The Chinese stock market has underperformed global financial markets for more than three years now, but there are signs the economic outlook may be improving. We look at the case for investing in China again.
China's gross domestic product grew by 5.3% year on year in the first quarter of 2024, a result above market expectations, and even higher than the already ambitious target that the Beijing government had set itself.
A few years ago, such a figure would have gone almost unnoticed, but today it makes headlines because it confirms the resilience of the world's second largest economy after a long rough patch.
"The Chinese economy is positioned to report positive performance in light of the continued implementation of expansionary policies and the government's commitment to do whatever it takes to stimulate growth," says Xiaolin Chen, head of international at KraneShares.
Has China’s economy turned the corner? It may be too early to tell, market commentators argue.
"Despite the bright start to the year, the National Bureau of Statistics has pointed out that the foundations of the Dragon's economic growth are not yet solid," comments Richard Flax, chief investment officer at Moneyfarm, who draws attention to the challenges still facing the Chinese economy “including the deflationary threat and the deep crisis in the construction industry, amidst plummeting new housing prices and lawsuits against Chinese brick giants."
Chinese Stocks Have Lagged the World
For about three-and-a-half years, the Chinese stock market has largely underperformed global financial markets, including those of other emerging markets. There are many reasons for this: the coronavirus pandemic and subsequent shutdowns, the collapse of the real estate sector, the burden of debt, geopolitical tensions with Taiwan and the United States, the export crisis and the flight of foreign capital.
By the end of 2022, China was finally coming out of its zero-covid policy, with optimistic forecasts of a robust recovery in consumption, while America was still in the grip of above-target inflation and rising interest rates. In short, the economic and social reopening in Beijing had led many to expect the longed-for turnaround, but it never happened. In 2023, the S&P 500 rose 22%, while the CSI 300 Index lost 13% (in euros).
A thick cloud of pessimism now hovers over the Chinese stock market. The Morningstar China Index NR has lost 42% of its value from the end of January 2021 to the end of March 2024, while the Morningstar Global Markets index did exactly the opposite (+40%) and the Morningstar Emerging Markets index was slightly positive (+4%; figures in euros).
As a result, Chinese equities are trading at valuations not seen in nearly a decade. According to CEICdata, the Shanghai Stock Exchange's price/earnings ratio is at its lowest since late 2014. Furthermore, according to Morningstar's Global Market Barometer, Chinese equities are currently undervalued by 31% relative to fair value (relative to stocks covered by Morningstar's analysis).
China - Uninvestable or Unloved?
And it is here that the market is divided between those who think the Chinese market is too good a contrarian opportunity to pass up and those who see it only as a value trap.
"The list of reasons to stay away is not a short one," commented Tom Stevenson of Fidelity International in a note.
"The Chinese consumer has emerged from the covid period with little desire to spend the money he had set aside during his enforced imprisonment. This is not hard to understand when you consider that youth unemployment is around 16%. Meanwhile, the real estate sector, which could account for 30% of gross domestic product (GDP) if one takes into account related activities such as insurance, the sale of household appliances and other ancillary services, continues to look like a slowly deflating bubble."
Add to these unfavourable demographics, with deaths exceeding births for the second consecutive year in 2023, suggesting that China's population is shrinking and ageing. "The so-called Japanification of China may be overstated, but the economy will have to become massively more productive to weather the demographic winds in the coming years," Stevenson continues.
Company Earnings Improving in China
In short, if a good chunk of international traders think China is “uninvestable”, there may be good reasons. And indeed, global investment flows agree, with as much as $18.2 billion taken out of China's open-ended equity funds by investors worldwide over the past 12 months.
But not everyone shares this view. China remains the world's second largest economy, still hosts one third of the world's manufacturing capacity, generates 18% of global GDP, accounts for 16% of all listed companies and 20% of total market capitalisation.
"Valuations can sometimes be low for specific reasons, but in this case Chinese stock valuations seem disconnected from fundamentals," says KraneShares' Chen.
"We observe steady improvements in Chinese companies' earnings, but their performance and price/earnings (P/E) ratios do not behave accordingly. This suggests that macroeconomic factors are influencing the current trend. If the macroeconomic environment remains stable and corporate liquidity increases, supporting corporate growth, the potential exists for a significant revaluation of these valuations.”
The Case for Active Management in China
A note by the management team of Plenisfer Investments SGR emphasises the importance of active management with a selective approach.
"Incredible opportunities can be found in China, but they must be handled with care.
"History tells us that investing passively in China does not work, and that the quality of the companies in the indices is very heterogeneous. There are many opportunities in China, but only if you do the research work to see where the value is. At a time when many international investors have given up on China, the conditions are favourable for those who are still willing to do the work.”
And indeed, in this article we explain why many ETFs in the China equity category have a Neutral or Negative Morningstar Medalist Rating.
According to Tessa Wong, China equities specialist at Allianz Global Investors, US attempts to limit China's technological development will result in an increased focus on domestic capacity building in key sectors, not least because the country “needs to find replacement growth in other areas, particularly in moving towards higher-value, more innovation-driven sectors”.
Indeed, Wong believes that China is in a relatively early stage of transition to a new model based on innovation and the development of new technologies. "And it is precisely in these sectors that we often find some of the most attractive opportunities, especially now that many stocks have shrunk to more attractive valuations."
