The China A-shares market fell 33% last year as a multitude of concerns—trade wars, slowing economic growth, tightening monetary policies, and political rhetoric—converged. But in an about-face, the Chinese market is the best performing global market this year, up just over 33% through April. This turnaround has investors wondering if the rally is sustainable. We think it is.
2018 in Review
To understand why China A-shares—which are mainland-based Chinese companies that trade on local stock exchanges—are up so strongly this year, we need to first delve into why last year was so weak. Many blame the trade war between the US and China for last year’s fall. But while it did play a part, we believe domestic issues were the main culprit.
Throughout 2017 and the beginning of 2018, the Chinese government was aggressively tightening liquidity, which removed leverage from the system and cut off credit, stalling the economy. At the same time, confidence in the market waned as government support of state-owned enterprises appeared to minimize the significance of private companies. This worried investors who believe private companies are a robust driver of economic growth.
The importance of the government’s influence on investor sentiment cannot be overstated. There are three main drivers of equity performance—company earnings, currency, and valuation. Earnings were positive through 2018, and currency, while negative, only hurt a small amount. The majority—nearly 90% of the negative performance—was due to valuation compression, a reflection of pessimistic sentiment due to the government’s policies (Display).
From Overreaction to Recovery
When a market gets overly pessimistic, conditions often become ripe for a recovery. In many cases, the market may breathe a sigh of relief that earnings, or a policy/rhetoric change, are not as bad as feared. Both factors happened in China.
As the above display shows, earnings contributed positively to performance in 2018, which eased investors’ concerns about falling profits. The government also turned stimulative, pumping liquidity into the system. And finally, politicians began emphasizing the importance of the private sector to the Chinese economy. The result was a 33% rally through April.
An Attractive Value
Despite this year’s run-up, Chinese stocks remain attractively valued in our opinion and likely still have runway to appreciate.
At the end of 2018, China A-shares were trading at a price-to-forward earnings multiple of 10.9x, lower than the 10-year average valuation of 14.5x and far below its peak over the last decade of almost 23x. Today, A-shares are trading at 12.8x. This compares favorably to the US market, which is currently trading at 17.7x. While China A-shares usually trade at a discount to the US market, the difference is currently wider than the historical average. From this perspective, Chinese stocks remain cheap relative to history and the US (Display).
Supporting a Continued Rally
Wild swings from year to year are not unexpected in emerging markets, and China is no exception. But, even though the performance from last year to this year has investors cautious about further upside, the returns on China A-shares remain in line with other emerging markets.
Further, money flowing into the Chinese market indicates that more upside is possible. Relative to other years, most of the money entering the market this year has come from foreigners. Part of this inflow is due to the growing presence of China A-shares in the MSCI Emerging Market Index—they are expected to quadruple from 0.8% to 3.3% by this December. Over the next four years, China A-shares will come to comprise more than 16% of the Index, so we expect foreign inflows will continue to support the market for years to come.
And yet, although foreigners have been flocking to the market, domestic money has not. Data show the number of new account openings and the use of margin are far below 2015 levels, during China’s last stock market bubble. If Chinese investors decide to enter the market, they could increase demand for A-shares and push the market higher.
Buy the Dips?
Over the remainder of 2019, we anticipate the Chinese market will be volatile. While investors may take profits after the strong first quarter, and headlines around trade may cause further swings, we believe the Chinese economy is on a stable footing. First quarter GDP of 6.4% was slightly better than forecasts, and investors have more confidence in the market and the government’s continued support. Companies are expected to increase earnings by over 20% in 2019, yet valuations remain reasonable.
In this environment, we believe active managers with long-term horizons have the opportunity to generate excess returns, as short-term volatility could offer attractive entry points.
For more on trends in the economy, markets, and asset allocation for long-term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.
- John Lin
- Portfolio Manager—China Equities