Q4 unlikely to produce another nice surprise for China stocks

HONG KONG, Sept 30 Mon Sep 30, 2013 1:42am EDT

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HONG KONG, Sept 30 (Reuters) - In early July, long-depressed Chinese stocks stepped into the unlikely role of stars among emerging markets. But the outperformance has ended, and it's very unlikely investors will see a repeat any time soon.

At the rebound's peak in early September, the MSCI China index of mostly offshore listings in Hong Kong was up 20 percent from June lows, while the onshore market spiked 16 percent.

Helping fuel that rally was a spate of reassuring data that considerably improved views of the Chinese economy. Also, China, with its closed capital system, was seen as a relatively safe haven among emerging economies, whose growth is threatened by more capital outflows when the U.S. Federal Reserve cuts its asset-buying programme.

But the recent rally reflected mainly a reduction in extreme bearishness on the Chinese market, and hence an improvement in share valuations, rather than a foundation for sustained share-price gains.

"It's not the beginning of a trend reversal," said Joseph Tang, who as Invesco Asia's investment director helps manage $1.3 billion in a series of China-focused funds. "It's too early to say if China equities have entered a long-term up trend."

Ahead of a one-week closure of mainland markets for National Day that starts on Tuesday, China shares trimmed gains and some with large recent gains have been hit by profit-taking. Still, the MSCI China index has risen more than 10 percent in the third quarter.

Long-term domestic issues clouding the outlook for offshore Chinese shares include growing indebtedness of companies, industrial overcapacity and still-soft growth.

It was a spike in mainland interbank lending rates in late June that raised fears of serious grief in the world's second-largest economy, triggering a slide in global markets.

The rally effectively began after the People's Bank of China intervened by ordering larger banks to lend to smaller banks and by promising to stabilise the market. A slew of positive July and August economic data, along with the approval of a Shanghai free trade zone, spurred further gains.

While some investors were concerned about missing the rally, "there has not been any real change in their outlook on China," said David Cui, Bank of America-Merrill Lynch's Shanghai-based chief China equity strategist.

Already, capital flows data suggests the interest in Chinese equities remains sluggish. Short selling interest in Hong Kong has remained largely above the 8 percent historic average throughout.

According to a Sept. 30 Macquarie report citing data from funds tracker EPFR, China-dedicated funds saw fund outflows intensifying in the week that ended Sept. 25 in a 19th consecutive week of outflows.

From conversations with clients, Cui said global macro funds appeared to remain the most pessimistic on China and that much of the recent interest in Chinese equities has been centered on the banking sector.

CHANGED VALUATIONS

Shares of mid-sized lender China Minsheng Bank, among the hardest hit at the height of the cash crunch, have rebounded nearly 30 percent in Hong Kong from a June trough.

Now up more than 4 percent on the year, Minsheng's H-share listing is now approaching normalized valuation, trading at 1 time book value, despite being some 12 percent below its historical median, according to Thomson Reuters StarMine.

The broader market is trading at a similar valuation. The MSCI China index is at about 10 times forward 12-month earnings, according to Thomson Reuters I/B/E/S data. This is still one standard deviation below its historical mean, suggesting that valuations remain cheap.

"China market (at) 9 times P/E is too cheap... 10 or 11 times would be a fair level," said Byhungha Kim, who as co-chief investment officer at Mirae Asset Global Investment manages $2.2 billion in a series of onshore and offshore China funds.

While this might suggest more near-term gains are possible, several risks lurk.

Ominously, the final reading of a private survey on China's factory activity in September came in at 50.2 on Monday, an unusual downgrade to a preliminary reading last week that came in at 51.2, suggesting that manufacturing likely grew at its fastest pace in six months.

Offshore Chinese markets are also vulnerable to a pullback in the onshore market after the third plenary session of the 18th National Congress in November, a policy meeting where China's new leaders usually set out economic priorities for their 10-year term.

(Editing by Richard Borsuk)

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