Chinese growth is disappointing. Global asset managers are liquidating large parts of their equity positions in the country, resulting in falling share prices. It seems like a godsend for bargain hunters, but passionate China investors are also on their toes.
China is not growing fast enough, so investors have been liquidating their positions in Chinese stocks at an unprecedented rate.
In the past month, the MSCI China Index saw a decline of over 10 per cent. Since its recent high in late January, the Hang Seng (HSI) Index in Hong Kong even dipped into a bear market with a decline of more than 20 per cent. In total, a total of converted $900 billion evaporated from China’s stock market.
The sell-off has made the Chinese market cheap. The MSCI China Index has an average price-earnings ratio of around 10 over the next 12 months, compared with a historical average of 12.1. However, a good entry point is not yet there, institutional China investors say.
Real estate
The country’s economic struggles can largely be traced back to problems in the real estate sector - which accounts for more than 25 per cent of all economic activity in the country - where, after years, indomitable demand has come to an end, and prices are falling.
Falling house prices, with a direct impact on savings largely tied up in real estate, are depressing consumer confidence and willingness to spend, the main driver of economic growth.
In the days of rapid growth, China could still camouflage its excessive borrowing drive to support construction activities by letting developers borrow more to pay off rising debts, but now it is struggling with the effects of long lockdowns imposed because of the pandemic.
According to Chen, the problems were long known, “but now it turns out that it is much longer and deeper than most expected”. “The Chinese market in general is unlikely to enter a new bull phase without fundamental measures for the property sector from the government,” said Jimmy Chen, portfolio manager of the China Growth Fund at Comgest.
Japan scenario
The contrast is stark compared to July. Back then, Chinese equity markets went up 10 per cent as investors were optimistic about possible policy easing measures. China’s main consumer price index fell 0.3 per cent year-on-year in July, so the country is now flirting with deflation. Substantial government measures, however, remain lacking.
“Chinese leaders are apprehensive about a Japan scenario,” explains Han Dieperink, CIO at asset manager Aureus, referring to a situation of prolonged low growth. “For that reason, they don’t want debt to rise too fast, and so that doesn’t mean an extra boost to the economy that investors were hoping for.”
“Yet that is what they have to do and will eventually do. Now that demand from citizens is insufficient, the government has to provide additional demand. The very failure to stimulate threatens the dreaded Japanese debt-deflation spiral. China will eventually change course, but communist leaders can hold on to existing policies for a long time, so further disappointments cannot be ruled out.”
The opportunities
Chen also sees plenty of opportunities in China for investors despite the aforementioned problems. “There are still companies that continue to grow well and gain market share, or are relatively immune to this challenging macro environment, and that is what we try to include in the portfolio.”
Comgest’s China Growth Fund finds the most attractive companies in sectors such as consumer services, communications services and healthcare. The asset manager does not hold energy, real estate, materials or banks in its portfolio.
According to Han Dieperink, “most of the pain in the real estate sector has been discounted”, but that is not the most attractive investment right now. “Look mainly at consumption-related sectors. Given its still strong competitive position, Chinese disposable incomes will continue to rise, and as in other countries that have operated with this Asian growth model, a consumer bull will follow next,” said Dieperink.
Earlier this year, Auréus had already swapped much of its China overweight for Vietnam, when it became clear early this year that the opening of the Chinese economy would be disappointing.
“That is a prototype emerging market where everything is right, but also one that both companies and investors see as a safe alternative to China,” said Dieperink. ‘In addition, Japan is also a relatively safe alternative from a governance and valuation perspective; China has become Japan’s most important export country in a short time. Incidentally, here too the financial sector is benefiting thanks to the return of inflation.”
China remains investable
Fully divesting from China is not smart, according to investors. Rising geopolitical tensions between China and the US and growing concerns about the ESG risks of investing in China are valid reasons to be critical of investing in China, but unless investors refrain from investing for reasons of principle, it makes sense to look at Chinese equities, “because many of the known risks are discounted in current valuations,” Chen said.
“The Asian equity index is currently significantly undervalued relative to the S&P 500, with the depreciation of Chinese stocks playing a big role. Historically, after such a large gap, Asian companies have been able to close the valuation gap,” said Frank Schwarz, portfolio manager at Mainfirst.
“With the current deflation of -0.3 per cent, China’s central bank is in a comfortable position to stimulate the economy with monetary measures. In Europe and the US, much more negative economic data are needed before such steps are considered by the ECB and the Fed,” Schwarz said. “There is a good chance that China will become the main driver of global GDP over the next 10 years.”
“The most critical part of China’s economic system at the moment, the real estate sector, can defend the People’s Republic strongly thanks to its characteristics of a planned economy,” Schwarz said. According to him, the stock market’s reaction to falling growth rates has been quite exaggerated.