Commentators have voiced disappointment over China’s sluggish post-Covid recovery and lack of big-bang stimulus, adding to concerns over weakness in the indebted property sector and geopolitical volatility. Many now fear policymakers will miss their 5% GDP growth target.
These issues have fused into a negative narrative on China that has shattered confidence in the market. Foreign investors pulled a record $12 billion from Chinese stocks last month.1
Valuations have sunk to historic lows. By August 31, the average price-to-earnings ratio for companies on the MSCI China A-Share Index stood 11% below 5-year averages, while price-to-book values stood 19% below 15-year averages. 2
However, companies’ earnings potential remains intact. Estimated earnings-per-share growth for companies in the A-share index stood 41% above five-year averages.3
What is largely absent from global commentaries is an appreciation of the government’s longer-term policy objectives and recognition of the factors driving market volatility.
US-China rivalry presses policymakers to focus on national security and economic resilience at home, putting more emphasis on future growth than current growth to reduce the risk of bigger shocks in future.
It figures that China’s current growth target matters less than it used to as authorities invest in high-tech industries to buttress growth and mitigate the threat posed by existing and future US sanctions.
However, if China’s long-term growth remains intact – as we believe – then now offers a once-in-a-generation opportunity to buy quality Chinese stocks with good earnings prospects at bargain prices – notably names that could be primed to perform once fears abate.
We have good reasons to believe that China’s growth is not about to collapse. The coiled spring of Chinese household savings offers upside potential that the market seems to have given up on.
We’re starting to see Chinese firms seize on the low valuations to buy back their own shares. This could be a first step in re-energising stock prices and revitalising investor confidence.
For us, this is an opportune time for investors to follow the numbers, not the crowd.
“This is an opportune time for investors to follow the numbers, not the crowd.”
Question of confidence
In flagging their disappointment, commentators have drawn negative comparisons between China’s post-Covid reopening and that of the West. At the start of this year, China’s quarter-on-quarter growth momentum outstripped market expectations, but it has since faded faster than forecast.
In the wake of China’s abrupt abandonment of zero-Covid rules late last year, households initially embraced their freedom. Retail sales surged almost 16% between November 2022 and February this year.4
But once the initial euphoria faded, they have returned to more conservative spending patterns. Headline data for July showed that retail sales had slowed to 2.5% year-on-year, versus an average of 8% year-on-year growth pre-pandemic in 2019.5
At the same time, we are seeing growing demand for travel and tourism. Intercity trips6 and subway and aeroplane passenger volumes7 are comfortably ahead year-on-year, while box office revenues were also elevated this summer.8
Importantly, Chinese authorities did not dish out the sort of hefty handouts that gave developed markets such a boost. Chinese households still retain the powder keg of untapped savings that they had built up during lockdowns, which equates to about 4% of GDP.9
For our part, we’re confident that a continued reduction in the household savings rate will allow a more complete recovery in services and consumption in the coming months.
Moreover, we’re seeing an industry destocking cycle as firms run down their inventories. As that cycle ends, companies will need to invest and hire again. That should spur wage growth and job creation over the next six months, giving households greater confidence.
Lack of a big bang
A big bone of contention for commentators has been the lack of a big-bang stimulus, and we agree that the policy response has been underwhelming to date.
Weakness in data for July did at least spur additional policy easing in August, including to the 7-day reverse repurchase rate, medium-term lending facility and one-year loan prime rate. This should help to loosen financial conditions further in due course.
Households are also set to receive a new tax break on child and elderly care. This could apply to around 80% of income taxpayers and be back-dated to the start of this year.
Additionally, banks are being pressed to cut mortgage rates, and a cut to deposit rates by major banks is also encouraging households to spend, while helping to protect banks’ net interest margins.
All of this adds to measures to support China’s beleaguered property market, including lower minimum downpayments and easing classifications for who counts as a first-time buyer in some cities.
The People’s Bank of China has also cut the FX reserve requirement ratio by two percentage points to 4%, continuing to lean against depreciation of the renminbi.
On reflection, we raise the risk that markets are being too dismissive of China’s policy response, that the cumulative effects of these small steps can add up.
We think authorities are set to shift more conclusively into an accommodative stance and raise fiscal spending, making full use of local government bond issuance to drive investment in areas such as infrastructure.
The widespread misconception among investors is that they should wait for a largescale stimulus and that stock prices can’t recover without it.
Stimulus provides broad market support. What matters far more for investors is visibility on company earnings. Only by analysing company fundamentals can investors understand how they will perform and how sustainable an investment they’re likely to be.
Visibility on earnings is more precious now than ever, with authorities aiming to nurture “little giants” – transforming small firms into industry leaders to spur innovation and help China compete with the US.
We predict strong demand for component-makers that cater to electric vehicles, where we see potential for high earnings growth. Notably, our “green” holdings are trading at a 49% discount to their three-year average10 – highlighting the strong investment potential.
Further, investor concerns centre on risks from debt in the property sector, which accounts for around a quarter of China’s economic activity.11
Indebted developers have struggled to complete projects as they adjust to new regulatory realities. Defaults from high-profile firms such as Evergrande and trouble at Country Garden, which until recently was viewed as a high-quality developer, have rocked market confidence.
The sector downturn has dented stock market sentiment. Yet real estate accounts for just 1.8% of the MSCI China A Index11 and 2.6% of the MSCI All China Index.13
We can expect more defaults and restructuring as the sector clean-up and consolidation run their course. But we also anticipate more policies to ensure this doesn’t become China’s own “Lehman Brothers moment”.
Remember, the state-owned banking sector remains a powerful lever that authorities can use to combat risk emanating from the property sector and spreading through the financial system.
Unmasking the opportunity
Underappreciation of China’s longer-term policy objectives are contributing to a false narrative and creating a self-perpetuating negative spiral in terms of market sentiment.
Authorities could prop up growth now, but that might build up risks that could be costly to growth later on in the form of a financial or real estate crisis leading to recession and a prolonged drag on the economy. We think it’s better to bite the bullet now. De-risking real estate now has a cost in terms of slower growth, but likely avoids a bigger price later on.
The cumulative effects of small-scale stimuli, inventory destocking and buybacks can help to underpin growth and restore market confidence in the second half of this year, in our view.
What we can say with confidence is that China’s stock market is cheap versus history, versus the US and versus other emerging markets. Quality names have been beaten up. But if the market recovery picks up as we expect, investors will quickly return to fundamentals.
That presents the best opportunity in a generation to invest in quality A-shares with good earnings prospects. Investors just need to see through today’s overly negative narrative.