Morgan Stanley's Views On USDCNY, Chinese Equities In 2016/2017

With outflows replacing inflows and additional risk factors, Morgan Stanley analysts believe the Chinese renminbi will depreciate against the USD on a fundamentals basis, and any tactical stabilization of the RMB should likely be short-lived.

Chetan Ahya and team at Morgan Stanley in their January 11, 2016 research note titled: “RMB Regime Change: Part 2” continue to recommend avoiding old economy China names and HK-listed China banks.

RMB to move to greater depreciation path from 3Q16 on

Ahya and colleagues note that on August 11, 2015, policy makers took up a shift to a new currency management regime, from managing the RMB stably against the U.S. dollar to anchoring relative stability in a trade-weighted index. They reckon the RMB regime shift will enter its second stage from 3Q16 onward.

The analysts say that though they were earlier anticipating the depreciation in the NEER to commence from 1Q17 onwards, recent developments including intense capital outflows and increased trilemma-related pressures (viz.: flexibility of exchange rate, openness of capital account and control over domestic interest rates) mean that policy makers will almost inevitably have to choose between exchange rate stability or preserving their ability to trim interest rates to manage deflationary pressures.

Ahya et al. assume a 2% depreciation of the NEER in 2H16 and anticipate the NEER would depreciate a further 5.5% next year. They argue that this would imply USDCNY will move to 6.98 by end-2016 and 7.31 by end-2017:

RMB regime change

The MS analysts note real interest rate differentials between China and the US also started to narrow from mid-2014, after having been stable over the preceding three years:

Declining FX reserves

Ahya and team argue the ideal solution to address the disinflationary pressures would be for policy makers in China to accept slower growth in line with the potential growth dynamic and effect a quick adjustment in the form of cutting excess capacity, lowering the ratio of investment to GDP, and rapid clean-up of banking system NPLs.

Highlighting the unattractiveness of the Chinese RMB, the analysts point out that even if one simplistically assumes the capital account flows are driven by carry trades in different forms by the real sector and financial sector, the following graph clearly shows a meaningful shift in attractiveness of those carry trades:

RMB no longer attractive

MS downgrades offshore China/HK equity index

Turning their focus to implications for equity markets, Ahya and team cite Morgan Stanley’s FX and economics team’s 2016 and 2017 forecasts for CNY/USD, which led them to downgrade their offshore China equity index base case targets by between 3% (Hang Seng) and 10% (HSCEI):

Price targets

The following table highlights how the new MS earnings forecasts differ from current bottom-up consensus. They note for all three indices, their forecasts are materially below consensus for earnings growth over the next two years. For instance, for HSCEI, the MS analysts forecast -2% in 2016 and +1% in 2017, while the consensus projects +3% and +10% respectively:

MS forecasts

Ahya and team continue to overweight MSCI Hong Kong in their EM/APxJ country model, and EW MSCI China (with less preference for HSCEI).