China: Starting from the Bottom

While India heads to the polls, elections are one factor investors in China do not have to consider. But plenty of other challenges have weighed on Chinese stocks, which have retreated heavily in the last three years in the face of domestic and geopolitical risk, a limp post-COVID recovery, an ongoing real estate crisis and an attempted restructuring of the economy towards a new growth model. A lot of negatives are already priced in to Chinese equities. Valuations are steeply discounted compared to other markets and Chinese stocks’ own history. This suggests limited further downside and a possibly convex opportunity for tactical gains – especially if a catalyst can be found for a rebound, likely in the shape of more meaningful government stimulus.

Chinese equities have heavily underperformed in recent years.

Chinese equities have suffered three back-to-back years of double-digit falls. Following an -11% calendar year decline, by the end of 2023 the blue-chip onshore CSI 300 Index was down -42% from its 2021 peak. The slump was even worse for offshore stocks. (The universe of Chinese equities includes A-Share listings on the Chinese mainland, offshore H-Share listings in Hong Kong, as well as listings in New York and elsewhere.) The broad MSCI China Index, covering both onshore and offshore stocks, was down -55% over the same period. These reversals have even taken Chinese indices below their 2019, pre-COVID levels to five-year lows. Overseas investors have headed for the exit, with global portfolios’ allocations to China dropping to decade lows.

A well-known litany of economic problems – including weak consumer demand and property sector travails – have pushed Chinese stocks down. The mood music on the Chinese economy has become almost universally glum.

The economic challenges dragging on Chinese equities are by now well known. The scarring from heavy, extended coronavirus restrictions has not been healed by a post-reopening recovery that has largely fizzled out. GDP growth is well down from the dizzying heights of the pre-pandemic era and deflation has set in. Animal spirits – especially amongst Chinese consumers – remain in the doldrums, pulled lower by an ongoing real estate crisis. The property sector’s difficulties were set off by deliberate government efforts to deflate a bubble and force the sector to deleverage. But the sector’s vast size – it is connected to around a third of GDP value creation – and centrality to China’s growth model since the financial crisis mean its weakness is dragging on the whole economy. Amongst other things, it has exposed heavily leveraged Chinese local governments’ weak financial position, as China faces a ‘great wall of debt’.

Chinese stocks have also been hit by domestic and geopolitical risk. Heavy-handed regulatory intervention by Beijing – most strikingly with the overnight termination of the for-profit education services industry – has rightly spooked investors. Meanwhile, tensions with the US have ratcheted up and both the Trump and Biden administrations have taken concrete action impacting the Chinese economy – including hindering its access to high-level technology.

Amidst all these difficulties, negative sentiment towards the Chinese economy, both at home and abroad, has become consensus – and near universal – a possible contrarian indicator.

A lot of negatives are already priced in, leaving valuations deeply depressed.

These difficulties are both well known and heavily priced into Chinese stocks. The blue-chip onshore CSI 300 Index trades at a P/E ratio of 11.4x. The wider Chinese equity universe is even cheaper; the MSCI China’s forward P/E ratio measures 8.9x. This marks a discount not only to other emerging markets (the MSCI EM ex-China’s forward P/E ratio is at 14x) but is steeply cheaper than developed markets. The MSCI World Index’s forward P/E is 18.9x, while the S&P 500 is at 21.1x.  

With sentiment so negative on Chinese stocks, this naturally raises the contrarian question: how much more downside could there be at these levels?

Beijing policymakers are resisting investor hopes of a ‘big bazooka’ stimulus – but prospects for more government support are growing.

Investors at home and abroad are watching eagerly for major government stimulus to kick the economy back into gear and trigger a stock-market rally off the currently low levels. However, policymakers have been resisting any ‘big bazooka’ stimulus akin to the vast 2008-9 infrastructure spending package. Although that earlier stimulus successfully protected China’s economy from the 2008 global financial crisis, Beijing policymakers also see it as a source of many of China’s current problems, including excessive leverage and unproductive infrastructure investments – and are therefore keen to avoid any straightforward repeat.

Instead, stimulus has so far been low-key and incremental. The People’s Bank of China (PBoC), the central bank, has gradually trimmed interest rates, most recently cutting the five-year Loan Prime Rate (the key mortgage benchmark) by 25 basis points, the largest cut yet. But the PBoC is only willing and able to go so far in a context of high developed-market yields, especially in the US (meaning deeper rate cuts could accelerate capital flight). The PBoC has also reduced banks’ reserve requirements, in an effort to loosen credit flows.

On the fiscal side, meanwhile, government support has largely been confined to rhetoric so far. However, that has recently begun to shift. At the annual meeting of China’s rubber-stamp parliament, premier Li Qiang announced issuance of 1 trillion renminbi ($139bn) of ultra-long-term special treasury bonds to bridge funding shortages and advance major projects. However, there were no specific details of how the proceeds will be used. And whilst announcing the issuance, Li told all levels of government they would ‘have to keep their belts tightened’ – indicating no wholesale move to throw money at the problem.

Beijing is right to tread cautiously. It does not have unlimited fiscal room and the Chinese economy needs to deleverage – not risk adding more unproductive liabilities with potentially unproductive investments. The shift from an infrastructure and property-driven model, aiming at simply maximising headline GDP growth figures, is appropriate at China’s current stage of development. Nonetheless, the pressure on policymakers to reinvigorate animal spirits is real – including to support equity markets. Approximately 200mn Chinese people own stocks – principally the urban middle classes. This is a constituency the Chinese Communist Party can ill afford to alienate. Beijing is sensitive to the need to boost stocks off their current lows. At the very least, policymakers are determined to put a floor under Chinese equities. Since the Lunar New Year holiday, Beijing has deployed the so-called ‘National Team’ of state-owned financial entities to buy up Chinese stocks. The result has been a +13% rally for the CSI 300 from February’s low point.

The Chinese economy retains real strengths. Deeply discounted Chinese stocks may offer a convex opportunity.

For now, Chinese stocks at deeply depressed valuations represent a tactical opportunity. Booming AI champion NVIDIA’s market cap now exceeds that of all Hong Kong-listed Chinese H-Shares – hardly commensurate with the scale and potential of the world’s second-largest economy, even as it struggles with a notch down in its growth. Policymakers are looking to reorientate the economy away from the GDP-gains-at-all-costs approach of earlier eras and now emphasise ‘high-quality development’, with a greater emphasis on higher tech, future leading industries, and national economic security. It is not clear that they have a comprehensive plan to deliver on all this – and the current transition is creating uncertainty.

But the Chinese economy retains real strengths, that also spill into its equity markets. Chinese players are increasingly clear leaders in electric vehicles, batteries and other clean tech – all areas with strong global demand runways. Some in the Chinese internet space – hit hard in recent years – are finding international success, such as Schein and Pinduoduo (through its global platform, Temu). Domestic consumer demand may be muted but the recent Lunar New Year holiday saw it trending up, and Chinese consumers sit on large savings piles. They also increasingly favour homegrown brands, meaning domestic equities are the best place to gain exposure to a recovery of animal spirits. Chinese shares have plumbed similar valuation depths on four previous occasions in the last 20 years. On each occasion they benefited from strong tactical recoveries, generating between +39% and +88% of equity returns from trough to peak. Downside risks remain; for example, China policy may become a political football in the approaching US presidential election. But geopolitical headwinds are already heavily priced in. With expectations now so low, the opportunity looks convex.

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