China economy hits bottom. Time to buy stocks?

China posts slowest growth since 2009, but other signs point to stronger-than-expected growth ahead. Some analysts say the time is right to buy Chinese equities. 

Aly Song/Reuters
Migrant labourers work at a demolished residential site in Shanghai Oct. 18, 2012. China's economy slowed for a seventh straight quarter in July-September, but other data released on Thursday pointed to a year-end rebound.

A slew of Chinese data, including quarterly growth numbers, adds weight to what observers have been saying for weeks — that the slowdown in the economy may have bottomed. This could just be what the country’s stock market needs to get out of the doldrums.

Thursday’s numbers did lift the benchmark Shanghai Composite Index, up 1.25 percent to its highest level in a month.

 New data showed China’s fixed asset investment growth was 20.5 percent in the year to September, industrial output grew 9.2 percent from a year earlier, while retail sales rose 14.2 percent from a year ago.

 The figures were all stronger than expected. China’s third quarter GDP meanwhile, grew 7.4 percent from a year earlier, the slowest quarterly pace since the first quarter of 2009. (Read more: China Third Quarter GDP Growth 7.4% on Year, Below Official Target.)

 Still, the number was in line with expectations and indicates that growth momentum has accelerated for two straight quarters and was “particularly strong” in September, according to Dariusz Kowalczyk, senior economist and strategist for Asia ex. Japan at Credit Agricole.

 “Quarter-on-quarter growth accelerated to 2.2 percent, the most in a year and 9.1 percent in annualized terms — well above the 7.5 percent (official) growth target,” he said. “Clearly, concerns over continued slowdown can now be put to rest. It is very positive for all risk assets.”

 The benchmark Shanghai stock market has underperformed major global stock markets this year against a backdrop of sluggish economic growth. While the S&P 500 index and major Asian indices have chalked up gains of more than 10 percent this year, the Shanghai Composite has shed about 4 percent.

 The fall in Chinese shares has puzzled some equity strategists who have argued for months now that China’s economy, while slowing, remains relatively strong and suggest that Chinese shares are cheap.

Where to Now?

Vincent Chan, Credit Suisse’s head of research for China, sees a 20 percent upside for Chinese shares at the very least, especially since stock market valuations are back at 2008 levels.

“In view of stabilization in the macro economy, we expect limited market downside — and the market should recover from here,” said Chan in a report published this week. “The current index level (of the Hang Seng Chinese Enterprises Index) implies that 2013 and 2014 earnings would have to drop 10 percent to 15 percent per annum and we think this is unlikely.”

Credit Suisse likes banks, materials, and transportation companies, and upgraded them to “overweight.” The firm downgraded consumer staples and technology, mainly Internet plays, to “underweight.”

“Our biggest ‘overweights’ are insurance and diversified financials,” Chan said. “Our top picks are China Construction Bank, Air ChinaJiangxi CopperPing An Insurance, and Shenhua Energy.” Chan said these stocks are now trading at valuations that are cheaper than their historical averages and too much pessimism has been priced in.

Bank Julius Baer’s head of Asian equities Mark Sheriff said China’s stock market appears to have stabilized.

“The Shanghai market appears to have finally bottomed at 2,000 (points), and until it falls below there, we would be spitting into the wind being bearish on it,” he said.

Calvin Wong, Towers Watson’s head of Greater China equity research, recommends buying consumption plays to take advantage of the shift towards domestic demand in China, which will be a “major driver of growth” going forward. (Read more: Chinese Give Luxury Goods a Pass, Go on Holiday Instead.)

Others are not convinced, with many money managers still bearish on China. According to Credit Suisse’s research, the net exposure of hedge fund managers have started to rise in Asia, but mainly in India, Taiwan, and Korea. In contrast, the exposure to China is still on the way down, falling from nearly 8 percent in March to 4.6 percent this week.

Some equity strategists believe that China is still a long way from solving systemic problems such as bad debts, and this could continue to weigh on investor sentiment.

“China’s economy may simply need more time to work through the bad debts in its system, and to digest the surge in credit-fueled investment that happened after 2008, so that the domestic economy can grow again on a healthier, and more sustainable basis. That may take some more time,” said Mikio Kumada, global strategist at LGT Capital Management.

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