The Chinese equity market has struggled since the government carried out a number of reforms in several industries including the property sector. However, we might have reached ‘peak pessimism’, and as a result, we have taken a more constructive view of Chinese equities from a tactical perspective.
This year, the Chinese government has carried out a series of rule changes aimed at prioritising social cohesion over economic growth. First came the crackdown on the technology sector, followed by reforms of the healthcare, education and property sector. The result has been that the Chinese equity market has underperformed this year. The sectors most affected by the new regulations have borne the brunt, but the wider market has also been dragged down. The property sector has been the backbone of the Chinese economy for several decades, so the reforms there are especially responsible for the broader slowdown now occurring.
Chart 1: Chinese equities have underperformed this year
Investing in Chinese equities already came with higher costs, a higher risk premium, and lower valuations compared to other regions. And the recent bout of regulatory tightening has led investors to price in an even greater ‘China policy risk’. However, we believe we are at or near the peak of negative sentiment and that at these levels, Chinese equities look attractive for several reasons.
First, economic indicators are showing marginal improvement, albeit from a low base. Citi’s economic surprise index for China has turned upwards in the last few weeks. Recent data on total social financing has been better than expected, while new mortgage lending is also showing tentative signs of recovery. Problems with supply chains could be easing, which would help exports and manufacturing. Indeed, recent export numbers were higher than expected, although still at low levels.
Chart 2: China economic surprise index showing signs of improvement
Second, valuations are attractive both compared to recent history and other regions. The short-term negative sentiment has impacted all parts of the market, not just those sectors affected by the rule changes. We expect some mean reversion as the dust settles and investors’ confidence begins to return. Finally, investor positioning has been low given the negative sentiment. This means that when sentiment does improve, there is plenty of room for positioning strength to grow.
Finally, there are signs that policy easing will soon begin. In the latest Q3 monetary policy report from the People’s Bank of China adopted a more accommodative tone. And in the coming Central Economic Work Conference in December, we expect policy guidance for the coming year to take a more pro-growth stance.
Chart 3: Chinese equities are cheap on both relative and absolute terms
Differences between onshore and offshore equities
While we believe both onshore and offshore Chinese equities look attractive on a short-term basis, there are some important differences between the two. First, the sectors that have been the focus of the regulatory tightening generally make up a lower weight of onshore indices than they do offshore indices. As a result, onshore indices have less ‘China policy risk’ priced in as investors judge they are less exposed to future regulatory action. This also means that onshore equities are more expensive because they have avoided a large part of the multiple and earnings correction that offshore equities have experienced this year. But we expect this gap will narrow over time as offshore equities recover, in part because the current policy cycle is already past its peak.
Second, offshore indices also have a higher proportion of ‘downstream’ sectors, those nearer the final consumer in the value chain. We expect commodity prices will soften and consumption will gradually recover in the coming months, conditions which should be favourable to offshore equities. Third, onshore equities have historically benefitted more directly from monetary and fiscal policy support.
A final point to consider is that Chinese authorities are attempting to reduce the dependence of retail investors on property for investments and savings. A rebalancing away from property towards equities could be a secular driver of the onshore market over the next few years, especially considering the proportion of Chinese household wealth in equities is very low, at least compared to that of develop markets.
Weighing up all the above factors, we believe offshore equities look more attractive on a tactical basis.
Long-term growth story remains intact
Investors with a longer-time horizon should also consider Chinese equities. We believe that China is shifting from a ‘growth first’ approach to one that balances growth with sustainability, which will reduce the chance of systemic risk events in the future, most obviously in the property market but elsewhere too. The regulatory shift is a short-term pain for many companies, but it will improve efficiency in the long-term by removing uncertainty around legal, regulatory and political boundaries.
The recent market impact has been amplified by the limited communication and unexpected speed of the policy action. In future, we expect communication will be significantly improved, which should reduce volatility and some of the uncertainty over how to price the ‘China policy risk’.
China’s long-term growth story remains intact and many sectors will adapt to the new rules and continue to post robust growth. For example, it is difficult to make a case that China’s technology companies have been so successful in the past 10 years thanks to lax regulation. In fact, their success is due to being highly innovative and having access to an enormous market that offers significant economies of scale. Whether the property sector will fully recover remains to be seen. But overall, the country’s growth story is arguably stronger now that some systemic left-tail risks have been diminished.
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