Chinese equities have been one of the worst performing major markets so far this year, with the Hang Seng and CSI 300 indices down nearly one third in US dollar terms to the end of October. Year to date, Chinese equities have underperformed the broader MSCI Emerging Market Index and, incredibly, even underperformed the MOEX Russia Index.
The causes of this underperformance are well noted. The impacts of a dynamic zero-Covid policy on the economy, a shaky real estate sector, and an escalation of US-led sanctions on Chinese tech have all weighed on economic output. Markets have almost reached capitulation. The market’s negative reaction following the 20th People’s Party Congress is clear evidence of this – there was not a huge amount that hadn’t been expected, and yet both the Hang Seng and CSI 300 indices posted mid-single-digit negative returns on the Monday after alone. In short, investors are extremely pessimistic about China’s outlook.
We disagree. While Chinese equities have their challenges, we think the outlook for the country is very positive from here. However, as with many markets, we believe discerning stock selection will be key to investor success.
Clear drivers of negative sentiment
This extreme negative sentiment has been driven by three things: the Ukraine war, the impact of dynamic zero-covid policies on economic output, and deteriorating Sino-US relations. Because of these three factors, there is a lot of negative sentiment baked into equity prices, and global investors are significantly underweight Chinese equities as a whole. The market’s response to this weekend’s election of a new Politburo Standing Committee (PSC) was evidence of this. Investors, desperate for any indication that the pro-growth agenda is back on the table, were rattled by the status quo. It now appears to be clear that national security will be given even-weighting alongside economic growth. Economic growth remains a key priority to be able to afford these endeavours, and markets seem to have overlooked this.
Across this backdrop, it’s easy to focus on the negatives. However, we are beginning to see some green shoots coming through and think positive surprises should drive a rebound. We’re looking for four potential catalysts, in particular.
Four potential catalysts
Firstly, liquidity. The pullback of foreign investment into China has thinned out liquidity across China’s markets. This has contributed to volatility and some of the erratic price moves. As a consequence, the People’s Bank of China (PBOC) has had to step in to shore up confidence. We think we’re near the bottom of this trend and see encouraging signs in reduction from the PBOC.
Secondly, policy changes. Any indication that the government is pursuing a pro-growth agenda or translation of growth policies into real economy changes will likely be viewed very favourably by the market. Real world policy implementation has been in a holding pattern for most of this year, awaiting the 20th party congress. With this now out of the way, the economic work conference in December will be the first real milestone by which we might see some change. However, this is expected to be incremental, with meaningful change unlikely until the Two Sessions meeting in March. At that point, the new leadership team will be officially in place and will likely be keen to progress their policy agenda. Clearly, policy change will always create winners and losers. Disciplined stock selection is crucial in this environment, and we are broadly positive for the outlook over the next six months.
Thirdly, earnings. Earnings have clearly been impacted by the disruption of dynamic zero Covid and it doesn’t appear that we’ve hit the bottom yet. Year-on-year retail sales growth fell to an anaemic 2.5% in September, contrasting with its long-run pre-pandemic average of 7%. However, with the September PMI in marginally expansionary territory at 50.1, we think the bottom is close. We’re not quite there yet, but we think that resumption of earnings growth is not far away.
Fourthly, valuations. The current P/E ratio of the Hang Seng Index is less than 6x. This contrasts starkly with the already depressed valuations in emerging and developed markets, at 9.5x and 16.5x respectively. Chinese equities have never been this cheap before, and this presents a once in a lifetime opportunity to buy businesses at all-time low levels. We don’t think there is scope for equities to fall much lower than they are now, particularly if earnings stabilise.
With these four potential catalysts in mind, while Chinese equities have been significantly beaten down over the past year, we believe we are likely at or near the bottom. We think China is poised to rebound strongly from here. Positive surprises impacting liquidity, policy change, earnings, and valuations are likely to be beneficial for investors. With any recovery, however, there will always be winners and losers. We think active stock selection in China is absolutely key to ensure that investors can make the most from these rebounds.
Merian Global Investors – now part of the Jupiter Group – entered into a strategic partnership with Ping An Asset Management (Hong Kong) in 2018.
Developed countries may face more political, economic or structural challenges than developed countries. Some investments may become hard to value or sell at a desired
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