China (still) rising

Chinese stocks have taken a significant hit in 2023, disappointing global investors. Real estate scandals, consumer caution and western ‘China bashing’ have been key factors. But Julian Howard believes that China's structural story is undimmed and, short term, sees a strong contrarian case.

27 November 2023

Although this year’s grim news – from conflicts to rising interest rates – tends to dominate headlines, 2023 has so far been surprisingly good for world stock markets. Cheered by an Artificial Intelligence (AI)-themed rally in big tech and some recent optimism that global interest rates may have peaked, the MSCI AC World Index has generated a healthy +8.2% in local currency terms to end October. But it’s been a very different picture in China, where the year-to-date underperformance of equities has been significant: in local currency net terms, the broad-based MSCI China Index has delivered -10.9% and the MSCI China A Index of onshore shares -6.7%.

The gap is easy enough in itself to explain - but its persistence is getting harder to. 2023 was of course supposed to herald the biggest economic event of the year in the form of China’s re-opening. But consumers there have proven cautious amid the distress in the real estate market. Residential square footage sold by housing developers has sunk by 21% versus a year ago. Completed projects still only account for nearly a quarter of sales as of September, revealing an on-going struggle to actually finish buildings before selling them. The financial travails of key developers like Evergrande and Country Garden reveal that a profound reset in real estate is still a work in progress. In the meantime, the threat of deflation persists, with the latest September CPI print showing Chinese inflation flat at 0% versus the previous year. And all that’s before we even get onto the geopolitics.

Across the world economy, a (wholly unrealistic) desire for strategic economic autonomy has arisen following the shocks of the pandemic, ensuing inflation and war in Ukraine. In the US in particular this has taken the form of a zeal for protectionism and economic nationalism, with China framed as a key threat. Consensus on the issue even transcends the culture wars - President Trump introduced import tariffs while under the current administration not only has there been no meaningful reversal of the policy, but huge amounts of subsidies have also been unleashed to promote an economic agenda that favours and stimulates domestic US industries to produce their own semiconductors and execute the green transition independent of ‘other economies’. The barely concealed target here is of course China and this, along with mounting geopolitical concerns of a showdown in the South China Sea generally and in Taiwan particularly, is weighing on global investor sentiment towards China. As recently reported by the Institute of International Finance, non-residents pulled a cool USD 14.9 billion out of Chinese stocks in September alone, the largest single monthly outflow since records started in 2015.

But things may have gone too far, too quickly. Today the emerging and contrarian case for China rests in part on valuation. The forward price/earnings ratio for the MSCI China Index suggests that China is trading at almost ‘half price’ versus the US. The former trades just under 11x forward earnings while the latter trades at just over 20x forward earnings as at end October. Removing Tencent Holdings - which makes up over 12% of the MSCI China Index and which trades at over 17x earnings - makes the MSCI China Index cheaper still. Clearly, there are drivers behind the valuation difference, but this sort of gap is rarely seen, with it only being this stretched in the last two decades in 2020 and then 2021. Cheap valuations are often cited as a reason in itself to invest in any given market, but there still needs to be a catalyst to light the metaphorical match and see price appreciation. China’s most recent economic data might serve in this regard. Its economy grew by 4.9% on the previous year, just shy of the official state growth target of around 5% for 2023. Unemployment has fallen a touch, from 5.2% to 5.0% in September, and household debt has also dropped slightly. While it would be unrealistic to expect the huge stimulus packages of old, help has nonetheless been forthcoming in a targeted way. The interest rate on existing mortgages was loosened by nearly 0.75%, while government-issued refinancing paper is helping suppliers to the distressed real estate sector. This should help take some of the pressure off the real estate market. But the long-run case for China surely transcends the ‘now’. While the country accounts for fully 18% of world GDP according to the World Bank, its stocks represent barely over 3% of the MSCI AC World equity index. While there is no iron law of economics to say that an economy’s equity market weighting should perfectly match its GDP weighting, China’s is surely one of the more extreme examples of under-representation. Furthermore, China may still be a nominally communist state but its authorities are keen to harness the stock market to drive investment in new areas such as semiconductor manufacturing, biotechnology and electric vehicles rather than the ailing property and infrastructure sectors. In other words, they now see it as a valid tool for building economic growth and prosperity rather than facilitating disorderly speculation.

Assuming the case outlined above is sufficiently persuasive, there is then the small issue of how investors should access China in the first place. There is a strong case for individual stock selection for picking through the nuances of the expansive Chinese equity market, but for many investors a top-down index-level exposure may well be sufficient within a long-term portfolio context. There is then a choice between MSCI China, ‘H’ Shares listed in Hong Kong, MSCI China A and a variety of technology-based indices. China A shares offer a more direct allocation to the structural story described given that they are onshore and more sensitive to domestic growth. This could be particularly advantageous for a globally minded investor who is likely already exposed to consumer technology stocks via an existing US allocation. And, unlike the broader MSCI China Index, China A skips the likes of Alibaba, Baidu and Tencent with their more inflated valuations. It also arguably offers the approved domestic growth story, with a lower allocation to real estate than its MSCI China counterpart, but higher allocations to the pure technology and healthcare sectors most likely to benefit from state-infused ‘guidance capital’ in order to meet China’s aims of equitable modernisation. A-shares also carry more exposure to mid-cap stocks with around a quarter of the MSCI China A Index allocated to firms with less than USD 10 billion market cap. These tend to be standalone firms more sheltered from US-China geopolitical tensions and anti-Chinese sentiment generally. They are also less subject to the regulatory interventions in the big offshore-listed firms which have been blamed by regulators for the “disorderly expansion of capital” that has allegedly created economic imbalances and inequality in the Chinese economy.

Sector difference matters – China A avoids potential corporate trouble spots:

Investing in stock markets anywhere has always represented the triumph of optimism over caution, and investing in China is a particularly potent example of this given the wall of negative news flow around the economy this year and its initially confusing stock market ecosystem. Bubbles, manias, interventions and unwinds have been an inevitable part of China’s equity journey given that its stock market internationalisation only really began in the wake of its entry into the World Trade Organisation in 2001. But beyond the continued growing pains lies a compelling story about a still fast-growing economy rapidly learning how to harness capital markets to facilitate resource allocation. Structural holders of Chinese equities both at home and abroad will have held firm throughout the recent volatility but the clamour of anti-Chinese sentiment in the West has clearly frightened many retail investors. Rockefeller International Chair Ruchir Sharma recently stated, “Given that anti-China sentiment is so high, ideological blinkers may be preventing commentators from seeing anything positive.” This is a shame given the undimmed long-term case for the asset class as well as the improving underlying fundamentals in evidence right now. For the former holders of the USD 14.9 billion-worth of Chinese equities that were dumped in September, the real question they need to answer is not whether they could risk staying invested but whether they can now risk not being so.