Classification: Public

The recent statement by Premier Wen Jiaobao on “fine-tuning macro policy at an appropriate time” and other remarks/announcements from policymakers suggest that macro policy will likely move towards some modest relaxation, probably around the end of the year. These remarks begin to demonstrate the government’s commitment to support economic growth and to avoid over-tightening of macro policy. According to Premier Wen, a key objective of future policy is to ensure the availability of funding for ongoing infrastructure projects, public housing, and SMEs. We also expect fiscal policies to support consumption and services (e.g., via the VAT reform and further tax cuts).

We believe the timing and magnitude of the policy easing will depend on CPI inflation, GDP growth and the performance of the housing market. Our base case projection for these three factors by the end of year is that CPI inflation will drop sharply towards 4%yoy, GDP growth will decelerate towards 8.5%yoy and property prices will decline by an additional 10% measured by the Soufun index. If these forecasts materialize, the government may feel comfortable with a modest increase in monthly lending towards the end of this year, an RRR cut early next year, as well as an increase in independent bond issuance by local governments and some more aggressive tax cuts in the 2012 fiscal budget. These policy actions should then support the equity market by mitigating the hard landing risk.

Based on our data analysis of market experience for the period between Sep 2008 and Mar 2009, the best performing strategy was to hold the beneficiaries of policy stimulus. We believe banks, infrastructure, steel, cement, transport and consumer are likely beneficiaries of the next round of policy relaxation.

We are not expecting an imminent announcement of a major stimulus policy as inflation has yet to fall below 5%, and thus the near-term upside potential of the market may be capped by the lack of confirmation from the government. But over the coming six months, we think the chance of some more visible policy easing will increase substantially. Therefore, the overall market and especially the policy beneficiaries will likely be well supported over the medium term.

We compiled a basket of preferred stocks in these beneficiary sectors. These names are: CCB, ICBC, Baidu, Tencent, Dongfeng Motor, Sands, CRG, CR land, Cosco Pacific, CNBM and Angang. We expect this basket to outperform the index on a six-month basis. The China Policy Relaxation Basket can found with the Bloomberg ticker DBHKCPTN.

• [Editor:editor]