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Weekly Market Analysis - Necessary Elements for a China Turnaround
Posted on3 Things to Know
Rebuilding Trust
Over more than three years, Chinese authorities have rolled out a slew of policy measures to bolster markets. Most recently, curbs on short selling, more ETF purchases, and incentives to boost consumer are being implemented in an attempt to increase investor confidence and reverse the direction of the market. These measures appear similar to what has been done before and that is unlikely to create a change in sentiment.
What it Will Take: Governance and a Demand Boost
New policies are needed to improve the profitability and investor friendliness of Chinese companies. Chinese regulators could take a page from the Tokyo Stock Exchange’s recent governance reforms and encourage dividends and buybacks, while implementing rules to prioritize shareholder interests. Stimulating consumer demand has also been missing in China’s arsenal thus far.
Will Investors Return?
A tactical rally is possible given depressed sentiment and valuations, but a sustained recovery is dependent upon increased demand and improved corporate governance. If policymakers do steer towards this direction, we would prioritize growth sectors, with high cash levels and negative net debt, as these are the most likely to lift dividends and buybacks. However, if these issues are not addressed, investors are unlikely to be interested to return other than for tactical trading.
Summary
Many China investors are anxiously awaiting further governmental actions to turn around financial markets. Their patience is wearing thin. Over the past 5 years, the MSCI China increased 60% on the early successes of their “Zero-COVID” policy and then lost 58% from the highs seen in February 2021, due to a major real estate crisis and series of regulatory missteps.
Global investors have reduced holdings materially and sold a net US$2.5bn worth of mainland Chinese equities in January 2024. It has been the sixth consecutive monthly outflow since August 2023, marking the strongest and longest net outflow since the Stock Connect between Hong Kong and mainland China started in 2014. Although Chinese retail investors have historically been responsible for roughly 70% of the Chinese shares’ turnover, they are now leaving too.
Given a clouded policy landscape, we find it hard to have strong conviction in the timing and magnitude of any potential Chinese equity market rally. We continue to suggest a neutral weighting within globally diversified portfolios.
Portfolio considerations
New policies are needed to reverse Chinese deflation and improve the long-term profitability and return on equity for Chinese companies. If better governance becomes an aim for listed companies based on policy directives, we would prioritize growth sectors including IT, healthcare, consumer staples, telecommunications services, and consumer discretionary, with high cash levels and negative net debt. We remain neutral on Chinese shares presently.
Source: Bloomberg, Feb 8, 2024.
Rebuilding Trust
Over the past four years, China’s current administration has been willing to derail national champions in the name of “common prosperity.” From e-commerce to online education to car-hailing, China has impacted corporate decision making, sacrificing rapid growth in revenues and profits for greater state control. As technology emerged as a national security issue for the West, Western governments sought to isolate their markets from China’s tech products. At the center of China’s malaise is an unresolved real estate crisis. China’s highly indebted property developers remain undercapitalized and at risk of default. More than 700 unfinished projects await completion nationally
After the Lunar New Year holiday, Chinese authorities attempted to boost their ailing economy and markets with a rare 25bp mortgage rate cut. Prior to the holiday, numerous policies were initiated including actions by Central Huijin, China’s sovereign fund, promising more ETF purchases, further curbs on short selling, encouragement of state-owned enterprises to purchase equity, a potential market stabilization fund and even a visit by President Xi Jinping to the stock exchange. Other major policies over the past year were focused on stimulating supply side activity, such as major regional infrastructure development. We doubt that these policies alone will be sufficient to change the course of the economy given the headwinds China faces in its real estate markets and the skepticism of sophisticated investors.
What it Will Take: Governance and a Demand Boost
Corporate governance refers to the rules that align corporate management with the interest of shareholders. In the past 22 years, China’s GDP grew by 12x, while equity indices grew by only 3x, implying that equity investors earned just a fraction of China’s cumulative economic growth. However, China’s market capitalization surged by 27x as corporate issuers raised nine times more financing relative to shareholder returns. By comparison, this ratio is 2x in the US and 1.5x for Japan.
To help fix this problem, Chinese regulators could take a page from the Tokyo Stock Exchange’s recent governance reforms to encourage dividends and buybacks. As the state is the owner of many companies, this could also be a more efficient use of government fiscal resources, rather than use huge fiscal actions to buy stocks. There is also a lot of cash sitting on the sidelines in China. MSCI China member companies have cash and short-term investments amounting to 38% of their market cap. In many growth industries like IT, healthcare, and telecommunications the companies are debt free, meaning that cash can be effectively deployed for buybacks and dividends without increasing credit risk. Chinese cash hoard is much greater than Japan, U.S., or its EU counterparts. This type of action would likely be more effective for company shareholders and government than the recent stimulus plans.
Will Investors Return?
Given how depressed sentiment is towards China, any substantial policy boost could help lift its markets. With a forward PE ratio of 8.5x, MSCI China valuations are more than 1 standard deviation below historical mean. Compared to the U.S. at 20.5x, Chinese equities are nearly 60% cheaper. Beware, a more significant stimulus package may cause a short squeeze in markets that could lift Chinese markets even if fundamental conditions have not recovered. A return to average valuations without any earnings growth would imply a 34% upside. And just one year ago, the index was at the historical average of 11.5x.
The largest contributors to China’s equity market underperformance are also structural. When we look at the root cause of the fall in China’s markets it is profits and losses. Earnings and dividends have both fallen to 2011 levels. The absence of demonstrable growth is the primary reason institutional investors have become highly skeptical of any policy that does not change the future trajectory of corporate results.
Stimulating consumer demand has been a missing strategy in China’s arsenal. China is presently experiencing deflation. This causes consumers to delay purchases in the anticipation of lower future prices. The most recent policies continue to emphasize infrastructure and industrial output that increase supply rather than demand – and this is unfortunately deflationary. Over time, current deflation and further deflationary policies create a dangerous slippery slope for a market with weak earnings and high debt levels.
