Chinese stocks have been staging a comeback that contrasts with market declines in most of the world. While a zero-COVID policy has weighed on the economy, a renewed focus on growth could provide fuel for equities, particularly in industries set to benefit from fiscal spending and green reforms.
Investor sentiment toward Chinese equities has improved with the gradual reopening of the economy. While the MSCI China A Index of onshore stocks fell by 13.4% in USD terms in the first half, it rose by 1.6% in the second quarter, with solid gains in May and June. In contrast, the MSCI World Index of developed markets fell by 20.5% in USD terms, as US stocks slipped into bear market territory amid growing fears of a recession.
China’s relative resilience follows a tough 2021. Last year, Chinese stocks underperformed as troubles in the overheated property market and a regulatory crackdown on education and technology companies rattled the market.
Equity Market Recovery Reflects Policy Support
What’s changed in 2022? This year’s performance divergence reflects China’s markedly different position in the economic cycle. Economic growth in China was weak in early 2022, weighed down by COVID-related shutdowns. As a result, monetary policy remains relaxed, while the government is ramping up fiscal stimulus to support growth. Meanwhile, in the US and Europe, central banks have taken aggressive efforts to combat inflation, which threatens to prompt a slowdown or recession.
China isn’t out of the woods just yet. The zero-COVID policy remains in place, but the economy is gradually reopening and President Xi Jinping has reaffirmed a GDP growth target of 5.5% this year. Although the sluggish start will make that target hard to achieve, the government appears to be reshuffling its priorities and plans to pump more stimulus into the economy to support growth.
Inflation is Benign—and Interest Rates are Falling
China can push harder for growth because inflation is relatively moderate. The consumer price index in China rose by an average annual rate of 0.9% in 2021 and is expected to reach 2.2% in 2022, according to consensus estimates. Inflation is low in part because China’s zero-COVID policy has suppressed consumer spending. China is also buying Russian oil at a discount, mitigating energy inflation. As the economy reopens, however, inflationary pressures may surface.
For now, though, China’s monetary policy is asynchronous to other major central banks. Chinese government bond yields are falling, while US and European bond yields have risen and are widely expected to increase further (Display).
Earnings to Benefit from Growth Push
What do these trends mean for company earnings and stocks? Here, too, China is on a different trajectory than most developed markets.
Until recently, investor sentiment toward Chinese stocks was negative. But corporate earnings forecasts have been revised downward, so much of the bad news is already priced into the market, in our view. In the US, earnings revisions remained positive at the end of June, and are widely expected to begin coming down amid growing expectations of an economic slowdown or recession.
We believe Chinese earnings forecasts will soon begin to turn up because of the supportive policy backdrop. The gradual reopening of the economy will also help, along with a reduction in regulatory scrutiny, which has been clearly telegraphed by government officials seeking to prioritize growth.
Equity Valuations Are Attractive
For now, Chinese stock valuations are very attractive, in our view. The MSCI China and MSCI China A onshore indices traded at a price/forward earnings ratio of 11.1x and 12.5x at the end of June, representing a discount to its own history and to US and global markets (Display).
Two Types of Opportunities
At these valuations, we’re seeing attractive opportunities in two areas—companies that were badly hurt by the domestic downturn over the last 18 months, and companies that should benefit from new stimulus.
In the first group, many consumer-facing companies suffered a severe drop in sales and profits because of the COVID lockdowns. Consumer confidence sank and cash-strapped households simply couldn’t afford goods and services. Similarly, manufacturing companies faced major operational disruptions as lockdowns kept workers confined to their homes. Some companies, such as automakers and technology manufacturers, were hurt by both trends. Their shares fell victim to extreme pessimism and select stocks now trade at extremely depressed valuations that understate their recovery potential.
Potential beneficiaries of fiscal stimulus can be found in several areas. Expansionary spending is expected to be funneled to areas including infrastructure and alternative energy. Infrastructure investment to upgrade the country’s electric grid network will support companies that are integral to these efforts. Incentives to promote electric vehicle adoption should fuel earnings for the battery and auto components supply chain. And China’s net-zero efforts will spark stronger performance of alternative energy companies, such as manufacturers of solar wafers and wind turbines, in our view.
In all these areas, investors must be selective and look for companies with quality features and solid fundamentals. Sustainable cash flows, robust business models and sturdy balance sheets will be essential to differentiate winners from losers if companies begin to show signs of stronger earnings growth later this year.
Investors who have had little or no allocation to China may want to take another look. With the market being driven by a very different macroeconomic narrative than the developed world, we believe a carefully curated portfolio of Chinese equities can provide equity return potential that will be hard to source elsewhere in the months ahead.
- John Lin
- Portfolio Manager—China Equities