China Equity Strategy: Industrial reflation amid weak CPI to expand equity valuations

Deutsche Bank Markets Research Asia China Strategy China Equity Strategy Date 13 July 2016 Strategy Update Industrial reflation amid weak CPI to expand equity valuations ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016. Yuliang Chang, CFA Strategist (+852 ) 2203 6195 yuliang.chang@db.com Joseph Huo Strategist (+852 ) 2203 6251 joseph.huo@db.com PPI may rise further, following M1/M2 spread -2.810.2 -15 -10 -5 0 5 10 15 -15 -10 -5 0 5 10 15 Jan-04Aug-04Mar-05Oct-05May-06Dec-06Jul-07Feb-08Sep-08Apr-09Nov-09Jun-10Jan-11Aug-11Mar-12Oct-12May-13Dec-13Jul-14Feb-15Sep-15Apr-16pptyoy %PPI (lag 6m)M1 minus M2 (3m MA; RHS)M1-M2vs. PPI (lag 6m) Correlation = 75% Source: Bloomberg Finance LP, Deutsche Bank Strategy Research Domestic rates remain low and supportive 2.8%2.5%4.0%3.2%1%2%3%4%5%6%7%8%Jul-14Sep-14Nov-14Jan-15Mar-15May-15Jul-15Sep-15Nov-15Jan-16Mar-16May-16Jul-1610y China gov't bond7d repo (20D MA)3m wealth mgmt product6m bill discount rateMarket rates stay low, suggesting accommodative financial conditions Source: Wind, Deutsche Bank Strategy Research Short-sell ratio stays at a high level of 11% 7.2%6.7%13.4%12.0%14.7%7.3%13.4%13.8%16.4%11.1%4% 6% 8% 10% 12% 14% 16% 18% 7,000 8,000 9,000 10,000 11,000 12,000 13,000 14,000 15,000 16,000 Jan-12Mar-12May-12Jul-12Sep-12Nov-12Jan-13Mar-13May-13Jul-13Sep-13Nov-13Jan-14Mar-14May-14Jul-14Sep-14Nov-14Jan-15Mar-15May-15Jul-15Sep-15Nov-15Jan-16Mar-16May-16Jul-16HSCEIShort sell turnover as % of total (5-day MA, RHS) Source: Bloomberg Finance LP, Deutsche Bank Strategy Research Both growth and rates outlook seem favorable for re-rating of Chinese equities With heightened uncertainty post-Brexit, global investors are weighing up the tug of war between softening growth and falling rates. Judging which side will dominate global asset pricing may prove difficult at the current juncture, given significant uncertainty regarding how and when Brexit might progress. For Chinese equities, we believe both the growth and the rates outlook seem favorable for valuation expansion from current discounted levels, considering that 1) strengthening industrial pricing (PPI) may further revive corporate growth and profitability, while 2) weak consumer pricing (CPI) and more DM monetary easing may keep domestic market rates subdued. Chinese equities have outperformed EU/JP but lagged EMs since 19 May. We believe our expected industrial reflation amid weak CPI presents a Goldilocks macro backdrop in the near term. Also considering the depressed valuations, stretched underweight/shorted investor positioning, and visible fund inflows from Chinese investors, we reiterate our positive market view and target HSCEI/MSCI China at 10,000/64 by end-2016. By sector, we prefer domestic demand and continue to suggest overweight financials, IT, and industrials; we recently also upgraded energy and downgraded utilities. Why PPI may pick up further and how that could help corporate fundamentals We think China’s PPI is likely to pick up further in the coming months, thanks to 1) rising industrial demand on the lagged effect of supportive policies, 2) low industrial inventory after lengthened and sizable destocking, and 3) an easier comparison base. The potential acceleration of supply-side reform (capacity cuts) could be a plus. Recently, domestic commodity prices grinded higher again, reversing the downward pressure seen in May. As activity stabilizes and PPI expands, nominal growth has rebounded notably YTD. Looking ahead, we see an extended nominal growth acceleration amid a rising PPI, further reviving corporate fundamentals, especially profit margin/ ROE. Specifically, many up-/mid-stream sectors have seen ASP and/or volume pick up in 2Q16 (including steel, coal, cement, etc), reinforcing our earlier expectation of strengthening earnings momentum; we continue to expect more consensus earnings upgrades as interim results loom. Why CPI may stay weak and how that may weigh on domestic market rates While recent floods may raise short-term food prices, we believe China’s CPI is likely to stay weak in the coming months, given 1) sluggish consumption demand, with the earlier industrial slowdown putting pressure on employment and household income; 2) rising food supply, which may drag consumer prices, and 3) a tougher comparison base. As global uncertainty intensifies, major cent