Unexpectedly strong earnings at listed Chinese companies have spurred analysts to raise their profit forecasts, creating room for about a 15 percent rise in Shanghai's benchmark stock index over the next three months.

The upbeat earnings, fed by China's steady economic recovery, are restoring optimism in the stock market after last quarter's gloom, but the rally could be derailed if the government moves more quickly than expected to tighten monetary policy.

"It's very clear that corporate earnings, propelled by the economy's recovery, are now improving much more quickly than the market had expected," said Wu Xiong, a research manager at Orient Securities in Shanghai.

"Investors could now adjust their investment strategy and take a much more optimistic approach," Wu said.

Mainland-listed firms' combined net profits rose 26 percent in the third quarter from a year earlier, leading analysts to boost their forecasts for 2009 Chinese corporate earnings growth to 20 percent from a flat performance forecast just two months ago.

That cut the average forecast price to earnings (PE) ratio of stocks. The 12-month forward PE ratio on Shanghai A shares stands at 18.3 as of November, down from 22.6 in August and well below the all-time high of 35.1 hit in 2007 during the market's bubble peak, data from Thomson Reuters showed.

The lower PEs, considered reasonable given China's growth potential, give China's benchmark Shanghai Composite Index room to rally in the coming three months or so by around 15 percent from its current level.

That would see the index breach its 2009 high of 3,478 points in early 2010, according to eight fund managers, analysts and economists surveyed by Reuters this month.

In a previous survey in early September, Orient Securities' Wu and the others proposed a defensive investment strategy, partly because of high stock valuations.

The market has staged several good-sized technical corrections since August, however, that have trimmed valuations.

Yuan appreciation

China's nearly 1,700 listed firms ended their third-quarter results reporting season by the end of October with a combined quarterly net profit of 290 billion yuan.

Analysts now expect a big fourth-quarter profit rise, especially given a very low base of just 37 billion yuan a year earlier, when listed firms took large provisions and de-stocking was at its peak as the global financial crisis dampened demand.

With the yuan widely expected to renew its rise against the dollar, market players said companies with substantial local-currency assets, such as banks and property counters, or with most of their costs in dollars, such as airlines, likely well perform.

"As China's economy recovers and exports improve in coming months, renewed yuan appreciation should not be a surprise," said a manager at a Chinese mutual fund in Shenzhen, who could not be quoted by name as he was not authorized to talk to the media.

"So firms with significant yuan assets will see those assets appreciate gradually and earnings of companies, with most of their spending priced in dollars will be boosted by cost-cutting," the mutual fund manager said.

The rally could also spill over into overseas stocks related to China, including components of MCSI (Morgan Stanley Capital International) China, such as Geely Automobile Co, and American depository receipts of New York-listed Chinese firms, such as oil giants Petrochina and Sinopec.

In addition, it could offer fresh impetus for foreign funds to enter the Chinese market after a recent relaxation of restrictions on foreign portfolio investment.

Threats to the uptrend

Analysts said a key factor that could derail a market uptrend would be an early exit from China's relatively loose monetary policy - for example, an interest rate hike before the start of the second quarter - as improvement in both the domestic and global economies makes it easier to return to a more normal policy stance.

After a series of strong economic data issued in mid-October, including 8.9 percent third-quarter GDP growth, and an industry survey in early November showing China's manufacturing sector expanding at its fastest pace in 18 months, evidence is mounting of strong momentum in the world's third-largest economy.

Overseas, Australia has raised interest rates twice since early October, its first hikes since March 2008, while Norway became the first European country to raise rates in early November.

Despite China's emphasis on policy continuity, a shift towards greater optimism in official rhetoric has unsettled the financial markets.

The indicated yield of China's benchmark five-year government bonds has jumped nearly 20 basis points since late September, reaching its highest level in a year this week.

"Pressures are building due to fears of monetary tightening, which may be a key deterrent for the index to rise sharply for now," said Shanghai Securities investment chief Zheng Weigang.

"Still, most market players believe an exit from pro-growth policies will be a gradual process, leaving enough of a time gap for the index to rise above its 2009 peak by early next year," Zheng added.

Reuters

(China Daily 11/16/2009 page5)