Taking stock of the Chinese stock market
Chinese equities went through a torrid period last year, with the Shanghai and Shenzhen stock markets down by about 25% and 35% respectively (figure 1).
The reasons for this are well known: trade tensions, a faster than expected moderation in activity, a retracement in previously-lofty expectations for the tech sector.
Despite this, there remain good reasons for a medium-term allocation to the Chinese stock market within a globally diversified portfolio.
Firstly, valuations for the Chinese stock market still look reasonable.
With hindsight, one can say that earnings expectations for the Chinese market were probably over-optimistic coming into 2018's first quarter, leading to historically elevated valuations being priced in.
As of January 2018, the forward price-to-earnings (PE) ratio for the MSCI China stood at its highest level in eight years, and was at its 13th percentile within its historical distribution.
Since the de-rating of 2018, valuations have dipped to more attractive levels, with the forward PE is currently straddling the 30th percentile of its distribution (figure 2).
Admittedly, the market doesn't look oversold, but valuations look reasonable enough to provide decent upside over the medium-term.
China’s ‘new economy’
Second, we think the top index constituents within the Chinese market are still well placed to benefit from China’s structural growth story.
It’s worth noting that the Chinese market is particularly concentrated; the top 10 constituents of the MSCI China (mainly tech and financial companies) make up more than 50% of the total index, in contrast to the MSCI World’s 10%.
The most prominent of these companies are arguably the BATs – Baidu, Alibaba and Tencent. Known colloquially as China’s version of the US FAANG stocks (Facebook, Apple, Amazon, Netflix and Google), the BATs’ impressive earnings and revenue growth have been often been touted as a sure-fire way to profit from China’s ‘new economy’.
As always, reality is more nuanced – high expectations have already been priced into the valuations of these firms, and the BATs will be hard pressed to maintain their current growth rates in increasingly crowded and mature market.
Nevertheless, as China makes the gradual shift towards becoming a consumer and services driven economy, both the tech and financial constituents of the stock market will be well placed to benefit from these structural trends.
One common pushback against having some medium-term exposure to China is in regards to fears of debt-driven slowdown.
No doubt, the size and pace of China’s debt figures are a cause for worry. Again, the underlying reality is much more nuanced.
We’ve long noted that China’s debt ratio will be biased upwards relative to other nations (particularly the US) given that corporate financing activities tend to be skewed towards debt rather than equity funding.
Already, authorities have taken efforts to deleverage the economy, with some tentative success.
Under most plausible scenarios, we still think the state retains sufficient fiscal room and control over the major financial institutions to keep systemic financial risks at bay.
The near-term horizon looks to be less bright this year, with domestic activity indicators continuing to disappoint.
However, we think a lot of bad news has now been priced in.
Tactically, we still hold an overweight exposure to emerging market equities (which includes China).
Further out, we think that Chinese equities retain reasonable upside potential over the medium-term, warranting a place within globally diversified portfolios.