Counting on the Chinese consumer

FOLLOWING some excitement around the turn of the year, China’s equity market has been grinding lower since January, as property market woes and geopolitical risks weighed on growth and sentiment.

We believe the most attractive investment opportunity in China is tied to the domestic consumer. We see sustained growth in consumer spending, which is likely to benefit media and entertainment companies.

Therefore, we have a preferred view of the communication services equity sector, which we expect to outperform China’s broader equity market.

Consumption-driven growth

In our view, authorities in China are determined to engineer an economic transition to make the economy less dependent on real estate, and increasingly powered by consumption over the longer term.

This transformation may involve targeted fiscal stimulus that can be implemented easily, or a reform of the hukou system, which manages the rural-to-urban migration of workers and is more challenging to execute. The latter would provide the safety net of social welfare to millions of migrant workers. This, in turn, is likely to be a game changer in stimulating consumption.

Other factors, such as an improvement in the employment outlook, would encourage consumers to spend more. Regardless of the path, we believe Chinese consumption will continue to grow, spurred by government policy and rising income.

As consumers increasingly live in a digital world, socialising, being entertained, learning, working, shopping, selling and managing finances are all conducted in the digital space.

Hence, the expected consumption growth is likely to significantly benefit media and entertainment companies, which provide the aforementioned services in a competitive and innovative environment.

In recent months, senior government officials have recognised the role of large Internet firms in innovating and creating jobs and expressed support for them, dialling back on the regulatory clampdown seen a few years ago.

Earnings upgrade

The improving policy backdrop adds a tailwind to the communication services sector, which has already delivered earnings beats in the first three quarters of this year. Earnings revision – a measure of how many companies have seen consensus earnings upgraded versus downgraded – has been positive for the sector, compared to negative earnings revisions seen for China’s broader market.

The consensus expects the communication services sector to deliver 56 per cent earnings growth in 2023 (versus 16 per cent for the broader market) and 15 per cent earnings growth in 2024 (versus 15 per cent for the broader market).

The superior earnings profile is partly reflected in the sector’s outperformance of the broader market so far this year. However, we believe that sustained earnings strength will enable the sector to continue delivering outperformance in the next six to 12 months.

Attractive valuations

Apart from the robust earnings outlook, the sector remains attractively valued, in our view. It is trading at 15 times its 12-month forward earnings, compared to an average of 23 times in the last five years – a hefty 35 per cent discount.

Relative to the broader market, the communication services sector trades at around 60 per cent premium on a 12-month forward price-to-earnings ratio. This is considerably lower than the average 84 per cent premium in the last five years. This supports our view that despite outperforming the market in the year to date, there is scope for further outperformance.

Unexpected regulatory changes that can impact growth or profitability are a key risk to watch when investing in China’s media and entertainment companies. In addition, competition in the sector can be intense and a surge in costs can eat into profit margins. Finally, a significant economic slowdown in China would affect consumer spending, impacting the sector’s performance.

On balance, we believe the benefits outweigh the risks, leading to our preference for the communication services sector in China.

The writer is senior investment strategist at Standard Chartered’s Wealth Management Chief Investment Office