10 minute read

In the September 2023 edition of CIO Insights, Reading between the headlines of China’s economic “crisis”, we argued that the market was too bearish in thinking that China was about to spiral into a systemic crisis. Since then, China equities have bottomed and in the past few weeks entered a technical bull market. 

Given the recent rally, we’ve received a lot of questions on whether we see further upside from here. In short: we do. But with the strong upturn over the past few weeks now behind us, a sustainable bull run will require structural improvements in corporate earnings.

Key takeaways:

• The recent rally has been driven by a reversion to the mean from extremely low valuations and investor positioning. The forward price-to-earnings (P/E) ratio of the MSCI China Index has recovered from a bottom of 8x earlier this year, to about 10.5x now. “Short China” is still one of the most popular trades among institutional fund managers.
• Further near-term gains could still come from a normalisation in valuations and positioning. The long-term average P/E of the MSCI China is 11.5x, representing an upside of about 10% from current levels. In terms of positioning, the largest Chinese equity ETFs have seen fund flows turning net positive over the past three months, but overall, investors are still underweight on the Chinese market.
• For a sustainable bull market, company earnings need to do the heavy-lifting. Revenues in key sectors have been in contraction in recent years amid China’s economic downturn, while profit margins have been on a longer-term decline. Recent stimulus measures and a recovery in the global manufacturing cycle suggest that the earnings cycle is starting to turn. Here, we see potential for earnings to return to a longer-term trend of about mid-single-digit growth per annum.

• Combining valuation and earnings growth suggests potential near-term upside of 15-20%. Looking longer-term, the market’s earnings profile is decent, but not as attractive as other markets. Our Economic Regime Asset Allocation (ERAA®) framework has maintained a market-weight allocation to China given a relatively more subdued trajectory for earnings. But for investors who wish to participate in the potential upside from valuations – and also understand the potential risks – our Flexible Portfolios are a good option to consider.

Attractive valuations and bearish positioning have driven the recent rally

The forward 12-month P/E ratio of the MSCI China Index stands at about 10.5x as of late May, up about 30% from a low of 8x in late January. Even so, it remains relatively low compared to historical levels. This, combined with extremely bearish investor positioning – which meant there was room for buying as sentiment improved – have been the primary drivers behind the current rally.

That said, valuations and positioning have not fully normalised despite the recent run-up. Fund flows data show that investors have started to return to the asset class, but still remain net underweight relative to global benchmarks.

Take ETFs tracking Chinese equities. As shown in the chart below, while the largest ETFs have started to see net inflows – or $87 million average over the past three months – they continue to post net outflows over a longer period. 

Data from UBS and Bank of America’s Global Fund Manager Survey tell a similar story, with global funds still underweight or short on China, but with the worst likely over. 

Taken together, this points to potential for further gains as bearish investors reallocate capital into the asset class. If we assume valuations continue to revert to their long-term trend (or a 20-year average P/E of 11.5x), that would imply a further upside of about 10% from current levels.

China’s economy is on the road to recovery

What’s driving renewed investor interest and improving valuations? For one, recent data show that China’s economy has been improving – with Q1 GDP growth beating expectations, inflation moving back into positive territory, and Purchasing Managers Indices (PMIs) and exports returning to expansion. 

The government is also continuing to provide fiscal and monetary policy support to avoid a loss of momentum in the economy. This includes measures like issuing 1 trillion yuan ($138 billion)  in special long-term bonds to stimulate key sectors and a new support package for the property sector, which includes 300 billion yuan for local governments to buy unsold housing inventory.

Revenues should recover as China’s economy regains steam

To understand the longer-term potential for Chinese equities, it comes down to their fundamentals – and in particular, earnings growth. Here, we break this down into revenues and profit margins.

Over the past few years, revenues for Chinese companies have been falling, weighed down by weakness in the economy. The dark blue line in the chart below shows that forward 12-month expectations for sales for the MSCI China Index have been contracting since mid-2022, with the latest estimates pointing to a 6-7% year-on-year decline. That compares with a longer-term trend of 5-6% growth over the past 17 years or so. 

The good news: a recovery in the economy has tended to pave the way for a recovery in sales. And with China’s manufacturing PMI moving back into expansionary territory (the light blue line in the chart below), that bodes well for revenues.

Profit margins for Chinese companies have been on a structural decline, but appear to be recovering

Profit margins, on the other hand, have been on a structural decline. This is partially driven by margin compression in the economy’s “traditional” growth engines. This includes not only financial firms, but also tech giants like Alibaba and Tencent. 

Having said that, expectations for profit margins have been gradually recovering from an all-time low of 9.8% in mid-2022. So far this year, they’ve hovered around 10.4%, but still below a medium-term average of 10.8%.

ERAA® maintains a market-weight allocation to China, given better growth prospects elsewhere

Put together, the current fundamentals of Chinese equities point to medium-term earnings growth running in the mid-single digits per annum – assuming that revenue growth and margins return to trend over time. 

And while those are reasonable returns, they aren’t as attractive relative to those in other markets, especially when accounting for their risk-return profile. Take the US – which has historically posted higher earnings growth with lower volatility. 

That’s why our investment framework, ERAA® – which takes a longer-term view on asset allocation – still recommends a market-weight allocation to Chinese equities in your portfolios.

This remains in line with our analysis last year, where we concluded that keeping a market-weight exposure to Chinese stocks was reasonable given the economy’s longer-term prospects – especially if it’s able to sustain gains in transformative sectors like electric vehicles and renewable energy.

However, for investors who understand the risks, and would like to participate in the potential upside from valuations, our Flexible Portfolios might be a good choice. With no minimum investment amount, they’re a flexible, cost-effective way to adjust your  exposure to Chinese equities. But, as with any investment decision, it’s essential you consider this within the context of your overall investment strategy.

Glossary of Terms

Fundamentals

The underlying economic and financial factors that drive an asset's value. For a company, fundamentals include the basics, like revenues, profit margins, and cash flow.

Valuations

This involves assessing whether an asset class is cheap or expensive relative to its own history, and also helps to gauge investors’ expectations of its future growth.

Market-weight

A market-weight allocation mirrors the composition of the broader market, so that exposure to an asset class is in line with its relative size in the market. 

Positioning

The current holdings of investors in a particular asset class. Positioning may be described as bullish (optimistic) or bearish (pessimistic).

Crowded trade

A situation where a large number of investors hold similar positions. When a trade becomes crowded, it can result in a sharp price reversal if sentiment shifts.