China rally - more to come?

The recent China shares rally was mainly due to strong annual results as well as positive corporate guidance on Q1. But near term consolidation should be expected as we gradually approach the end of the result season.

The current valuation of H shares (those listed in Hong Kong) indicates that many stocks are fully valued. Hence there is less room for earnings to be revised up in the short term. The PE ratios for 2007 are A shares (China listed) 35-40 and H shares 16.

Favoured sectors include banking (fairly valued but with positive catalysts of potential cut in business tax in 2H07, strong loan growth, improving net interest margin after rate hikes); consumer (those with a strong brand name and signficant market share, e.g. Mengniu, China Mobile); auto/auto parts (valuations remain attractive at mid-teens); selective materials (coal, cement, glass); Internet (focusing on on-line advertising segment); and shipbuilding/repair (the sector is in the fast-growing phase with asset injection opportunities).

The government intends to raise interest rates steadily in the rest of this year (every time by a modest 27bps). This could be used as an excuse for profit-taking in the near term and the market is expecting another rate hike in the coming 1-2 months.

Fund managers who have visited companies in Beijing/Tianjin recently report that the growth outlook is still positive. However, quite a lot of the upside has been reflected in share prices and a number of fund managers have raised their cash level lately.