The Year of the Horse: 3 Reasons Chinese Stocks Could Gallop Ahead in 2014

As we head into 2014 (the year of the horse), I’m still bullish on equities in one country: China.

While Chinese stocks have massively underperformed their U.S. and developed market counterparts year to date, I’m retaining my overweight to the country’s stocks, as I wrote inmy new 2014 outlook.

In fact, there are three reasons why I expect Chinese stocks to gallop ahead over the long term.

1. Economic growth is stabilizing. China did not experience a hard landing in 2013 as many market watchers feared, and the economy now appears almost certain to meet its 2013 growth target of 7.5%. In addition, as China’s gross domestic product (GDP) level is much higher now than a decade ago, China can afford to grow at a slower rate than in the past without damaging employment and wage growth.

2. Authorities appear serious about reforming China’s economy. Thereforms agreed to at the government’s policy-setting meeting in Novemberare far-reaching, aiming to strengthen the market-based economy with financial liberalization and land reforms and potentially changing the economic role of the government. Efforts to further liberalize the financial markets have mitigated concerns regarding the stability of China’s financial sector. Land reforms and the easing of China’s one-child policy should support China’s move toward a consumption-oriented, rather than an investment-led, economy. This shift, in turn, should help sustain, and stabilize, China’s growth over the next five to 10 years (consumption-driven growth tends to be more stable than investment-led growth, according to my team’s research. In addition, today China arguably has too high of an investment rate).

3. Chinese valuations are attractive. Chinese stocksstill look cheapconsidering the country’s growth and profitability prospects. In fact, as I wrote back in June, there’s nowa strong case for viewing the Chinese market as a value – rather than a growth – play. In addition, the two main factors that have been depressing Chinese stocks — potential instability in the local financial sector and a potentially unsustainable growth model – are being addressed by the government’s reform agenda. As the reforms progress, Chinese valuations should benefit.

To be sure, there is a chance that Chinese stocks will trot or even stumble, rather than gallop, in 2014.

Arguably, the biggest risk is that the Chinese reform progress becomes hindered by resistance from entrenched interests, as reform policy implementation is a key factor in my overweight outlook for China. There’s also the risk thattensions in the region over a disputed air zonecould worsen and lead to military conflict.

Finally, in the near term, Chinese growth could slow as support from housing and infrastructure investments fades with the transition toward a consumption-led economy, and asthe overheated housing marketandballooning shadow banking system debtrequire policymakers to keep credit conditions tight.

Still, for the three reasons I cite above, I’m still bullish on China for now.

Sources: Investment Directions, Investment Strategy Group research, Bloomberg

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