China is entering 2010 with stronger than expected economic growth, a red-hot stock equities market and healthy increases in corporate earnings. And although exports have been dampened by the global slowdown and weak demand from the U.S. and Europe, China has benefited from massive government stimulus and surging domestic demand, as a growing chunk of its population acquires middle-class status.

Money managers are assuming economic growth for 2010 for China of more than 2009’s estimated 8.9%, and corporate earnings growth of 20%-30%. By late 2009, the Shanghai Stock Exchange was up by some 60% from its lows; although that market is no longer cheap, it still offers opportunities if economic growth and earnings continue to be strong.

Exports, which make up more than a third of China’s economy, have shrunk. But the slack has been taken up by increased domestic consumption and the stimulus provided by the government’s two-year plan to spend US$586 billion on building roads, bridges, railways and other infrastructure projects. The government has been working to decrease China’s reliance on exports through measures aimed at spurring domestic activity. For example, it has introduced a program of consumer discounts for trading in old cars and household appliances for new ones.

In addition, banks have been encouraged to lend and, year-over-year, new loan growth has been running in the 35% range. Low interest rates have promoted both strong consumer spending and investment by individuals in assets such as stocks and real estate, as well as business expansion. Retail sales have remained buoyant, suggesting that measures to spur domestic demand and reduce reliance on exports are paying off.

Chinese corporations benefited from lower costs of raw materials in 2009, which helped support profit growth. In 2010, the drivers of growth will be rising domestic demand combined with a continuing global recovery, which should reignite demand for exports.

“It’s important that China maintain growth of at least 8%, and the government is prepared to step in to see that it happens to ensure continued employment,” says Francis Chung, director of Asian equities for HSBC Halbis Capital Partners Ltd. in Hong Kong.

“The main concern is when China will start to tighten, and by how much,” says Chuk Wong, manager of Dynamic Far East Value Fund, sponsored by Dynamic Mutual Funds Ltd. of Toronto. “Currently, the inflation outlook is mild and credit conditions remain healthy, which bodes well for the real economy and the value of financial assets. But the pace of growth could be hurt if [China’s officials] tighten too early or too fast.”

So far, the rally has been driven by liquidity coming back into the market, says Agnes Deng, investment manager with Baring Asset Management (Asia) Ltd. in Hong Kong and manager of Excel China Fund, sponsored by Excel Funds Ltd. of Toronto: “We are at the point at which we need to see improved earnings delivered by companies. The market is no longer dirt cheap. It will reward companies that deliver higher than expected earnings and punish those that don’t meet expectations.”

Inflows of outside capital into China’s rapidly growing economy are adding to valuation pressures in real estate and stock markets. Thus, the potential for fiscal tightening and a rise in interest rates is a key risk for the Chinese market.

Deng likes industries that are sensitive to economic recovery, including commodities, and the more cyclical consumer-discretionary stocks. Favourite holdings include Ctrip.com International Ltd., an Internet-based travel booking agent that has 70% of the business in China. She also likes New Oriental Education and Technology Group Inc., which offers a range of educational services, including English and other foreign-language training, admission test preparation courses and assessment tests.

On the commodities side, Deng favours China National Petroleum Corp., which is the sister company of PetroChina Co. Ltd. and a builder of natural gas pipelines. Deng expects demand for natural gas to increase as China develops.

Wong’s favourites tend to be companies that are benefiting from the growing wealth of the Chinese consumer. They include Anta Sports Products Ltd., a manufacturer of athletic footwear and apparel that has received a boost from the “Olympic effect.”

Another stock he likes is China Shineway Pharmaceutical Group Ltd., a provider of traditional Chinese medicine such as herbal products. “Health care is benefiting from rising incomes as well as medical reform in China,” he says. “More people are covered by health insurance as government programs are expanded.”

@page_break@Wong is staying away from companies that have interest rate-sensitive property and those with high levels of debt.

Some sectors are also viewed as being a bit risky. For example, Mark Lin, vice president of international equities with CIBC Global Asset Management (Asia) Ltd. in Montreal and manager of the CIBC Asia Pacific Fund, is cautious on China’s banks. They have been lending aggressively to stimulate the economy and there is a danger that bad loans might surface. IE