This post originally appeared on Advisor Perspectives.
In March, spring was upon the Chinese equity markets — they soared with the promise of a summer of good cheer and bounty. But come June, the markets plunged, just as dramatically as they had surged less than two months back. And now, with the sell-off continuing, many investors are wondering if it is indeed the beginning of a long period of hibernation for Chinese stocks.
We don’t think so. Setting aside the negative reports, a clear-headed analysis of recent data and events indicates that a section of the global investment community may not only be misreading the situation in China but also overlooking the fact that China has turned out to be one of the most attractively priced major markets for long-term investors. Let us explain both parts of this argument.
WHY THE PANIC OVER THE STOCK MARKET DOWNTURN IN CHINA IS LIKELY EXAGGERATED
For all the noise about a stock market crash in China, both the MSCI China Index and the Shanghai Composite Index are still at a level higher than they were on January 1 this year, despite their steep fall since mid-June. So, to put this “crash” into perspective, the Chinese equity markets have undergone what appears to be a significant correction following a phenomenally strong and swift uptrend over the past twelve months, especially in the period between late March and mid-June this year.
- Chinese stock prices first rocketed and then plummeted, all in the span of a single quarter (2Q of this year), which makes it unlikely that the market decline was the result of any dramatic change in China’s economic fundamentals. In fact, there is reasonable consensus on what has really happened in the country recently. Speculators had significantly pushed up the prices of Chinese
- The stock market correction is unlikely to affect the broader Chinese economy in a significant way because economic activity in the country is not linked to asset prices as much as it is in developed markets, such as the U.S. In China, equities form only a small part of both financing for the real economy and household assets. Therefore, the effect of low stock prices on employment, consumer spending and investment is expected to be subdued. What’s more, the current market downturn does not appear to indicate weakness in any other local financial market. Typically, in a country like the U.S., bond yields decline when there is extreme pessimism in the financial markets, which can portend a stock market crash. But in the case of China, bond yields have not recorded any significant fall to correspond with the decline in stock prices.
- We believe that many investors have misinterpreted Beijing’s recent policy actions to calm the markets as a sign of extreme panic and the perceived failure of these policies to halt the downside have negatively reinforced this erroneous interpretation. A key to successful asset allocation is the ability to capitalize on situations where a large part of the investment community misreads the efficacy of government actions. Recent years provide considerable evidence of country after country, from the U.S. and the U.K. to Japan and now the Euro-zone, introducing unorthodox, and sometimes unprecedented, policy measures to stimulate and stabilize their economies. Not all of these policies were initially greeted with enthusiasm by the markets, but all of these measures eventually worked, reviving each country’s economy and driving its equity market higher.
- In a bid to prop up its stock markets, the Chinese government has taken a series of drastic steps in recent weeks, including several that appear to be a page out of the U.S. government’s playbook at the peak of the global financial crisis in 2009. And just as it was at the start of the U.S. government’s interventions six years ago, the markets and investors have not yet fully appreciated the Chinese government’s measures. Eventually, some of these steps are expected to have the intended effect, as they did for the U.S. In any case, with a single-party government, China has the political flexibility to implement many more growth-inducing and market-stabilizing steps.
WHAT ARE THE OPPORTUNITIES AMID THE DOWNTURN IN CHINA?
With various China market indices losing value in the range of 17 percent to 22 percent between May and July, many investors are worried that international equity portfolios, especially those that are overweight China, will be hurt in the short to medium term. We believe the contrary. Even a cursory comparison between the current P/E and average 12-month forward P/E of the MSCI China Index shows that valuations of the China markets as a whole have reached significantly more attractive levels compared to recent quarters, although they are not entirely cheap. Thus, given the relative undervaluation of the MSCI China Index vis-à-vis most other world equities, we believe the international and emerging markets asset classes that include China are poised to begin an extended period of relative outperformance. So, remaining overweight China may actually benefit the portfolios of foreign equity investors.
Investors stand to gain from the events in China in another way. The institutional investors that have been skeptical of the Chinese government’s moves to stabilize the mainland share markets have forced down the prices of major Chinese blue chips that trade in Hong Kong and the United States. In fact, some Hong Kong-traded shares of Chinese companies are now priced more than 30 percent lower than the shares of the same companies trading in mainland China, offering an opportunity to take advantage of these attractive valuations.
As such, China’s GDP growth rate has moderated from its historical highs as the country makes a complex transition from an economic model based on exports and investments to one that is centered on consumption. Against this background, we have focused our stock selection on companies able to take advantage of the move to consumer-led growth. The burgeoning middle class is keen on quality, brand and value-for-service. Some of our holdings are direct plays on these attributes, with a focus on online shopping, gaming and entertainment, social networking, internet search and content, as well as PC and smart devices. Other holdings are indirect plays such as same-day delivery of goods purchased online, insurance for new automobiles, affordable drugs and preventive healthcare.
Promoting the consumption of information can invigorate domestic demand and act as a new growth point for the economy. Although mobile penetration in China has reached 90 percent, there is ample room for 4G upgrades and data usage increases. Chinese data usage levels are substantially lower than those of other emerging Asian countries.
The government’s continued fight against air pollution should result in a meaningful transition from coal to natural gas. The recent collapse of crude oil prices may also lead to lower natural gas prices in China if more frequent adjustments to oil-linked contracts are adopted. Also, additional wastewater treatment projects are expected to be announced this year. Half of the RMB 430 billion investments earmarked for the wastewater and recycled water sector are yet to be deployed.
To conclude, the distinct undervaluation of the MSCI China Index relative to other world equities increases the likelihood that the emerging markets asset class begins an extended period of relative outperformance. If so, this represents an opportunity for investors to consider realigning their asset allocation. Our investment team feels 2015 could mark the beginning of a several year long period where the international asset classes outperform. Overweighting China reflects our confidence that its shares have the potential to add significant value to our international and emerging market portfolios.
This article is for informational purposes only. This article is not intended to provide tax, legal, insurance or other investment advice. Unless otherwise specified, you are solely responsible for determining whether any investment, security or other product or service is appropriate for you based on your personal investment objectives and financial situation. You should consult an attorney or tax professional regarding your specific legal or tax situation. The information contained in this article does not, in any way, constitute investment advice and should not be considered a recommendation to buy or sell any security discussed herein. It should not be assumed that any investment will be profitable or will equal the performance of any security mentioned herein. Thomas White International, Ltd, may, from time to time, have a position or interest in, or may buy, sell or otherwise transact in, or with respect to, a particular security, issuer or market on our own behalf or on behalf of a client account.
FORWARD LOOKING STATEMENTS
Certain statements made in this article may be forward looking. Actual future results or occurrences may differ significantly from those anticipated in any forward looking statements due to numerous factors. Thomas White International, Ltd. undertakes no responsibility to update publicly or revise any forward looking statements.
Photo: SimonQ錫濛譙