China Strategy Spotlight:The improving fundamentals are not yet priced in

　　What we are communicating to investors: improvement may continue (p2~26)

　　China’s macro data pleasantly surprised across the board in March and this is being echoed by more micro indicators, e.g., cement/steel price hikes, strong new construction orders, etc. Corporate earnings also recovered notably as industrial profits/A-share non-financial earnings accelerated to 7.4%/7.5% in 1Q16. Looking ahead, we expect fundamental improvement to continue in April, driven by infrastructure and property investment. Our economist recently upgraded 2Q16 GDP to 7% and we expect consensus to see upgrades in coming weeks. We believe the potential earnings upside is not fully priced in, as indicated by light investor positioning and significant valuation discount.

　　We expect Shenzhen Connect to be announced soon in 1H16 and implemented in 2H16. We suggest focusing on: 1) highly discounted H-shares; 2) H-share new economy small-caps; and 3) HKEx, local brokers and AMs.

　　Performance and valuations: H-shares remain deeply discounted (p29~38)

　　MSCI China was flat throughout April, outperforming A-shares, Asia ex. JP but underperforming EM and major DMs. Energy and staples led with >5% gain, while defensives and financials dragged. MSCI China’s (ex. ADR) 12m forward P/E stayed at 9.2x, and is still at a 20% discount to historical average. Utilities, discretionary and financials trade near the bottom of their valuation range. H-share P/B is only 6% higher than the 08 GFC trough; we expect more earnings upgrades to sustain the rally. A-shares slid 2%, led by energy and large-caps. CSI300 12m forward P/E is at 12.1x, with non-financials at 16.8x.

　　Macro and earnings: 1Q16 earnings improved; consensus to upgrade (p39~44)

　　March macro data beat across the board as: 1) official and Caixin PMI topped estimates by 0.8/1.3ppt respectively; 2) industrial production jumped to 6.8% from prior 5.9%; 3) FAI grew 10.7% in 1Q16 (vs. 10.4% estimates) and property new starts/sales momentum carried on; 4) credit creation remains strong as adjusted TSF balance growth rose to 17.1% from prior 15.8%. On earnings, 1Q A-share earnings were flat yoy, while growth of non-financials improved to 7.5% from -24% in 4Q15, in line with the visible improvements (+7.4% yoy in 3M16) in industrial profits. Select early cyclical sectors in MSCI China, such as materials and capital goods, have started to see consensus earnings upgrades.

　　Liquidity and sentiment: H-share investor positioning is still light (p45~48)

　　H-share investor positioning is still light as overall sentiment remains fragile, for short-sell stays elevated at 12% of market turnover. Southbound connection continues to gain traction as expectation on SZSC launch rises. As for A-shares, sentiment subsided as new investor numbers and margin trading statistics both moderated on the margin. Onshore yield curve steepened as investors are re-pricing the monetary policy outlook. The corporate bond yield spread widened as numerous credit events took place.

　　Risks

　　Key downside risks center on the: 1) timing and pace of the next Fed rate hike; 2) risk of a hard landing in China; 3) risk of further sizable RMB depreciation, and 4) the potential outbreak of a major credit default in China.