Chinese equities: A rally of substance?

"Hahahahaha! The signs of a bull market are more and more clear.” So said the headline of a front-page story run by China’s state-owned Shanghai Securities News on July 3.¹

Three days later, and with other state-run publications getting in on the act – a front-page editorial in the China Securities Journal said the foundations had been laid for a “healthy bull market”² – domestic Chinese stock indices recorded their biggest one-day gain in more than a year. The Shanghai Composite index closed at 3450 on July 9, a two-and-a-half-year high, having surged 16.5 per cent in the space of just eight trading sessions.³

The rally left Chinese shares 30 per cent up on their March nadir and in positive territory for 2020. As of July 24, the Shanghai Composite index was up 4.8 per cent year to date; by contrast, the S&P 500 was down 0.5 per cent.

Although the dizzying rally has coincided with evidence of a rapid recovery in Chinese economic activity, many commentators have questioned its durability.

Recent events have revived memories of 2014 and 2015 when Beijing last urged its population to buy stocks. Since that previous effort ended in tears as a massive stock bubble promptly burst, this caution is perhaps understandable.

Stretched valuations?

However, while the rally in share prices may have gone too far, too fast, as evidenced by the fact the market has fallen back since July 9, that does not mean Chinese shares are overvalued when compared to international peers.

As seen in Figure 1, at the end of June, the MSCI China index was trading at a multiple of 15.2 times estimated future earnings. While that may have represented its richest valuation in two-and-a-half years, it left Chinese equities no more expensive than the broader emerging market universe.

Compared with US shares – the S&P 500 index is trading on a forward P:E ratio of 24.9, a level not seen since the heyday of the dot.com bubble – the Chinese market looks relatively cheap. This is especially true when one considers China appears to have got the COVID-19 pandemic under control. China’s official death toll of less than 5,000 is in marked contrast to what is occurring in the US, which had reported over 150,000 deaths by the end of July – almost a quarter of the global total.⁴

Figure 1: Chinese stock valuations do not look excessive

While China has a bad reputation when it comes to providing official numbers, with coronavirus data being no exception, in the two months to July 22 the country reported an average of just 12 new infections per day.⁵ This has in turn enabled a rapid economic recovery. Output expanded 3.2 per cent in the second quarter following a record 6.8 per cent slump in the first three months of the year.⁶

“Although the first cases of COVID-19 were in China, it has done a good job of protecting the population and the economy,” says Alistair Way, head of emerging market equities at Aviva Investors.

However, he concedes the recovery has been far from uniform. Retail sales for instance were four per cent lower in the second quarter compared with the same period a year earlier.⁷ Nonetheless, he says the Chinese market “looks like a relatively decent place to be in a global environment where there’s still a lot of bad fundamental news”.

Lies, damn lies and statistics…

With most other countries struggling to fire up their economies at the same time as preventing the disease from flaring up again, China’s economic numbers, like its coronavirus statistics, are raising eyebrows.

However, Xiaoyu Liu, emerging market equities portfolio manager at Aviva Investors, argues there is no reason to doubt the idea the economy has recovered strongly, with multiple data points coming from various sectors of the economy telling a similar story.

“Even for those who may not want to put too much store in official numbers, unofficial figures on things like electricity usage are painting a similar picture. Anecdotally, I hear people are now queueing up to get into restaurants in Shanghai. Life is pretty much back to normal,” she says.

While Beijing’s efforts to prop up the market may explain some of the rally seen in early July, other factors look to have been equally potent. For instance, international institutional investors have generally been running underweight positions in Chinese equities for some time, with the majority of companies viewed as being of a low quality given their bad corporate governance records.

“My perception is that a lot of funds have been struggling to cut underweight positions and it feels like there’s more to come. It doesn’t look like we’re anywhere near the bubble stage in terms of valuations, certainly nothing like the mania we saw in 2015,” says Way.

Tech boom

Interestingly, despite a ratcheting up of trade tensions and proposals from Washington to make it harder for Chinese companies to list their shares on US exchanges and for US pension funds to invest in them, US-listed Chinese stocks have performed equally impressively. “That suggests there is far more to this story than just Chinese retail investors getting overexcited,” says Way.

A further explanation for the recent strength of the Chinese market is that it is increasingly dominated by giant internet companies, unlike most other emerging equity markets that are heavily weighted towards commodity producers and other cyclical economic activities. “From an emerging-market equity investor’s perspective, it’s suffering significantly less earnings pain. It’s a really good place to be relative to other areas of the universe,” says Liu.

Both she and Way concede the valuations being attached to some shares, especially in the technology and pharmaceutical sectors, look extreme. Way says Meituan Dianping provides a vivid example of the degree to which market shifts have become skewed, leading to ever rising levels of market concentration. Shares in the food home-delivery company have almost tripled since they were floated in September 2018.⁸ Meituan Dianping, despite never having made a profit, is valued at HK$1.13 trillion (US$147 billion), giving it a bigger weight in the MSCI Emerging Market index than the entire Indonesian stock market.

“It’s part of the overall growth against value dynamic, with investors of all natures preferring to buy concept stocks, technology stocks, internet stocks, and largely ignoring the rest of the market,” says Way.

Noting that the Chinext index is trading on a forward price: earnings multiple of 40, Liu says it is clearly pricing in extremely optimistic growth assumptions. However, she says this is no different to what is happening in other markets around the globe.

Flush with liquidity, investors have been bidding up the price of shares in any company deemed capable of delivering growth, especially in the technology and pharmaceutical sectors. “It’s quite hard to justify some of these valuations. But this shift from value into growth (stocks) is a global phenomenon, even if China may be the ultimate expression of it,” Liu says.

Getting the travel bug

With the majority of growth stocks highly priced, Way and Liu are looking to other areas of the market for value.

Way believes domestic travel and tourism has potential, with many stocks languishing at depressed levels having sold off sharply earlier in the year. “Online travel agents that are focused on the domestic economy, such as Trip.com and the Macau gaming companies, have been among the weakest areas of the market this year. We see upside potential so long as things continue to normalise,” he says.

As for Liu, she sees long-term value in insurance stocks given Chinese GDP per capita last year rose above $10,000.⁹ “This is the level at which people start to feel they have enough money to take out health and life insurance policies for the first time,” she says.

Tensions between two superpowers

While both managers are relatively bullish on the Chinese market’s prospects, they are aware of the risks. China’s high debt load represents an ever-present worry, but a more immediate concern is worsening relations between the US and China.

Recent weeks have seen a ratcheting up of tensions between the two superpowers over a range of issues including: US efforts to damage Chinese telecoms equipment maker Huawei; China’s new national-security law in Hong Kong; Washington’s rejection of China’s claim to the South China Sea; and a blame game over the source of the coronavirus outbreak.

While the trade accord struck between the two nations in December last year holds for now, it remains an uneasy peace. Washington is reportedly considering restoring tariffs as Donald Trump looks to make reprisals against Beijing, which he blames for causing the pandemic, the centre of his re-election bid.¹⁰

Way believes the risk of a further escalation in tensions has not been fully priced in. If the US started to roll back on previously agreed deals, emerging markets, and particularly China, would react badly.

“Trump is aware a trade war would damage US consumers and companies, so it’s unclear it’s the most rational thing for him to do in an election year. On the other hand, these tensions are unlikely to dissipate in a hurry, regardless of the result of November’s election,” he says.

But the biggest concern of all is that a second wave of coronavirus infections forces a renewed lockdown of the Chinese economy. Beijing and some other areas of the country suffered sizeable new outbreaks in June. Although each was contained relatively quickly, the danger of a more damaging episode will remain until a vaccine or cure for the disease can be found. For now, however, investors seem likely to continue to put such fears to one side.

In its article on July 6, the China Securities Journal said a vigorous stock market was now more important to the economy than ever. Policymakers are clearly hoping that Chinese consumers will respond to an increase in the value of their share portfolios by consuming more. That in turn should support the economy.

While the obvious danger is that such blatant propaganda could fuel an unsustainable bubble, this looks to be a distant threat. For now, there are still attractive opportunities to be found in Chinese equities.