With the launch of the new Crown vaccine, a significant recovery in China (click for Goldman Sachs China Economic Outlook 2021) and a more predictable outlook for the U.S.-China relationship, 2021 is a highly anticipated year for the start of the 14th Five-Year Plan.
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Against this backdrop, Goldman Sachs Research expects the MSCI China Index and CSI 300 Index to return 15% in 2021, driven by rising corporate profits (expected to grow 20% and 15% in 2021/22) but flattening stock market valuation multiples (15.6x) as domestic policies return to normalcy over time.
The policy has always been an important driver of stock market returns, and this is particularly true in China’s unique socio-economic environment. Past experience shows that investing in line with the country’s strategic policy direction can pay off, and Goldman Sachs believes that the 14th Five-Year Plan will set the stage for three key trends (digitalization, autonomy and domestic demand, or the “5D’s” – Digitalization, Domestic Dependency, and Domestic Demand). Digitalization, Domestic Dependency, and Domestic Demand) and redefine the areas of investment that are expected to yield superior returns in the future.
In the equity markets, corporate profits are expected to grow by 15%/20% in 2020/21, supported by a favourable base effect and a continued structural shift to “emerging China” and the digital economy, which are estimated to contribute 37% of earnings share and 12 percentage points of EPS growth in 2021.
In fact, the rise of these two sectors, which now account for 67% and 50% of the MSCI China Index market capitalization, has fundamentally changed the way Goldman Sachs Research analyzes China equity valuations: China market valuations are currently at the top of their historical range (15.6x, 2.3 standard deviations), but we do not use a top-down “carpetbagger” approach to calculate index targets. ” approach to calculating the index’s target P/E ratio, but instead apply a partially summed valuation framework and take into account the valuation premium due to growth stocks. This approach suggests a fair P/E ratio of 15.6x for the MSCI China Index by the end of 2021, unchanged from current levels, suggesting the ability to maintain higher valuation multiples until stock market duration concerns take hold (i.e., when the pace of global recovery accelerates, likely after the second quarter) if strong earnings are achieved.
Lower positions remain a positive anchor for China equity liquidity: global active funds are historically underweight China H/A stocks (-410 bps), despite China’s advancing financial market reforms and very active IPO market, which could lead to structural allocation benefits and strategic trading opportunities.
Taken together, the macro and market environment is supportive of a strong end to the year and a good start to next year for Chinese equities and contributes to Goldman Sachs’ view that China remains one of the top investments in regional markets.
While 2020 brings renewed awareness of the limited ability to foresee the future, Goldman Sachs believes that the negative impact of forecast error will be less if a more strategic, long-term view is taken when investing in the China market. Specifically, the investment recommendations for 2021 are tied to structural growth, designed to benefit from the endogenous growth potential of policy, the rise of consumer goods, medical/technical advances and a fundamental shift in fixed-asset investment orientation
Given the high valuation of the stock market over the next two years and the 17% compound annual growth rate of earnings per share, the market faces the following downside risks:
U.S.-China relations:
Goldman Sachs’ U.S.-China relations indicator has recently eased as market expectations of U.S.-China trade friction (particularly trade restrictions and tariffs) may have eased following Biden’s election victory. However, some of the uncertainty is not yet fully reflected in China equity valuations.
China Real Estate:
The Chinese residential market is likely the second-largest asset class in the world (and even the largest when inventory is taken into account), second only to the U.S. bond market in nominal value. From an economic perspective, Goldman Sachs economists estimate the housing sector’s contribution to GDP to be around 20% (through direct and indirect channels such as real estate fixed asset investment, real estate construction supply chain, consumption and wealth effects). Therefore, it is necessary to pay close attention to the repeated emphasis of top policymakers on “housing without speculation” and its impact on aggregate demand.
China leverage:
Ongoing policy normalization and policymakers’ focus on controlling financial risks could cause intermittent shocks in asset markets, especially with increased bond defaults (although still low globally) and systemic concerns about highly indebted firms. In short, overall systemic leverage levels have reached historic highs, implying an increased sensitivity of risky assets to changes in liquidity conditions, all else being equal.
Regulation of private companies:
Private companies now account for 77% of the MSCI China Index market capitalization and 68% of the average daily trading volume. If regulators tighten oversight of the private sector, as was widely feared in 2018, equity risk premiums in the sector could rise, putting market valuations under pressure.
