4Q17 Market Outlook - gfgroup.com.hk · 9/27/2017 · -5% Sep 27, 2017 3 4Q17 Market Outlook Figure 3: Signs of overbuying Sources: Bloomberg, GF Securities (Hong Kong) Valuation

4Q17 Market Outlook

Sep 27, 2017 Equity Research | Investment Strategy

To buy, or not to buy?

Alex Fan, CFA SFC CE No. ADJ672 [email protected] +852 3719 1047 Frankie Wan SFC CE No. AVK969 [email protected] +852 3719 1052 GF Securities (Hong Kong) Brokerage Limited 29-30/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong

The million dollar question

The Hong Kong market has performed exceptionally well this year, beating major global indices, with the HSI rising for eight straight months before correcting slightly in Sept, driven by earnings recoveries/growth and strong southbound fund inflows, and helped along by the weak US dollar and strong global markets. Most investors appear to have made decent profit this year and remain heavily invested.

The HSI recently hit a 28-month high, but there are signs it is overbought and that its valuation is approaching resistance level. The biggest gains have been in auto, property and tech stocks, and there are doubts about whether the market can rise further and which sectors could still outperform. Moreover, amid growing political and geopolitical risks, the chance of a major market correction is rising.

We remain positive on the medium term market outlook, but believe short-term headwinds justify a cautious stance in 4Q17.

Headwinds and risks

In the near term, we see increased upside resistance due to technical and valuation factors. Downside pressure between now and the end of the year will come from the political risks of a government shutdown, debt default and tax reform hurdles in the US, geopolitical risk related to North Korea, monetary policy risk from the unwinding of quantitative easing by major central banks, and economic risk from the slowdown of China’s economy in 2H17. Judging from current market conditions and past cycles, we estimate these could trigger a 5-10% market pullback from the Sept peak.

Market outlook Positive

Over the medium term, we believe the Hong Kong market will continue to ride on the global market uptrend and resilient Chinese economy, supported by its relatively low valuation compared with other key markets. After a short term strengthening, we believe the US dollar will resume its weakness, which together with the strengthening renminbi, make Hong Kong stocks more attractive. Southbound funds continue to be invested in Hong Kong via the Stock Connect as the need for asset diversification remains high. Strong interim results indicate that corporate earnings have resumed growth after two consecutive years of poor earnings, while management guidance and the latest monthly data in 3Q17 are fostering confidence that the earnings outlook remains promising in the near term. Overall, we believe positive drivers remain in place but that upside is capped by valuations in the short term. When the short term risks subside, we believe the HSI could rise to 28,500 in 4Q17, equivalent to 13x 2017E P/E, and the HSCEI could rise to 11,700, or 9x 2017E P/E.

Sector outlook and top picks

We continue to recommend tech, auto, insurance, financial intermediates, healthcare and environmental protection, while adding banks and oil for 4Q17 Internet-related demand and smartphone upgrade needs remain strong in China and overseas markets, leading to sustained earnings growth in tech hardware, software and the internet sector. In the auto sector, ability to compete amid high SUV sales growth, the rising market shares of domestic brands, greater demand for luxury/high-end models, and the policy-driven NEV segment will be the determining factor. Structural change in insurance premiums towards regular and protection-type products will have a positive impact on insurers’ new business value, leading to a further re-rating of the sector. The increasing connectivity between the China and Hong Kong markets is creating business opportunities for exchanges and securities companies, which are also benefiting from rising stock market turnover. In light of the growing market risks ahead, we maintain our recommendation for exposure to the undemandingly valued healthcare and environmental protection sectors, which provide more defensive and visible earnings growth. Meanwhile, we are beginning to see the light of hope in the banking sector, with its 2Q17 results clearly indicating improving asset quality and a bottoming out of NIM, suggesting a strong likelihood of a further re-rating. A stable oil market and continued global economic growth should be positive for oil companies, which have emerged from an earnings trough on a strong footing. Both banks and oil have low valuations and a high yield. Our watchlist portfolio is up 52% YTD, beating the market. Our portfolio recommendations for 4Q17 are Tencent, AAC Tech, BOC, Ping An, HKEx, Geely Auto, Brilliance China, CSPC Pharma, BJE Water and CNOOC.

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Sep 27, 2017

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4Q17 Market Outlook

Short-term headwinds HSI up 25% YTD, outperforming global markets The Hong Kong market has performed strongly

this year with the HSI recording eight consecutive months of positive returns before consolidating in Sept, matching the eight-month rallies in June 2006-Jan 2007 and March 2007-Oct 2007, and getting close to the 11-month rally seen in April 2003-Feb 2004. In our view, 1) a strong global market, 2) weak US dollar/strengthening renminbi, 3) southbound fund interest, and 4) earnings recoveries/high growth are some of the key driving forces behind the strength and length of the market rally. However, we believe there is a high risk that the latest correction which began in Sept may continue for some time given mounting uncertainties ahead, before the market rally can resume.

Figure 1: Global market performance YTD

Sources: Bloomberg, GF Securities (Hong Kong)

Figure 2: Global market performance over the past three months


Signs of overbuying After rising sharply in first eight months of the year, the market is now showing

signs of being overbought in the short-term. Previous experience suggests that once the HSI is 15-18% higher than its 200-day moving average, it experiences a major correction (2010: 35%, 2013: 19%, 2015: 36%, 2016: 12%).

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4Q17 Market Outlook

Figure 3: Signs of overbuying


Valuation getting rich From a valuation point of view, the HSI is trading at 12.6x 2017E P/E, close

to 1SD above its average P/E since 2010 (11.6x+1.3x=12.9x). Historical patterns show limited upside for the index when its P/E exceeds 13x. In the period of extreme optimism in 2015, the highest P/E level was 13.7x, while the other two valuation peaks in 2011 and 2016 were 12.9x and 13.3x, respectively. Hence, unless we see further positive factors in the near term, market upside this year may be capped. The HSI upside is likely to be capped at 28,500, or 13x 2017E P/E, while the HSCEI is likely to be capped at 11,700, or 9x 2017E P/E.

Figure 4: HSI P/E


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4Q17 Market Outlook

Figure 5: HSCEI, P/E


US political risk While economic and earnings outlooks remain promising, market risks are growing

rapidly. Although the US government avoided a government shutdown and debt default in Sept after President Donald Trump reached a deal with the Democrats to extend the debt limit and funding bill by three months, political risks have been postponed but not removed. Before the new deadlines in Dec, the While House has to negotiate its tax reform plan with both Republicans and Democrats, which will make the task even more difficult. A failure to raise the debt ceiling limit will require cuts to spending in other areas, since the federal government would lack funds to pay interest. The US’s debt to GDP ratio is currently over 100%, and the government may run out of funds within two weeks if it cannot issue debt. In addition, Moody’s said that US will lose its AAA rating if it fails to raise the debt ceiling, which would cause market turmoil. Looking at past experience, during the 16-day government shutdown of Oct 2013, the Hong Kong market saw a 4% correction in one month. A more serious example is the debt-ceiling negotiations of Aug 2011, which resulted in the loss of the AAA credit rating from S&P, and caused the HSI Index to plunge 17.3% in one month. Although the government shutdown may ultimately be avoided with a last minute agreement, uncertainties will still increase the chance of a market correction.

Figure 6: Stock market performance during period of US political risk in 2011


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4Q17 Market Outlook

Figure 7: Stock market performance during period of US political risk in 2013


Geopolitical risks growing US-North Korea relations have deteriorated in the last few months and

are now a key focus for the market. The risk of military action has risen after North Korea’s sixth nuclear test and its repeated ballistic missile testing. Looking back at the period after the last three North Korean nuclear tests (Feb 12, 2013, Jan 6, 2016, and Sept 9, 2016), the HSI declined 4-5% two months after the nuclear testing. Although the latest nuclear testing on Sept 3 this year only caused a minor correction in global stock markets, it is too early to tell whether this geopolitical risk will not have any further impact on the markets, and if US-North Korea relations deteriorate further leading to military conflict, the negative impact on the market should not be underestimated. Global central banks beginning to tighten Global central banks’ extremely accommodative

monetary policies have been one of the main supporting factors for stock markets in the past few years. However, several central banks have already changed policy direction. The Bank of Canada raised interest rates at both their July and Sept meetings. The Bank of England’s monetary policy meeting in Sept indicated a higher chance of tightening at the next meeting. More importantly, at the Sept FOMC meeting, the Fed announced that it would begin its balance sheet reduction plan, decreasing its balance sheet by US$300bn in the first year and US$600bn each year thereafter. If the reductions continue for four years, the Fed’s balance sheet will decrease from US$4.5trn to US$2.4trn. In addition, Fed officials’ projections for the Fed fund rate indicates three more interest rate hikes next year after one more this year. Meanwhile, the ECB is also likely to announce a gradual QE exit plan at its Oct policy meeting. We expect monthly purchases to drop from Eur60bn to Eur40bn in 1Q18, and for the programme to end gradually in 2H18. The moves by the Fed and ECB mean that the expansion of money supply has come to an end. Investors may start to face a higher interest rate environment as well as tighter market liquidity.

Figure 8: The Fed’s balance sheet reduction plan

Sources: Bloomberg, Fed, GF Securities (Hong Kong)

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4Q17 Market Outlook

US dollar rebounds as Fed prepares to hike and concerns rise after German election Investors

have recently started to shift their focus to monetary policy. After the Sept FOMC meeting, Fed Chair Janet Yellen claimed that the Fed is on course to raise interest rates going forward, even though inflation is likely to remain subdued in short-term. Yellen also warned that the Fed should be wary of hiking rates too gradually, since it may result in overheating in the labor market and financial instability. Moreover, the German election result also raises concern about political risk in the EU. Although Angela Merkel has secured a fourth term as Chancellor, the market has begun to worry about the extreme-right Alternative fur Deutschland (AfD) party’s successful entry into the country’s parliament for the first time. The result of the election shows that eurozone integration will face challenges in the next few years, and that will put pressure on the euro. Given these two factors, we believe the US dollar may see a longer and larger rebound, which may lead to a correction in the Hong Kong stock market. China’s economy to slow from high base last year The Chinese economy performed well in

1H17. GDP growth unexpectedly remained at 6.9%, driven by two traditional factors: strong exports growth and property investments. However, we do not expect these two factors to be sustainable in the second half of the year. While exports growth may start to slow due to a high base last year, property investments will also slow on the back of tightening measures, higher financing costs and lower housing demand. China’s economic data is therefore likely to indicate a slowdown in the coming months, which would be negative for the Hong Kong and China stock markets.

Figure 9: China exports growth (USD, YoY %)


Figure 10: China housing prices and new loans


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4Q17 Market Outlook

Risk of a 5-10% correction The Hong Kong market suffered four major corrections over the past

eight years, with the market falling 12-36% triggered by a variety of reasons (2010: 35%, 2013: 19%, 2015: 36%, 2016: 12%). In 2010, the market crash was due to the European debt crisis. In 2013, it was dragged down by China’s liquidity crisis. In 2015, the market plunged due to Chinese stock market turbulence, while in 2016, the correction was a result of uncertainties surrounding Donald Trump’s policies. This time, market risks are mainly from US political risk and geopolitical risk surrounding North Korea, which are likely to be temporary in nature without long-term impacts on economic fundamentals. However, if these risks develop further causing market concerns, the Hong Kong market is likely to give up some of its gains this year. Given better market fundamentals now than during previous upcycles, and as the risks are more political in nature, we would expect a small market correction of between 5-10%, but would consider this an opportunity to buy at lower levels.

Figure 11: HSI pullback in 2010, 2013, 2015 and 2016


Positive factors remain intact Hong Kong market riding on global markets upcycle; valuation remains relatively attractive

Despite the short term pressure, we believe the positive factors remain intact. The improving economic outlook and corporate earnings have led to a clear uptrend in global markets since 2016, while the Hong Kong market has followed this trend with even stronger performance than other key global markets, with the HSI climbing over 53% from its trough. As the leading stock market globally, the US market remains in uptrend territory, with key indices repeatedly marking new highs recently, driven by encouraging corporate earnings, sustained economic growth and a market-friendly Fed, resulting in its high valuation. Compared with major global markets, the Hong Kong market’s valuation is still comparatively attractive given its promising earnings/economic outlook.

Figure 12: Good economic trend in the US, EU and China


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4Q17 Market Outlook

Figure 13: Global market P/E valuations


Figure 14: Global market P/B valuations


Weak US dollar far from over A weak US dollar traditionally increases the attractiveness of the

Hong Kong market for foreign investors. The uncertainty driven by the Trump administration, weaker-than-expected US inflationary pressure, and the likely unwinding of the ECB’s monetary policy towards tightening could potentially lead to continued weakness for the US dollar in the medium term, after a likely short term rebound. In addition, the strengthening of the renminbi has further increased the attractiveness of Hong Kong equities with Chinese assets and renminbi earnings.

Figure 15: HSI vs US Dollar Index


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4Q17 Market Outlook

Figure 16: USD/RMB


China fund inflows have increased significantly… Southbound buying interest through the Stock

Connect programs has accelerated since 2016 and has become a key driver of the Hong Kong market. During the first eight months of this year, southbound net buying totaled HK$192.2bn, up 38% YoY, or 78% of last year’s HK$245.9bn total net buying. Southbound trading accounted for 10.4% of total market turnover in Aug, up from 8.6% in Dec 2016 and 3.3% in Dec 2015. In Sept (up to Sept 26), this ratio increased further to 11.9%.

Figure 17: Southbound trading’s increasing impact on the Hong Kong market

Sources: HKEx, GF Securities (Hong Kong)

Figure 18: Southbound net buying rising rapidly


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4Q17 Market Outlook

…and are set to continue due to asset diversification needs… The increasing need for mainland

Chinese investment funds to diversify their asset classes through the Stock Connect has shown no sign of changing. Total southbound net buying since the launch of the Stock Connect has now exceeded HK$579bn, as of Aug. Given various restrictions on official channels for capital outflow, the Stock Connect mechanism has become the most effective channel for mainland investors to facilitate their asset allocation needs. Among the different types of financial institutions in China, insurance companies are considered to have been a major contributor to the rise in southbound trading since the launch of the Stock Connect mechanism. Insurers typically allocate 12-15% of their investable assets (Rmb17,784bn as of Dec 2016) to equity markets, which we believe will increase gradually over time and be highly dependent on stock market performance. However, of this ~12% equity exposure, we estimate that insurers have gradually increased their exposure to the Hong Kong stock market via the Stock Connect. In fact, according to news reports quoting a Xinhua News interview with CIRC officials, insurance companies have so far invested Rmb174.3bn via the Shanghai Stock Connect scheme, accounting for 33% of total southbound net buying as of June 2017. Given the A-H price gap and the ease of using the Stock Connect, we expect insurers’ exposure to Hong Kong equities to continue to rise over the next few years, ensuring a steady stream of buying interest for the Hong Kong market, barring any significant market correction. Assuming mainland insurers increase the proportion of their equity investments in Hong Kong via the Stock Connect from 10% of their equity exposure in 2017 to 22% in 2019, together with the contribution from other mainland investment funds, we believe annual southbound net buying will increase by 25-33% per annum from HK$245.9bn in 2016 to HK$502.5bn in 2019.

Figure 19: Southbound net buying to rise further

Sources: HKEx, GF Securities (Hong Kong) forecast

…while overseas interest has also risen sharply In addition, interest in the Hong Kong market

from overseas investors has increased. Average daily turnover (ADT) in the Hong Kong market has increased from HK$63,467m in Dec 2016 to HK$98,408m in Aug 2017, up 55% during the period. If we strip out the amount from southbound trading, which has increased by 87% from HK$5,462m in Dec 2016 to HK$10,200m in Aug 2017, non-Stock Connect trading has increased from HK$58,005m to HK$88,208m, a rise of 52% during the period, indicating increasing foreign interest.

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4Q17 Market Outlook

Figure 20: Overseas investor turnover rising too


Operating data at listed companies remained promising in 3Q17 After two consecutive years

of earnings declines, Hong Kong-listed companies are widely expected to see earnings growth turn positive this year and next. There have been continued earnings upgrades by analysts this year, with earnings forecasts for HSI Index-constituent companies revised up by 12% since the beginning of the year. The latest interim results season confirmed this expectation as overall results met or beat expectations with only a few exceptions. In particular, high growth sectors such as tech and auto and recovering sectors such as commodities and materials reported strong results, beating expectations in many cases, while other sectors also performed well, providing strong fundamental support for the market. Company and sector monthly data in 3Q17 have mostly continued the positive momentum, leading to continued confidence that corporate earnings growth will continue.

Figure 21: Consensus earnings forecasts


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4Q17 Market Outlook

Figure 22: Earnings upgrades for HSI-constituent stocks


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4Q17 Market Outlook

Figure 23: Interim results highlights


Sector outlook Industry leaders the clear winners We expect sector leaders to continue to benefit from greater

economies of scale, stronger pricing power and greater ability to capture opportunities arising from industry consolidation, which will boost investor confidence in sustainable earnings growth in an economy that is seeing medium-level growth and tougher competition. We therefore believe that companies with greater market shares, a larger market cap, stronger government support, a better execution track record, and better earnings history will continue to be favored by investors. In

Sales growth NP growth

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Consumer staples

Want Want 151 HK -3.7% -14.5% 44.50% 47.80%

Tingyi 322 HK 4.2% 54.6% 31.63% 29.10%

China Mengniu 2319 HK 8.1% 4.7% 33.7% 35.6%

Tsingtao Brewery 168 HK 2.1% 7.4% 40.8% 42.0%

Hengan 1044 HK -0.2% 13.4% 48.10% 48.60%

Vinda 3331 HK 11.3% -0.2% 31.3% 30.5%

Consumer discretionary

CSS 116 HK 2.7% 7.8% 27.0% 24.4%

Sun Art 6808 HK 2.1% 22.7% 22.8% 23.3%

Li Ning 2331 HK 11.1% 66.8% 46.7% 47.7%

Anta 2020 HK 19.2% 28.5% 47.90% 50.60%

Auto and dealers

Geely 175 HK 117.9% 127.7% 17.70% 19.20%

BCA 1114 HK 14.1% 28.2% 2.4% 4.1%

GWM 2333 HK -1.0% -50.9% 25.83% 19.88%

GAC 2238 HK 62.2% 57.4% 17.1% 16.5%

BAIC 1958 HK 36.1% -59.1% 21.9% 26.2%

BYD 1211 HK 0.2% -23.8% 19.5% 18.6%

Zhongsheng 881 HK 20.7% 121.2% 8.90% 10%

China Zhengtong 1728 HK 7.1% 103.6% 9.2% 11.1%

Gaming

Sands China 1928 HK 19.5% 23.0% 32.5% 33.2%

Galaxy Ent 27 HK 11.8% 81.0% 18.4% 22.7%

Wind

China Longyuan 916 HK 9.7% 5.5% 40.5% 38.7%

Datang Renewable 1798 HK 16.2% 115.1% 40.1% 43.0%

Huadian Fuxin 816 HK -2.9% 0.6% 41.6% 35.8%

Xinjiang Goldwind 2208 HK -9.8% -21.9% 30.6% 32.1%

Environmental

BJE Water 371 HK 16.2% 21.6% 34.4% 33.5%

CEI 257 HK 68.7% 48.5% 41.6% 36.2%

Internet & software

Tencent 700 HK 56.8% 64.2% 57.7% 50.6%

Kingsoft 3888 HK 76.2% Loss to profit 68.7% 60.0%

Kingdee 268 HK 15.5% -21.1% 79.3% 80.1%

China Soft 354 HK 43.7% 3.9% 27.8% 27.6%

Tech/smartphone

AAC 2018 HK 55.4% 57.0% 41.10% 41.00%

Sunny Optical 2382 HK 69.8% 149.2% 16.7% 20.6%

FIH Mobile 2038 HK 89.6% Profit to loss 5.8% 2.6%

Truly 732 HK 11.4% Profit to loss 11.4% 8.4%

Tongda 698 HK 11.7% -23.6% 24.4% 25.4%

BYD Electronic 285 HK 13.2% 119.0% 8.0% 12.1%

Q Tech 1478 HK 108.7% 145.5% 9.3% 12.1%

Healthcare/pharma

CSPC Pharma 1093 HK 17.2% 27.1% 49.4% 57.3%

GZ Baiyunshan 874 HK 2.4% 39.2% 38.0% 37.4%

Sinopharm 1099 HK 8.7% 9.0% 8.1% 7.9%

Shanghai Pharma 2607 HK 10.2% 11.1% 11.8% 12.3%

Banks

ICBC 1398 HK 2.4% 1.8% 2.21 2.16

CCB 939 HK 2.5% 3.7% 2.32 2.14

BOC 3988 HK -5.4% 11.5% 1.9 1.84

ABC 1288 HK 6.4% 3.3% 2.31 2.24

CMB 3968 HK -0.3% 11.4% 2.58 2.43

CITIC Bank 998 HK -2.1% 1.7% 2.05 1.77

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Insurance

China Life 2628 HK 18.3% 17.8% 3.1% 3.4%

Ping An 2318 HK 32.9% 6.5% 11.3% 13.6%

CPIC 2601 HK 24.5% 6.0% 6.2% 5.4%

PICC 1339 HK 5.7% 14.1% 4.4% 4.1%

NCI 1336 HK -13.8% -2.9% 5.6% 7.5%

Oil

PetroChina 857 HK 32.0% 2287.2% 11.20% 11.10%

Sinopec 386 HK 32.6% 40.1% 11.50% 9.20%

CNOOC 883 HK 38.2% Loss to profit -16.2% 23.9%

Coal

Shenhua 1088 HK 53.1% 142.9% 33.1% 35.6%

China Coal 1898 HK 41.1% 913.3% 11.4% 22.9%

Yanzhou Coal 1171 HK 82.2% 819.8% 23.3% 35.3%

Power

Huaneng 902 HK 35.0% -96.1% 55.4% 37.5%

CR Power 836 HK 10.1% -65.3% 65.3% 47.0%

Datang Power 991 HK 2.9% -36.1% 69.2% 48.8%

Materials

Anhui Conch 914 HK 33.1% 100.6% 30.71% 32.97%

CR Cement 1313 HK 16.6% 536.8% 23.8% 29.5%

Maanshan 323 HK 67.5% 263.0% 13.4% 11.0%

Chalco 2600 HK 82.8% 1006.5% 8.0% 6.8%

Jiangxi Copper 358 HK 9.9% 51.4% 2.7% 3.3%

Railway

CRRC 1766 HK -6.0% -23.4% 22.4% 17.9%

China Railway 390 HK 11.2% 41.1% 8.2% 9.2%

China Railway Const 1186 HK 8.3% 12.0% 10.2% 8.8%

Telecom

China Mobile 941 HK 5.0% 3.5% 17.9% 17.5%

Unicom 762 HK -1.5% 69.0% 1.3% 2.5%

China Telecom 728 HK 5.3% 7.4% 9.7% 9.7%

Securities

CITICS 6030 HK 3.5% -6.0% 30.0% 26.2%

Haitong 6837 HK 0.8% -5.6% 26.9% 27.6%

Property

Vanke 2202 HK -4.5% 36.5% 22.1% 30.4%

Evergrande 3333 HK 114.8% 833.8% 28.3% 35.8%

CR Land 1109 HK -21.0% -33.1% 33.8% 34.9%

COLI 688 HK 6.5% 25.2% 28.8% 31.0%

Longfor 960 HK 1.2% 18.1% 27.9% 36.5%

Country Garden 2007 HK 35.5% 39.2% 21.0% 22.0%

Airlines

Air China 753 HK 8.8% -3.7% 14.8% 9.9%

China Southern 1055 HK 11.8% -11.1% 13.0% 7.6%

China Eastern 670 HK 4.5% 34.4% 15.4% 13.1%

Shipping

COSCO Shipping 1919 HK 45.6% Loss to profit -4.6% 8.6%

COSCO Shipping En 1138 HK -7.7% -53.2% 34.3% 26.7%

COSCO Shipping Dev 2866 HK -5.9% Loss to profit 6.1% 22.3%

Sinotrans 368 HK 29.8% Loss to profit -12.0% 1.0%

COSCO Shipping Ports 1199 HK 0.4% 123.8% 39.1% 35.7%

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Sep 27, 2017

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4Q17 Market Outlook

addition, the rising popularity of ETFs and the characteristics of insurance companies’ risk appetite also mean that large caps and blue chips will be favored. A blue-chips-only carnival In fact, investors have been chasing large-cap stocks during this rally.

By rising 25.1% YTD, the HSI has beaten the HSCEI, which rose 16.7% during the period. Meanwhile, the HS Large Cap Index rose 28.5% YTD, and the HS Mid Cap Index rose 25.8%, compared with 11.6% for the HS Small Cap Index. While investors were positive on the equity market, there was a clear flight-to-quality stance, as small-cap stocks typically lack growth predictability and suffer from weaker transparency.

Figure 24: Large and mid-caps outperforming small caps (YTD)


Figure 25: Sector performance YTD


Figure 26: Sector performance over the past three months


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4Q17 Market Outlook

Figure 27: Consensus sector earnings growth forecasts for 2018


Tech hardware, software and internet-related names remain attractive Internet-related demand

in areas such as gaming, advertising, payments and cloud services remain strong, as seen from BAT’s (Baidu [BIDU US], Alibaba [BABA US] and Tencent [700 HK, NR]) operating results, while smartphone upgrades and the new Apple [AAPL US] iPhone are likely to lead to further business growth in the supply chain. In fact, interim results show that Tencent’s results stood out on almost all fronts, Kingsoft’s (3888 HK, NR) entertainment software business grew rapidly, while Sunny Optical (2382 HK, NR) and AAC Tech (2018 HK, NR) reported stronger-than-expected earnings, with positive management guidance for 2H17. We expect upgrade demand for electronic products to continue in both China and overseas markets, leading to sustained earnings growth for leading companies in this segment of the economy.

Figure 28: Apple iPhone quarterly shipments

Sources: Apple Inc Note: Calendar quarter

Stock picking in the auto sector The auto sector is likely to be mixed given single-digit unit sales

growth this year, meaning investment opportunities will need stock picking. After growing 2% YoY in Jan-Aug 2017, we forecast PV sales will grow 3% YoY in 2017, with SUVs the only growth sub-sector, rising 19% YoY, while NEV sales will remain robust. With the expiration of the 25% purchase tax discount for vehicles with engines of 1.6 liters or below at end-2017, we foresee a mini rush in auto sales in 4Q17, especially for domestic brands which focus more on smaller PVs. Besides, 4Q17 is the traditional peak season as consumers make purchases before CNY. We believe domestic brands will continue to gain market share, especially from Korean brands given Sino-Korean political tensions, weaker new product offering from Korean automakers, and improving product quality from domestic automakers, particularly in the SUV segment. Besides, we expect high end/luxury brands to grow rapidly given rising purchasing power in both high and lower-

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Sep 27, 2017

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4Q17 Market Outlook

tier cities, and upgrade demand due to purchase restrictions in major cities. In this segment, we believe German brands will gain more market share. In particular, BMW has entered a new product cycle, adding the new 5-series sedan on top of its popular X1 SUV, while the X3 and new 3-series models are in the pipeline. Mercedes Benz has also seen success in the SUV market with the popular GLC. We continue to favor Geely Auto (175 HK, Buy) given its strong sales growth, high SUV concentration, and the likely success of its new Lynk & Co brand in the mid-to-high end market as well as its potential in the global market. We also like Brilliance China (1114 HK, Buy) given the likelihood that it will resume rapid earnings growth with BMW’s new product lines for China.

Figure 29: China auto sales

Sources: CAAM, GF Securities (Hong Kong) estimates

Structural change in premium growth has led to a re-rating in the insurance sector We remain

positive on the insurance sector. Since the beginning of this year, there have been structural improvements in insurance products under new regulatory policies from the CIRC, with a shift in focus from single premiums to regular premium products, from bancassurance to agency channel, and from wealth management to protection-based products, which we believe have been behind the sector re-rating. Interim results from insurance companies revealed strong new business value (up 29-59% YoY among major insurers), new business margin (34-41%) and embedded value (up 7-16% YoY) which are likely to remain buoyant in 2H17. Higher bond yields and an improving A-share market are also likely to lead to better investment returns this year, while the bottoming out of the 750-day MA of the 10-year Chinese government bond yield could potentially reduce provisions and release accounting profits. Valuations in terms of P/B and P/EV are around the historical average level; we believe the sector will see a further re-rating.

Figure 30: 750D MA of Chinese government bond yield

Sources: Wind, GF Securities (Hong Kong) Note: Assuming that the government bond yield remains consistent after Sept 4, 2017.

Re-rating of banks may just be beginning Banks’ interim earnings were in line with expectations,

with an improvement in asset quality with lower NPL ratios and QoQ increases in NIM, alleviating a key market concern. Higher loan yields and relatively stable funding costs (especially for larger banks) helped NIM to improve, while improving corporate profits will further lower NPLs, in our view. Despite the sector’s low growth potential, its low valuation and consistent high dividend yields are attractive to long-term investors looking for stable incomes. We believe banks can play catch up as investors start to re-rate this underperforming sector. Financial intermediaries and exchanges Trading in the secondary market has become more

active this year, with average daily turnover (ADT) rising 19.9% YoY to HK$80.3bn in 8M17, and increasing to HK$96.9bn in Sept MTD. Moreover, with the Bond Connect and the upcoming

('000 units) 8M17 YoY Growth (%) 2017E YoY Growth (%) 1H18E YoY Growth (%) 2018E YoY Growth (%)

Total auto sales volume 17,511 4.3 29,492 5.0 13,939 4.4 30,882 4.9

Passenger vehicles 14,807 2.2 25,245 3.3 11,651 3.5 26,293 4.4

Sedan 7,157 (2.2) 11,879 (2.5) 5,321 (2.0) 11,706 (1.2)

MPV 1,285 (16.2) 2,033 (18.5) 877 (13.0) 1,799 (11.6)

SUV 5,991 17.1 10,799 19.0 5,247 15.0 12,418 15.4

CUV 374 (27.2) 534 (26.4) 207 (35.0) 369 (30.8)

Commercial vehicles 2,704 16.9 4,247 16.4 2,288 8.9 4,589 8.0

Bus 299 (10.9) 503 (5.6) 213 1.0 508 (0.9)

Truck 2,405 21.6 3,744 20.3 2,075 10.0 4,081 9.2

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Sep 27, 2017

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4Q17 Market Outlook

inclusion of A-shares in the MSCI Index, financial intermediaries and stock exchanges are likely to benefit from growing business opportunities. Defensive sectors with sustainable earnings The environmental protection sector has

underperformed YTD as investors have been concerned about the progress of PPP projects and uncertainties on project returns. However, the accelerated roll-out of PPP projects and particularly the sharp increase in project execution have alleviated investor concerns about the implementation and feasibility of PPP projects. Total investment in PPP projects under execution has exceeded those at the preparation stage, accounting for 20% of total investment. Interim results of leading players such as Beijing Enterprises Water (371 HK, NR) and China Everbright International (257 HK, NR) were up 22% and 49% YoY, respectively, indicating their operating strength. We believe companies with a state-owned background, a strong project pipeline and good execution track record are more likely to deliver sustainable earnings growth in the sector, while valuations are attractive given their high earnings growth. Although the healthcare sector lacks strong underlying re-rating drivers in the short term given

stringent government regulations such as the zero mark-up policy on drugs in hospitals, we see opportunities for large pharma companies focusing on biosimilars and innovative drugs, those with higher exposure to the new NDRL, TCM pharma companies facing less policy headwinds, and those with operational and financial strengths that can benefit from industry M&A. Leading drug makers like CSPC Pharma (1093 HK, Accumulate), for example, reported 27% YoY earnings growth in 1H17, with an improving profit margin, proving its earnings sustainability. Commodities and materials sector The coal, metals and cement sectors have outperformed the

market this year on the back of an earnings turnaround as product prices have surged. Among these sectors, we expect further price upside for aluminum as it has the greatest potential in terms of capacity reduction and supply cuts in 4Q17, due to the government’s air pollution control measures in the greater Beijing area. However, valuations have become quite rich after the strong run this year, meaning there is limited upside, in our view. Meanwhile, in the coal and steel sectors, there has been less pressure to shut down capacity this year compared with 2016, meaning less supply-side support for prices, while there was also no major supply cut plans for cement industry, which controls supply mainly through seasonal production cuts due to power control measures. Compared with aluminum, we see limited price upside given weakening demand from the property and infrastructure sectors. On the other hand, global oil prices seem to have found some kind of equilibrium as OPEC’s production controls have helped to mitigate rising production of shale oil in North America. The Trump administration’s preference for traditional fossil fuels and the US’s potential withdrawal from the Paris Climate Accord should also help oil demand in the long term. After suffering significant earnings declines or losses in 2016, we have seen strong earnings rebounds at Chinese oil companies with their encouraging interim results; they also have low valuations and attractive dividend yields.

Watchlist and stock picks Watchlist Our ten-stock watchlist has continued to provide satisfactory performance this year,

generating a 52% return YTD, beating the HSI’s +25% and the HSCEI’s +17% during the period. Moving into 4Q17, we remain positive on tech, autos, insurance and financial intermediates, and maintain our recommendation for exposure to healthcare and environmental protection as market volatility justifies a defensive stance, while adding banks, given a likely further re-rating, and oil, given visible earnings growth, and as both sectors have low valuations and high yields. Tencent (700 HK, NR): The company’s comprehensive internet ecosystem continues to enjoy rapid growth on all fronts. Driven by 59% YoY growth in gaming, 55% YoY growth in advertising, and 177% YoY growth in payment and cloud services, its 2Q17 revenue surged 59% YoY, and net profit was up 70% YoY, exceeding market expectations. Earnings momentum looks set to continue given its strong pipeline in games and strong potential in advertising, payments and cloud services. AAC Tech (2018 HK, NR): 1H17 profit grew 57% YoY on 55% YoY growth in sales and a GPM as high as 41%. RF Mechanical and Haptics solutions grew by a strong 130% YoY, meaning non-acoustic revenue surpassed that of acoustic. Major upgrade trends involving stereo sound and waterproof features have driven sales of dynamic components, according to management. The outlook remains promising with the launch of the new iPhone and specification upgrades among Android device vendors. Besides, its optical lens module business is growing faster than the market had expected, with greater clarity in terms of ASP and shipment volume potential for the next few years, and should become another earnings driver in the next few years.

Sep 27, 2017

18

4Q17 Market Outlook

BOC (3988 HK, NR): Interim results were better than expected, with net profit growing 11.5% YoY, the highest among large banks. NIM improved by 4bps from 1.80% in 1Q17 to 1.84% in 1H17 given a better macro environment and optimization of its asset liability structure. NPLs came down to 1.38% in 1H17, 7bps lower than in 1Q17, as its special mention loan and overdue loan ratios edged down to 2.77% and 1.97% respectively in 1H17, down 34 bps and 18 bps, respectively. An increasing contribution from retail banking has offset slower corporate banking growth. We expect further earnings growth in 2H17 and 2018 on the back of stronger net interest income and lower credit cost. Ping An (2318 HK, Buy): 1H17 profit grew 7% YoY, with underlying profit (excluding one-offs) up 39% YoY, leading its Chinese peers. Embedded value (EV) grew 16% HoH, with a 24% YoY increase in life and health insurance EV. The company’s agency force exceeded 1.3m (up 19% HoH), and productivity increased 18% YoY. Management expects its agent number to grow by 15% annually in the next five years, followed by 10% per annum due to demographic changes, providing a solid base for new business growth. HKEx (388 HK, NR): Interim profit was up 17% YoY on 10% higher revenue as average daily turnover (ADT) rose 13% YoY and IPO capital raised was up 26% YoY. Market turnover has increased further in 3Q17 with ADT rising 20% YoY in 8M17. Recent improvements in the A-share market should lead to stronger revenue from Northbound trading. With the latest addition of the Bond Connect, HKEx is one step further to becoming a one-stop-shop serving mainland and foreign investors, hence reinforcing its global competitiveness in the exchange market. As the Hong Kong and mainland stock markets remain in an uptrend, we believe its business outlook remains bright and expect higher revenue growth in 2H17. Geely Auto (175 HK, Buy): Interim profit surged 128% YoY as unit sales grew 89% YoY, ASP was up 16% YoY and GPM edged up 1.5% to 19.2% in 1H17. It has plans for a rich product portfolio over the next few years, with a new compact SUV (Vision X3), new HEV and PHEV Emgrand sedans, and the Lynk & Co 01 to be launched in 4Q17. Performance during the typically weak 3Q season has remained encouraging, with unit sales growing 88% YoY in 8M17, achieving 65% of its full year target. We expect sales to remain strong for its existing Geely brand, while the new Lynk & Co brand could provide further positive surprises, leading to a further re-rating. Brilliance China (1114 HK, Buy): Interim profit grew 28% YoY on the back of 40% growth for its BCA-BMW JV as its unit sales increased 30% YoY. The launch of the new 5-series in June marks the start of a new product cycle for BCA-BMW as well as a broader product portfolio (1-series, 2-series, 3-series, 5-series, X1, while the X2 and X3 are in the pipeline for the next two years), enhancing its competitiveness in the luxury market, and enabling it to maintain high earnings growth. CSPC Pharma (1093 HK, Accumulate): 1H17 earnings rose 27% YoY, broadly in line with earnings growth driven by continued momentum in innovative drugs, accelerating generic drug sales growth, and price increases for Vitamin-C as well as stable performance in its caffeine business; GPM rose 7.9pp to 57.3% on a better profit mix and improved sales in finished drugs and Vitamin-C. We believe NBP remains the major growth driver for innovative drugs while oncology drugs are catching up, and the upcoming implementation of the new NDRL should further underpin volume growth in both segments. Management’s strong track record provides confidence of sustained earnings growth. BJE Water (371 HK, NR): Interim profit was up 22% YoY on a 16% YoY increase in revenue, as sewage and reclaimed water treatment revenue grew 21% YoY and water supply revenue grew 40% YoY. Net processing capacity increased by 2.5mtpd to 29.7mtpd, maintaining its >30% growth rate since 2009. Management guided for 3-4mtpd new capacity this year, for turnover to grow 23% YoY, and net profit to rise by 30% YoY, or >40% if stripping out fair value movements of derivatives. Capex will come down from Rmb11bn to Rmb7bn as it pursues an asset-light strategy. We believe BEW has a solid track record in securing new projects and delivering high earnings growth, and its valuation is attractive. CNOOC Ltd (883 HK, NR): Interim profit came in at Rmb16.25bn in 1H17, similar to Rmb16.19bn in 2H16, and compared with a Rmb15.56bn loss in 1H16. Interim dividend was generous at HK$0.2/share, up 66.7% YoY, representing a 48% payout ratio. 1H17 production is 52% of its full year target with a 10% lower all-in-cost average of just US$33.1/BOE, helped by lower DD&A and exploration expenses. We believe the stock is attractive under a stable crude oil price environment.

Sep 27, 2017

19

4Q17 Market Outlook

Figure 31: Watchlist for 4Q17

Sources: Bloomberg consensus, GF Securities (Hong Kong)

Figure 32: Watchlist highlights

Source: GF Securities (Hong Kong)

Figure 33: Top-10 watchlist record

Source: GF Securities (Hong Kong)

Figure 34: Portfolio performance record

Sources: Bloomberg, GF Securities (Hong Kong) Note: Data up to Sept 26, 2017; portfolio rebalanced to equal weight each month end

Stock Ticker Rating Price (HK$) 2017E P/E (x) 2018E EPS YoY (%)

Tencent 700 HK NR 337.60 42.9 28.4

AAC Tech 2018 HK NR 126.10 24.2 26.9

BOC 3988 HK NR 3.91 5.7 6.5

Ping An 2318 HK Buy 60.70 13.1 17.3

HKEx 388 HK NR 211.40 36.6 12.0

Geely Auto 175 HK Buy 22.20 18.7 30.8

Brilliance China 1114 HK Buy 21.00 17.3 48.2

CSPC Pharma 1093 HK Accumulate 12.90 28.9 25.5

BJE Water 371 HK NR 6.23 13.4 25.2

CNOOC Ltd 883 HK NR 9.90 13.2 14.1

Company Ticker Highlights

Tencent 700 HK Proxy for the internet sector, strong growth in multiple sectors and through acquisitions

AAC Tech 2018 HK Apple proxy; optical lens module business stronger than expected

BOC 3988 HK Improving NPLs and NIM; strongest 1H17 growth among large banks

Ping An 2318 HK Underlying profit up 39% YoY in 1H17, leading peers. Agent number up 19% HoH; management upbeat on agency growth

HKEx 388 HK Rising market turnover and increasing mutual access between Hong Kong and China exchanges to continue

Geely Auto 175 HK Strong product pipeline; NEVs ready; upside from Lynk & Co

Brilliance China 1114 HK Entering a new product cycle with a new 5-series, which will be followed by an X3, X2, and new 3-series

CSPC Pharma 1093 HK Volume-driven growth from the new NDRL implementation; innovative drugs maintaining strong growth

BJE Water 371 HK Rich project pipeline with strong execution ability; asset-light strategy to relieve debt burden

CNOOC Ltd 883 HK Benefitting from a much more stable oil price; continued efforts to lower all-in-cost boosting profit margins with visible growth

Stock Ticker Stock Ticker Stock Ticker Stock Ticker Stock Ticker

Tencent 700 HK Tencent 700 HK Tencent 700 HK Tencent 700 HK Tencent 700 HK

Chinasoft 354 HK Tongda 698 HK Tongda 698 HK AAC Tech 2018 HK AAC Tech 2018 HK

AAC Tech 2018 HK AAC Tech 2018 HK AAC Tech 2018 HK Geely Auto 175 HK Tongda 698 HK

ASM Pacific 522 HK ASM Pacific 522 HK ASM Pacific 522 HK Guangzhou Auto 2238 HK Geely Auto 175 HK

Geely Auto 175 HK Geely Auto 175 HK Geely Auto 175 HK NCI 1336 HK Brilliance China 1114 HK

Li Ning 2331 HK CSS 116 HK CSS 116 HK Ping An 2318 HK China Life 2628 HK

China Life 2628 HK China Life 2628 HK China Life 2628 HK CSS 116 HK HKEx 388 HK

CSPC Pharma 1093 HK China TCM 570 HK China TCM 570 HK China TCM 570 HK CSPC Pharm 1093 HK

CRSC 3969 HK CRSC 3969 HK CRSC 3969 HK CRCC 1766 HK Wisdom Education 6068 HK

BJE Water 371 HK BJE Water 371 HK BJE Water 371 HK BJE Water 371 HK BJE Water 371 HK

Jan-Mar Apr May Jun Jul-Sep

Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17

Monthly

Watchlist 1.0 1.3 -6.5 8.2 5.5 6.2 6.0 -3.8 5.7 9.6 6.3 -0.2

HS Index -1.6 -0.6 -3.5 6.2 1.6 1.7 2.1 4.2 0.4 6.1 2.4 -1.6

HSCE Index -0.2 2.9 -4.5 4.4 5.0 -0.2 -0.5 3.7 -2.2 4.5 4.3 -2.9

YTD

Watchlist 20.6 22.2 14.2 8.2 14.1 21.1 28.4 23.6 30.6 43.1 52.1 51.8

HS Index 4.7 4.0 0.4 6.2 7.9 9.6 11.9 16.6 17.1 24.2 27.1 25.1

HSCE Index -1.1 1.8 -2.8 4.4 9.6 9.3 8.8 12.8 10.3 15.2 20.2 16.7

Since 2015

Watchlist 30.0 31.6 23.1 33.1 40.4 49.1 58.1 52.1 60.7 76.1 87.2 86.9

HS Index -2.8 -3.5 -6.8 -1.0 0.6 2.1 4.3 8.7 9.1 15.8 18.5 16.6

HSCE Index -20.2 -17.9 -21.6 -18.2 -14.1 -14.3 -14.7 -11.5 -13.5 -9.7 -5.7 -8.5

Sep 27, 2017

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4Q17 Market Outlook

Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months

Company ratings

Buy Stock expected to outperform benchmark by more than 15%

Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15%

Hold Expected stock relative performance ranges between -5% and 5%

Underperform Stock expected to underperform benchmark by more than 5%

Sector ratings

Positive Sector expected to outperform benchmark by more than 10%

Neutral Expected sector relative performance ranges between -10% and 10%

Cautious Sector expected to underperform benchmark by more than 10%

Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report.

Disclosure of Interests (1) The proprietary trading division of GF Securities (Hong Kong) Brokerage Limited (“GF Securities (Hong Kong)”) and/or its affiliated or associated companies do not hold any shares of the securities mentioned in this research report. (2) GF Securities (Hong Kong) and/or its affiliated or associated companies do not have any investment banking relationship with the companies mentioned in this research report in the past 12 months. (3) Neither the analyst(s) preparing this report nor his/her associate(s) serves as an officer of the company mentioned in this report and has any financial interests or hold any shares of the securities mentioned in this report.

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4Q17 Market Outlook - gfgroup.com.hk · 9/27/2017 · -5% Sep 27, 2017 3 4Q17 Market Outlook Figure 3: Signs of overbuying Sources: Bloomberg, GF Securities (Hong Kong) Valuation