Since the end of 2009 (when capital markets had largely stabilised following the global financial crisis), the MSCI China index has risen by about 10% in USD terms (to 31 December 2016). But that figure includes reinvested dividends. In aggregate, share prices are marginally lower at the end of 2016 than they were seven years earlier, which equates to an underperformance of the MSCI World index of around 70% over those seven calendar years. Despite strong performance year to date, Chinese equities therefore still have room to catch up.
Looking beyond the relative and absolute underperformance, there are five key reasons to believe that Chinese stocks are poised to rebound. The first and most topical of these is MSCI’s decision to include China A shares in its benchmark indices. While the initial weighting will be a relatively small one (0.7% of the MSCI Emerging Market index), this will gradually increase over time to 10% or more. As such, the effect on flows is likely to be limited but the psychological impact of the decision should lift sentiment. Second, and more fundamentally, the macro picture is improving by virtue of broad-based economic strength and diminishing pressure on the Chinese yuan. Third, valuations are compelling, with the MSCI China index trading at a forward price/earnings (P/E) ratio of 13x. It is also noteworthy that technology comprises a relatively high proportion of the index (around 33%) and, if internet stocks are excluded, the forward P/E of the residual index is around 10x. Fourth, China’s rating has recently been elevated by a number of brokerages, including a triple upgrade from Goldman Sachs. Fifth, China remains a large underweight in many global portfolios, meaning that investors are yet to participate in the recovery – macro improvements and broker upgrades alone should compel investors to raise exposure and the recent MSCI decision can only help in this respect over the medium-to-long term.
It is also worth considering that the broad rally we have witnessed in developed markets has been predicated on a recurring valuation expansion for a number of years. Hence, stocks have steadily become more expensive, and this is a natural by-product, or even an intended consequence, of the asset-purchase programmes of central banks. Conversely, we saw a big trough in P/E multiples in China around a year ago due to deep concerns over the yuan valuation. Consequently, we have, so far, seen just 12 months of P/E expansion from a very low base in China, so there are firm grounds for optimism over the potential for an extended stock market rally.
There are, of course, risks to this thesis, the most notable being the potential legislative impact of the Trump administration on emerging markets and the unsustainability of Chinese economic growth rates. The former is not really a China story as such since the effects of a US protectionist agenda will be felt right across Asia. Nevertheless, given that we are focused on domestic consumption themes, we mostly invest in companies that create products and services in China and sell them to the local market. Consequently, in terms of the Trump trade impact, we have an advantage in that we are well insulated because of our low exposure to exporters.
In terms of growth, it is absolutely inevitable that the pace of economic expansion in China will slow significantly over the longer term because of its status as the world’s second-largest economy. But, over the last 6-12 months, we have seen a broad-based recovery in China and this is flagged by pretty much any chosen metric: Industrial production, property sales, domestic consumption, exports and inflation indicators have all trended up.
However, the really important point is that the headline GDP number, which most people focus on, is seriously beguiling because of the underlying divergence in performance across industries. Some are growing at around 20% per annum as consumers spend more in areas such as education, travel and entertainment. Conversely, ‘old economy’ heavy industries are really struggling and this is reflected in share-price performance. According to recent analysis, stocks exposed to ‘New China’ have outperformed their ‘old economy’ counterparts by around 7.5% per annum since 20111.
Consequently, while we are optimistic over the potential for a China catch-up trade, we additionally believe that our ‘economic transformation’ portfolio is concentrated in areas where stocks may outperform the broader market.