers that took part in HSBC's quarterly survey have an overweight stance in Greater China equities, significantly higher than the 50% who said they were overweight in the fourth quarter of 2008. None of the respondents was underweight -- again a marked improvement from the previous 38%. Around 33% are neutral, up from the previous 13%.

Bonnie Tse, HSBC's head of premier, wealth management and mid-market segment for personal financial services in Asia-Pacific, says the optimism is coming from expectations that China's stimulus policies will support domestic demand and economic growth.

China's now much-talked-about stimulus package is aimed at combating the most serious economic threat to the mainland since the Asian financial crisis in 1997. With foreign reserves and a budget surplus amounting to around $2 trillion, investors are confident that China has the capacity to further stimulate the economy if needed.

The potential positive impact of the US stimulus and recovery measures on China's economy is also a factor in the improved sentiment for China, she says.

Twelve of the world's largest fund houses by assets under management (AUM) participated in the quarterly survey. They are AllianceBernstein, Allianz Global Investors, Baring Asset Management, Deutsche Asset Management, Fidelity Investment Management, Franklin Templeton Investments, HSBC Global Asset Management, INVESCO Asset Management, Investec Asset Management, JF Asset Management, Schroders Investment Management and Societe Generale.

In a recent briefing, Emerson Yip, who is part of the investment management team of the JF Hong Kong Fund and JF Greater China Fund at JP Morgan Asset Management, said he expects China's economy to overtake growth rates in Asia and its stock market to outperform in the region. Although recent economic data confirmed that China was unable to escape the fallout from the financial turmoil and global recession, JP Morgan Asset Management is still looking at around 7% GDP growth for 2008, working on the assumption that the policy stimulus will work and generate the expected multiplier effects, Yip says.

JP Morgan Asset Management is overweight only in two markets in Asia: China and Singapore, mainly because of the respective government stimulus packages of both countries.

One of the main challenges for Asian fund managers in the current quarter, according to Threadneedle Asset Management, is to assess how far the fiscal packages unveiled to date will go to offset the effects of the downturn in global trade.

The construction and basic materials sectors can serve as a guide for the impact of the fiscal packages, says Gigi Chan, who manages the Threadneedle China Opportunities Fund, because these sectors are the early beneficiaries of planned infrastructure spending.

"The expectation, of course, is that the investment in infrastructure will trickle down into the pockets of domestic consumers," says Chan. "It's too early yet for there to be any sign of the most recent fiscal injection in consumption data but evidence from a recent visit to Beijing and Shanghai showed that the domestic consumption theme that has been evident in recent years is still intact."

Chan, who is based in London, says it is striking to see the demographic changes happening in China.

While some factories have closed in response to slowing exports, Chan notes that this is a rational response to a cyclical slowdown. The fact remains, she stresses, that real income has doubled in urban areas over the past few years.

Despite this improvement in wealth over the past few years, Chinese consumers remain under-geared compared to Western norms. The government is keen to maintain the momentum that has built up in domestic consumption and, to this end, it is encouraging loan growth of around 15% this year, Chan says. Chinese banks don't have the problem assets that are hampering many of their Western counterparts, so they are much more willing to increase lending.

"I'm confident that the resulting consumption, together with government spending on infrastructure, will help mitigate the effects of slower global trade on the Chinese economy," Chan says.

Not everyone is a fan of China, however, and Aberdeen Asset Management is among the few fund houses voicing their concern about the extreme optimism over the mainland market.

With the global gloom deepening, and the West in danger of turning in on itself, the world badly needs China to keep the motor of its economy ticking over, Aberdeen has noted in a recent report. After all, China contributed around 20% to global growth last year.

Recent data has shown a grimmer picture of the outlook for China. With double-digit growth the norm for the economy, growth slowed to just 6.8% year-on-year in the final quarter of 2008.

"That is akin to a hard landing," Aberdeen says.

Until China's fiscal stimulus package kicks in during the summer months of July and August, Aberdeen wonders what will keep activity going until then. Many are counting on the potential for increased bank lending because of the abolition of bank lending restrictions.

But Aberdeen believes opinion on the impact of the removal of those restrictions is divided.

On the one hand, China's banks look quite stable. The big four lenders have received lots of state aid over the past few years, especially ahead of their initial public offerings (IPOs) -- a reported $500 billion -- and this has helped them recapitalise.

On the other hand, lower rates are bad for margins and it's not clear who the recipients of new loans will be. As in the West, the needy borrowers are not necessarily the ones able to repay.

Aberdeen believes forced new lending could spell trouble later. First, this represents a policy reversal after years of prudential measures such as loan reserve ratio tightening, which saved the system from excesses. Second, this is the wrong point in the cycle to be expanding loan demand. Third, whatever their appearance, the fund house doubts the banks' credit management skills.

Thus, Aberdeen believes there is every potential for non-performing loans to rise -- if not in percentage terms ("that hardly seems possible when loan growth was 14 times higher in December compared with a year earlier", the fund house says), then in absolute numbers. Plus, Chinese banks have fairly opaque rules on classifying dud loans and often roll these over to avoid declaring non performing loans (NPLs), the fund house says.

Other sectors in China already face structural problems, Aberdeen points out.

Excess manufacturing capacity was hidden as long as US-led consumer demand stayed up, allowing many factories to churn out goods at just above marginal cost, the fund house says. Now the scope to cut overheads is limited by tighter environmental and labour compliance and the real trigger for bankruptcy is that orders have simply dried up.

The slide in exports is nothing compared with that of imports, Aberdeen adds, which have responded to sharply lower industrial production. The situation may reflect aggressive destocking as well as an interruption in global trade finance, and so may prove to be temporary. However, the fund house doesn't believe the picture for end demand is about to turn round. Its best guess is that net exports will be flat.

Until quite recently housing had appeared firm, but tales that defaulting developers as well as weakening consumer confidence have led to falling prices, also worry Aberdeen.

"After last year's stock market collapse, the arguments for bottom-fishing have certainly increased. But as we've contended, for the banks, prospects are up in the air and their commercial savvy about to be tested. For all sectors, earnings for the 11 months until end-November grew just 4% year-on-year and in the final three months they were terrible," Aberdeen says. "History is no guide to P/E and other ratios in this relative ex-growth environment. As we lumber into the Year of the Ox, our stance of extreme wariness has not changed."