Hong Kong shares rallied on Friday to help the HSI Index finish above the 23,000 for the first time in two weeks. Prior to Friday, the Hong Kong China shares listed on the HK Exchange had been dragged lower by China which is down 5% year-to-date.
 
In a research report released last Tuesday on 14 January, Macquarie Equities Research (MER) conveyed their outlook on China in 2014 and why they expect this year to be a solid year for Chinese shares listed on the Hong Kong Stock Exchange.

MER expects 2014 to be a solid year for Chinese equities (A shares not included) despite some likely significant volatility as we go through the year as investors assess: 1) actual or perceived impact of QE3 tapering, starting in Jan, and 2) implementation of the ambitious reforms laid out in China’s once in a decade reform directive last November.
 
MER’s sector picks for 2014 are Overweight on Auto, Brokers, Insurance, Gas & Renewables, Construction and Cement, and Underweight on Coal, Metals & Mining, Telecoms, Machinery, Retailing and Grocery Retailers.
 
Also a very critical year for the new Chinese senior leaders…
 
The new senior leadership in Beijing is expected to deliver some impressive progress in the bold and comprehensive structural reforms (economic and social) in 2014 since it is the first full year of their administration and the first year for parts of the ambitious reforms to be rolled out. And it is critical to show some progress to win needed support from within the party and from the broader society. Plus, the newly appointed senior leadership's credibility is on the line. Among the many key areas to be reformed from now to 2020, MER has identified the two most significant ones that will likely have long lasting impacts on the Chinese economy – state-owned enterprises (SOE) reform and financial reform.
 
…the world economy to be the best since GFC
Outside of China, global developed economies appear to be gradually recovering and the tapering of Q3 is set to begin this month as the US will cut back US$10bn asset purchases per month. The QE tapering will of course have some impact on investor sentiment. But bottom line is the global economy is now in the best shape since GFC, which bodes well for China as exports have been a drag on growth in the last few years.
 
SOE reform and financial reform to make the most impact
1) SOE reform. The Chinese economy has been dominated by SOEs and the transformative economic growth over the last thirty years has been largely driven by SOEs. Now the country is at a crossroads where without making significant changes to SOEs in terms of corporate governance and management incentive schemes, among other things, the Chinese economy cannot be driven to the next stage. At a very high level, what's key in the SOE reform is to separate the management and operation of the SOEs from capital ownership, ie, the Temasek Model, whereby the State will still own the majority, if not 100%, of the SOEs in strategically important sectors but will not get involved in those companies’ operations. For the not-so strategically important sectors, private capital - foreign or domestic - will be invited to participate. The intended end result is that SOEs will become a lot more competitive and operationally efficient (and more profitable). To play this as an investor, one can identify the low hanging fruit. For example, some SOEs (e.g.infrastructure construction companies or oil refiners) have very low margins at the moment so margin expansion should be relatively easy. Or one can identify the SOEs (e.g. Anhui Conch) that may have started to put management incentive schemes in place to better align management and shareholders' interests.
 
2) Financial reform. Chinese banks are on one hand protected with fat margins and profits by the government and on the other hand are saddled with the burden to finance economic growth and make loans, including non-performing ones. One key way to solve the dilemma is to have a much better functional capital market to directly link enterprises that need capital and savers and institutions that have capital to invest. The government is changing the way IPOs get approved, bringing in private capital to the banking sector, and experimenting with more innovative financial products such as securitization instruments. A clear beneficiary of the financial reforms is the broker sector and any companies that pay unduly high interest on their borrowings (e.g. small to mid sized businesses).

Key Macro Data this week
Finally, here are some of the important economic releases to watch out for this week.
 
Mon 20 Jan: Japan Machine Tool Orders (Dec), China 4Q GDP, Industrial Production (Dec), Retail Sales (Dec)
Wed 22 Jan: Japan Monetary Policy Statement, Eurozone 3Q Government Debt
Thu 23 Jan:BoJ Monthly Economic Report (Jan),China HSBC/Markit Flash Manufacturing PMMI (Jan), Eurozone PMI Manufacturing (Jan), Consumer Confidence (Jan), US Existing Home Sales (Dec)
 

Source: Macquarie Research - 20 Jan 2014