As China Polices Cash Outflows, Morgan Stanley Sees Bull Market in Stocks

Morgan Stanley analysts are looking past growing warning signs on China's economy to predict a big rally in the country's stock market.

The Shanghai Composite Index may surge 42% from Jan. 3 levels, according to a report last week from the New York bank. Such gains would mark a turnaround from recent performance: The Shanghai index is down 1.2% in the past 12 months, even as stocks from developing countries have rallied 22% on average.

A big driver of Chinese stocks could be the capital controls the government has put in place to stem a recent tide of currency outflows; with less flexibility to move money out of the yuan, local investors may have little choice but to keep their money in the domestic stock market, according to the firm. And with markets such as bonds and real estate looking increasingly inflated, stocks may be the best choice.

Stricter foreign-exchange policies "will likely serve to bottle liquidity," wrote the analysts, Jonathan Garner, Laura Wang and Corey Ng. "The more explicit comments by the authorities on the need to rein in "asset bubbles" are referring to conditions in the property and bond market, and not stocks."

Morgan Stanley's bullish call comes as more investors, including Quantum Fund co-founder Jim Rogers, warn that China will struggle to manage an ongoing slowdown in its economy, the world's second largest, not to mention a debt burden that has ballooned in recent years. According to Bloomberg, Chinese debt has swelled to roughly 2.7 times gross domestic product, close to the level of three times that has triggered financial crises in some nations in years past.

The country also faces the growing threat that President-elect Donald Trump will follow through on his pledge to label China a currency manipulator and slap tariffs on imports of as much as 45%.

China's foreign exchange reserves -- used like fuel to slow depreciation in the nation's currency -- fell by $320 billion last year to $3.011 trillion, following a record drop of $513 billion in 2015, according to Reuters.

The $3 trillion threshold is seen by some analysts as an important psychological threshold, and Chinese officials are tightening rules to keep residents and foreigners from moving money out of the country en masse.

The yuan has slid 5.6% over the past 12 months to about 6.9 per U.S. dollar. Investors including the hedge-fund manager Kyle Bass of Hayman Capital predict that the Chinese government will eventually have to undertake a steeper devaluation; a falling currency would hurt returns for dollar-based investors in the Chinese stock market.

Reuters reported today that China's foreign-exchange regulator has told some banks that it plans to step up scrutiny of cross-border money transfers, while pushing investment analysts to avoid publishing negative views on the yuan.

Morgan Stanley acknowledges there are big risks.

For starters, Chinese securities regulators have accelerated reviews and approvals of initial public offerings -- a move that could increase the supply of new stocks in the market, according to the firm. IPOs could increase in number by 60-80% versus 2016 levels.

Second, government agencies have urged insurance companies to avoid short-term stock-trading strategies, according to Morgan Stanley, and instead rely more on fixed-income investment.

What's more, the National Pension Fund has been delayed in its plans to start putting money into the onshore stock market.

There's also the possibility that inflation might surge to the point where China's central bank has to raise interest rates, damping investor sentiment. And heightened trade tensions with the U.S. could "adversely impact China's export performance and hence, growth," the analysts noted.  

Despite the risks, Chinese companies are likely to increase their earnings in 2017 by 6%, following an estimated 9% decline in 2016 and 6% drop the year before.

And price-to-earnings multiples for stocks in the index could climb to 22 times, from 17.6 now; over the past five years, they've traded in a range of 9.5 to 25.

The National Pension Fund could start investing in the market during the second quarter of 2017, Morgan Stanley estimates.

Top stock picks include information-technology firm Haige Communications, which could jump 80%, and materials producer Tianqi Lithium Industries, set for a 67% surge, according to the analysts.

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