Active Thinking

At GAM Investments’ latest Active Thinking forum, Jian Shi Cortesi discusses low valuations in Chinese equities, government support for China’s property market and earnings growth.

14 June 2023

Looking at the MSCI China Index historically, the index is currently at the very low end. From a very low point in October 2022, the index rebounded quite strongly on the hope of the reopening following China’s zero-Covid restrictions. However, over the last few months, the market has been disappointed and the stock price corrected again. It is currently more than 50% below the previous peak. The MSCI China Index has delivered little performance for 10 years. This shows how lowly valued the market is as in the last 10 years both the economy and corporate earnings have grown, yet stock prices have not risen in line due to valuations contracting. We see a similar picture within the MSCI Asia Index. Since the rebound in October last year, the index has corrected slightly but has done better than the MSCI China Index. The main reason for this is that the other Asian markets such as South Korea, Taiwan and India have performed much better in the last few months.

According to International Monetary Fund (IMF) data, approximately 70% of global growth will come from Asia this year, with about a third coming from China, 15% from India and the rest from Asia. India’s contribution to global growth will be more than the whole western hemisphere put together. Many talk about China’s GDP growth disappointing this year. However, we need to put this into perspective. For example, despite the economic challenges in Europe, the market is doing well, while in China, the question is whether GDP growth will be 4%, 5% or 6%. The absolute scale shows us that China and Asia remain the key driver for global growth.

What is holding China equity back?

We believe there is a confidence gap among investors when it comes to China equity. Confidence is weak due to:

1. The post Covid recovery: In March and April we saw strong economic data including PMI numbers, GDP growth and retail sales. However, last month the official PMI was weaker than expected, although the Caixin PMI, which covers small and medium-sized enterprises, was better than expected. Nevertheless, the market reacted negatively. This demonstrates that as overall the confidence level is very low, any bad news receives more attention.
2. Constraints on large policy stimulus: China has learnt over the last 20 years that every time a government embarks on a forceful stimulus programme, a few years later it must deal with the consequences. Therefore, I believe the government is trying to balance the need to support the economy in the short term, while not creating problems for the long term. As a result, we have not seen very strong stimulus coming from the government other than incremental supportive policies, such as cutting interest rates, increasing bank lending etc. The extent of these policies has so far been below expectations.
3. Real estate drag: The real estate market remains slow even though property prices are now roughly stable, or the year-over-year property price increase is between 0-1%. But home building activities are very slow which also drags on related sectors, for example home appliances. Real estate also drags on the demand from related products such as steel, cement etc.
4. Geopolitics and US-China tensions: Every week there is news that makes investors uncomfortable.
5. Finally, every time sentiment is already low on China, investors raise the structural headwinds such as ageing populations.

Looking at these factors, investors have reason to be cautious and are not in a hurry to allocate to China equities.

When looking at the MSCI China Index’s performance relative to the MSCI World, China has underperformed dramatically since 2021. Behind that underperformance was the contraction of valuations. The price of sales of the MSCI China relative to MSCI World was about 1.1 a decade ago. Today that ratio is approximately 0.5, showing how much China has derated. The price-to-book ratio of MSCI China is also at historic lows and underlying these low valuations are the investor concerns previously referenced.

Supportive measures

It has recently been reported that the Chinese government is working on further supporting the Chinese property market. We have already seen a number of supportive measures but these have been on a limited scale. There has been a mortgage rate reduction, especially for first time home buyers, but not to a large degree. Home purchase restrictions have also been loosened in some smaller cities but in some larger cities there are still restrictions. For example, in some places it is necessary to pay tax locally for three years in order to buy a property. In the last two years, the government had very strict rules on bank loans for developers, where banks could not lend to developers if their debt ratio exceeded a certain level. The government has loosened that for some large developers but there is room for further expansion on that supportive policy. Finally, another supportive policy would be allowing developers to raise capital to help with their cash situation. If we see more policy support on property, it is most likely to be along these lines.

It is important to note that the property market problem in China is related to home builders; certain home building companies got into heavy debt and ran into liquidity issues. However, home buyers in general do not have problems; they can pay the mortgage. This is very different from the sub prime crisis in the US during 2008.

Recent findings

Recently JP Morgan held a China summit at which they observed overall cautious sentiment on China. Many international investors arrived bearish, and anecdotally US investors seemed the most cautious.

JP Morgan highlighted that the most discussed topics at the summit were AI and geopolitics, with electric vehicles referenced positively given China is fast emerging as a leader in the sector.

The most upbeat panel at the summit included the CEO of the Hong Kong Exchange. He mentioned that currently the total market cap of China equity and debt is about 1.5x Chinese GDP. That number in the US or Japan is 6x. With GDP growth combined with the expansion of the capital market, the total debt plus equity market cap could increase by 4x in the next one or two decades. Starbucks’ CEO highlighted that the company already has 6000 stores in China, with 1,000 stores in Shanghai alone and every nine hours, it is opening a new store in China. The growth potential was cited as the reason for investing heavily in China.

Looking forward, the market hopes for more supportive policies to stimulate consumption. Another positive catalyst for Chinese equities would be increased communication between the US and China. Both could lift sentiment and allow valuations to expand.

Drivers for growth

In my view, the more certain driver for stock prices would be earnings growth. Looking at earnings growth projections, the fastest earnings growth this year would come from service sectors, not surprisingly after the post Covid reopening. We expect the goods sectors and financial sectors, as well as the fixed asset investment related sectors, to grow between 12% and 14%. The area that looks weak is manufacturing, especially related to consumer electronics, which is also impacting the demand for technology hardware and semiconductors. The overall EPS growth estimate is 16%. In the first quarter we saw good earnings coming from the MSCI China universe. In particular, internet companies have been leading earnings growth and reporting better than expected earnings. However, the market has not yet responded. Looking at earnings revisions on a monthly basis, the revisions picture in May turned quite positive compared to previous months.

In terms of investor flow for Asia excluding China, I believe the region has been quite oversold. According to Goldman Sachs, since the peak in 2021, international investors sold USD 114 billion of emerging markets ex China. Since the rebound, investors have bought back USD 34 billion so there is still a lot of room for foreign buying.

In terms of investment opportunities, we see opportunities in:

• The China re-opening including travel platforms, sportswear, restaurants.
• Within the state-owned enterprise (SOE) reform: This is an area China relies on for future pension payments and the government has voiced their goal to improve SOE valuations. Today many SOEs trade at below book value.
• Clean energy: In the last 12 months we have seen much stock price correction in clean energy names.
• Finally, the technology cycle is bottoming in Taiwan and Korea technology. We have seen that many of these stocks have derated to close to historically low valuations over the last two years. These sectors have started to rebound and investor sentiment has begun to warm given the potential benefit from demand AI computing on these companies.