China: More stock market fireworks to come?
Chinese equities are making a flying start to the year, with especially technology-related stocks jumping 10% or more. The MSCI China Index is already up 8% after a few trading days in the new year, whereas European and American equities on average rose just a few percent.
As Chinese equities have underperformed in the past two years, the big question among investors is whether this jump is a mere bear-market rally or is it the beginning of a new growth phase for Chinese equities.
Some headwind is turning
Since the outbreak of the Covid-pandemic, the Chinese government handled the situation with strict lockdowns, hurting economic growth and travel-related consumer spending. Now, the government seems to have changed its course and prioritises economic growth again with the decision to drop almost all of its Covid-measures. With the Chinese new year starting on 21 January, this could be the trigger of renewed consumer spending. Economic conditions are further improved by dropping food inflation in the past months and growth in credit provision. The government is also engaging with some developers in the real-estate market to mitigate some negative spill-over effects from the debt crisis. In technology-related sectors, companies have restored their profit margins as cost-cutting programmes have had their effect. And the issue that Chinese companies with a US listing could be forced from the US stock exchange if they do not give the US insights in their books, seems to be improving. The Public Company Accounting Oversight Board in the US said on 15 December it had gained full access to inspect and investigate firms in China. So, many risks and headwinds have turned for the better, although some key issues still remain.
Investing in China poses fundamental threats and dilemmas
One of the main issues regarding investing in China is the still prevailing threat of the covid pandemic. The majority of the Chinese people has not been vaccinated, as people are afraid of side effects. Lifting most of the covid measures could lead to high death tolls, crowded hospitals and shortages in drug supplies. This in itself may backfire on consumer confidence and the economy, with renewed supply and demand disruptions.
Another constant dilemma for investors is China’s use of data to control people, even leading to human-rights abuses against the Uyghurs, a large ethnic minority in China. Especially, data from Tencent and Baidu is being claimed by the authorities to be used for this purpose.
The most important threat regarding investing in China, though, are the unpredictable policy shifts we have seen in the past two years. China’s government is changing its policy towards higher levels of central control, security and redistribution of wealth. Companies in China are struggling to make sense of this business environment with a constant stream of new regulations. For instance, some businesses have been ordered to shut down. Also, online behaviour is controlled. This poses a direct threat to entrepreneurship and, as such, to investors. Especially, technology-related companies are affected, which are responsible for almost half of the MSCI China index.
Stock price increases to be funded by earnings growth
These risks for investors require at least a discount in stock price valuation, which is currently only marginally lower than average. For instance, the price-earnings ratio of the MSC China index is around 11 times the expected earnings, while the 7-year average valuation is at 12 times (data from Bloomberg). In order to have higher stock prices, earnings growth needs to be a driving force. Fortunately, earnings-growth expectations are improving on the back of economic recovery with 9% earnings-per-share growth in 2023 and 14% next year.
Prudent to stick to neutral view towards China
All in all, pros and cons are currently balancing each other out, as especially unpredictable regulation and policy worry us. We therefore have a neutral view towards emerging markets and China in general.
Global Equity Team
Piet Schimmel – Senior Thematic Equity Expert