UBS Sees 20% Drop for Biggest China Stocks on Profit Drop

UBS AG says it’s time to start cutting Chinese profit forecasts again.

Chen Li, the lender’s chief China equity strategist, estimates companies in the nation’s CSI 300 Index will post a 3 percent drop in earnings this year, versus consensus forecasts for a 14 percent gain. As analysts downgrade projections to account for a weak property market and depreciating yuan, China’s biggest non-bank stocks may extend this year’s drop to 20 percent, Chen says.

The Shanghai-based strategist sees parallels with 2012, when the nation’s slowing economy spurred analysts to reduce profit estimates and the CSI 300 index fell more than 20 percent from its May high through the December low. The gauge has retreated 8 percent so far this year amid concern that a housing slump will add risks to an economy that analysts already predict will grow at the slowest pace in 24 years.

“It will be a down year for stocks,” Chen said in a May 13 interview at the Swiss bank’s office in Shanghai. “Property will be the biggest risk.”

Chen predicted China’s stocks would tumble in 2011, when the CSI 300 plunged 25 percent. He forecast a 20 percent rally in December 2012. While the gauge subsequently advanced more than 25 percent in two months, it erased most of those gains by mid-year.

Yuan Impact

Chinese President Xi Jinping said last week that the nation needs to adapt to a “new normal” in the pace of economic growth. New building construction fell 22 percent in the first four months of the year, while home sales slid 18 percent in April. Data on industrial output, retail sales and investment for April released this week all trailed analysts’ estimates.

The CSI 300 fell 1.3 percent to 2,144.08 at the close, versus a 0.3 percent gain in the MSCI Emerging Markets Index. The Bloomberg index of the most-traded Chinese shares in the U.S. dropped 0.2 percent to 100.71 in New York yesterday, extending this year’s decline to 5 percent.

The yuan has lost 2.8 percent versus the dollar this year and touched its weakest level since October 2012 last month.

A weaker Chinese currency has hurt businesses, including airlines and developers, that borrowed money in dollars to fund projects, Chen said. A further 3 percent depreciation would cost the companies about 30 billion yuan ($4.8 billion), equal to as much as 9 percent of their total earnings, Chen said.

The CSI 300 index’s “downside risk” is between 15 percent and 20 percent, excluding banks, he said.

Reform Trade

Bullish forecasts on Chinese stocks from some of Chen’s peers have so far failed to come true. The Communist Party’s biggest policy changes since the 1990s, unveiled in November, led Goldman Sachs Group Inc. to raise its recommendation on Chinese shares to overweight and spurred Citigroup Inc. to predict returns of at least 20 percent in 2014.

Chen is less pessimistic on shares of China’s smaller companies this year. He sees downside of 7 percent to 8 percent for the ChiNext index, which is dominated by private companies in industries such as technology and health care. The gauge has tumbled 19.6 percent from this year’s peak in February, approaching bear market losses of 20 percent.

“If the ChiNext index decreases another 10 percent, I would be very interested in buying,” said Chen, who in January predicted a plunge in the gauge on prospects a revival of initial public offerings would divert funds from existing shares. “Small-caps still have earnings growth.”

Stimulus Bets

Some investors anticipate the government will step in to bolster the property market and arrest the slowdown in economic growth. While the CSI 300 index slipped 0.1 percent yesterday, the Hang Seng China Enterprises Index rallied 1.4 percent after the central bank asked lenders to expedite mortgages. The gauge extended early gains amid speculation that policy makers will also reduce lenders’ reserve requirements.

A reduction in those ratios alone won’t be effective as companies will still face relatively high borrowing costs, Chen said. China’s economic expansion may slow to as low as 7 percent in the third quarter, he said.

“Slowing property investment will hurt the economy,” Chen said. “The third quarter will be a challenging one for GDP growth.”

— With assistance by Shidong Zhang

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