China: A volatile bottoming process ahead

- Reviewing our calls in July: "(1) We predicted a near-term rebound of MSCI-China on the back of monetary loosening expectations. (2) We expected more volatility after the near-term rebound due to concerns about continued downward earnings revision risk. (3) Among others, we identified investment opportunities in: (a) China’s mid-cap consumer space; (b) beneficiaries of western China development strategy; (c) and China's visible railway capex (such as China Railway Group). Looking back, the rebound did occur, with MSCI-China rising 4.1% in July FY10. Yet, the rally was much shorter than we expected, with MSCI beginning to correct on August 10 on renewed slowdown concerns."
- Bottom building amid volatilities: "We expect China’s equity market to experience more volatility in the coming months due to downward earnings revision pressure as the economic slowdown ripples through the whole economy, but recommend buying on dips because: (1) China’s real GDP growth, on a sequential basis, may have bottomed out at 7.2% QoQ in 2Q10. Yet we believe China’s final demand growth will not bottom out until late FY10, because the modest sequential rebound in GDP in 3Q will be driven by a slowdown in de-stocking and the widening of the trade surplus on sharply falling imports, rather than by a decent recovery in final demand; (2) improving liquidity conditions – (a) China’s M2 growth (which tends to lead H-shares performance), on sequential terms, is expected to bottom out, with trend growth reaching a trough of 11.8% 3m/3m, saar in September before rising to 16.8% in December; (b) we estimate new loans made by Chinese banks in 2H10 will reach around Rmb3 trillion, up 37% YoY; (3) we believe the worst of the policy tightening environment may be behind us."
- Key investment risks: "(1) The market may be concerned about a return of government tightening measures, if CPI continues to surprise on the upside. (2) Asset-inflation risks, mainly on the property front. (3) China’s A-share market to face potential supply side pressure in 4Q10."
- Sector views: "In our model portfolio, we are overweight on (1) mid-cap consumer names in the staple, low-end discretionary, and service areas, (2) menswear, (3) beneficiaries of western China development strategy and China’s visible railway capex, (4) insurance, and (5) mid-cap banks. We stay neutral on telcos, and underweight on commodities, energy, and property. We reduce our weighting in IPPs from OW to UW."

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