Is China’s stock market finally too cheap to be ignored?

China’s economy is in a sorry state.

Gross domestic product (GDP) grew by 6.3% year-on-year in the second quarter, a figure that looks impressive but was largely due to a low base in 2022 when China imposed draconian Covid-19 lockdowns in Shanghai and other major cities. The export boom that has powered China’s economy through the pandemic is also long over. Worryingly, China is now struggling with dangerously low inflation, with consumer prices dipping into deflationary territory in July for the first time in two years.

This has shocked investors, many of whom were expecting a quick recovery after China abruptly abandoned its zero-Covid policy. But not us.

Since November last year, we have taken a contrarian position on China. At a time when Wall Street analysts were turning increasingly bullish over the prospects of Chinese equities, we remained unconvinced and have recommended investors to underweight China in their portfolios.

We were right.

We reiterate our view again that China is no longer an attractive market to invest in.

Related articles:

Downgrading China: New economic regime and rising geopolitical tensions bode ill for China's future

As China shifts away from zero-Covid, its stock market has rallied near 30%. Will it last?

A painful and perilous economic recovery awaits China. Buyers beware.

China: Be careful when entering the Dragon’s Den

Policy stimulus could disappoint (again)

Policymakers have recently sought to put things right by pledging more forceful stimulus to stimulate the economy, with a wide-ranging policy document released by the National Development and Reform Commission (NDRC) promising more measures to boost consumption and support private enterprises.

Importantly, China has signalled more support for the beleaguered property sector that accounts for about a quarter of its economy. There was also no mention of President Xi’s signature slogan that “houses are for living in, not speculation” during the July Politburo meeting, fuelling hopes that curbs on the property sector could be eased further.

On 15 August 2023, the People’s Bank of China (PBOC) unexpectedly cut key policy rates for the second time in three months, in a fresh sign that the policymakers are ramping up monetary easing efforts to boost a sputtering economic recovery.

For investors hoping the government will roll out more decisive stimulus to jumpstart the economy, hold your horses! We’ve been here before: brief bursts of optimism after policy pledges have repeatedly turned into losses in the past. Could this time be different? Very unlikely.

While the central bank has moved to cut interest rates, the real cost of borrowing has in fact been rising given that inflation has been falling (Chart 1). Deeper rate cuts may be needed. The central government has also been reluctant to loosen its fiscal purse strings, eschewing large-scale stimulus in favour of smaller, piecemeal measures that have so far been unable to reverse China’s economic malaise. The latest round of consumption-boosting efforts is no different, with measures such as holding more promotional events like food festivals and extending the opening hours of museums and amusement parks unlikely to provide much impetus to growth.

Chart 1: Real cost of borrowing has been rising in China

Even if policymakers are willing to splurge, their hands are tied, as local governments are saddled with heavy debt loads after years of over-investment in infrastructure and massive spending on pandemic control measures before zero-Covid was abruptly abandoned.

In particular, borrowings from local government financing vehicles (LGFVs), which are off-balance-sheet entities used by local governments to fund infrastructure and support the local economy, is expected to swell to a record CNY 66 trillion this year, or equivalent to more than half of the country's economy, according to the International Monetary Fund (IMF).

China’s crackdown on its property has also led to plummeting revenue from land sales, depriving local governments of one of their biggest revenue sources. Local government budgets are showing signs of strain: according to S&P Global, two-thirds of local governments are now in danger of breaching unofficial debt thresholds set by Beijing that signify severe funding stress. The problem has gotten so extreme that some cities are now unable to provide basic services, and the risk of default is rising.

With policymakers now intensifying efforts to restructure LGFV debt, it is likely that local governments will be forced to rein in their borrowing, reducing the scope for more aggressive fiscal measures to stimulate the economy. This is important because local governments are fundamental to China’s economy. They account for 85% of overall fiscal spending in China, with policymakers tasking provincial and city officials with meeting ambitious growth targets. 

Furthermore, calls for major stimulus also run counter to policy objectives. President Xi Jinping’s repeated calls for “high-quality growth” imply the country must end dependence on infrastructure spending to boost growth. Policymakers are also concerned that looser monetary policy could encourage reckless borrowing, saddling the country with yet more debt. Meanwhile, policymakers have shunned the stimulus cheques that fuelled the post-pandemic recoveries in the US and elsewhere, fearing free cash may give rise to welfare dependency and lower productivity.

With the low-hanging fruits of infrastructure spending, deeper policy rate cuts, and cash handouts being non-starters, policymakers have limited options to boost its faltering economy.

As such, expectations for more large-scale stimulus to boost the economy could prove futile. And herein lies the danger: if China’s economy does not pick up, deflationary pressure will persist. If the expectation of falling prices becomes entrenched, it could further dampen demand, erode corporate profitability, and deter borrowing and investment, all of which could lock the economy into a Japan-style deflationary trap that will be hard to escape.

Deep economic challenges to overcome

Beyond its near-term issues, China also has deeper economic challenges to overcome.

Even if China decides to deliver more aggressive stimulus, it remains an open question whether the measures can revive the economy. Consumer confidence remains fragile as consumers continue to feel the lingering impact of unpredictable pandemic lockdowns and regulatory uncertainty, leading many households to save more than they did before the pandemic. Consumers are hoarding cash – household savings deposits surged to an all-time high of CNY 132 trillion as of June 2023, that’s more than 17% higher than the levels in the same period last year (Chart 2).

Chart 2: Household savings continue to rise even after zero-Covid

The jobs market also points to a bleak outlook for consumer spending. Even as China cracked down on the private sector, the country’s largest employer, it has failed to create enough jobs in other sectors to offset the decline. Youth unemployment soared to a record high of 21.3% in June – that’s more than four times the national rate – with many young, qualified jobseekers unable to secure employment. China has since suspended the release of youth unemployment figures.

China’s private sector, which accounts for more than 60% of the economy, also remains scarred by the regulatory crackdown and zero-Covid over the past few years. The government has tried to win back the private sector with pledges for more support, but in an environment where policy changes can happen overnight at the stroke of a pen, many businesses have been unwilling to invest. Private fixed-asset investment fell by -0.2% year-on-year in the first half of 2023.

In the face of low confidence amongst consumers and businesses, even a “big-bang” stimulus package may not be enough to arrest China’s economic decline.

And then there is the property crisis to worry about. While there have been green shoots of recovery in the early months of the year, China’s property market is faltering again after a four-month rebound, with the value of new home sales by the 100 biggest real estate developers falling for the second consecutive month by -33.1% in July from a year earlier (Chart 3).

Chart 3: Home sales have resumed declines after a nascent recovery

The recent missed interest payments on two offshore bonds issued by Country Garden, one of the few private property developers that have so far not defaulted, was also a stark reminder of China’s ongoing housing slump. Country Garden had previously been held up by authorities as a model developer, and was able to issue domestic bonds with government guarantees. A default would further damage the confidence of homebuyers in the country. As sentiments continue to remain poor, consumer demand will likely remain weak, setting up a vicious cycle for China’s property market. Evidently, the issues plaguing China’s property market are so deep that even government backing may not be enough.

It is truly saddening to see this, as China’s property market is a cornerstone of the economy that accounts for anywhere between 20-30% of GDP. Given its significant role in China’s economy, it will be hard to replace this growth driver. 

That’s not all. Problems are popping up again in China’s enormous and opaque shadow banking sector. Several clients of Chinese trust firm Zhongrong International Trust have disclosed recently that they have not received payment on maturing investment products, casting fresh doubts on the health of China’s shadow banking industry.

While the size of the missed payments is relatively small, it is important to note that Zhongrong’s top shareholders are a state-owned enterprise, Jingwei Textile Machinery, and private asset-management company Zhongzhi Enterprise, which is one of the largest in the trust industry. This raises the possibility of more trouble ahead.

It looks like China’s policymakers have their plates full.

Long-term prospects look bleak

Besides, there are lingering long-term structural issues to worry about.

We have said before that China’s embrace of a top-down state-controlled economic growth model will likely usher in a low-growth period and imperilling the long-term profitability of private companies as state goals are now more important than profits. The risk of policy mistakes will also be higher. It should be apparent by now that China’s economic malaise is symptomatic of the limits of its centrally-planned structure.

A rapid deterioration in US-China relations is also a cause for concern, with multinational companies – already having to contend with China’s abrupt policy shifts – increasingly caught in the crossfire of rising US-China tensions. As US ratchets up its sanctions against China to contain its technological ambitions, China has also been targeting foreign companies as a form of retaliation.

As a result, many companies have been pursuing a “China plus one” strategy, keeping some production in China, while moving the rest to countries such as India and Vietnam. With China an increasingly challenging (and uncertain) place to do business in, it is likely that more multinational companies will shift their production facilities away from China in order to spread operational risks.

China will also likely adopt a harder line against Taiwan. Not only has President Xi refused to rule out the use of military force to bring the island under Beijing's control, but the People’s Liberation Army has also reportedly been told to be ready by 2027 to reunify with Taiwan. If a conflict does occur, it could render Chinese equities uninvestible overnight if major economies impose sanctions on China for its use of military force, akin to those imposed on Russia for its invasion of Ukraine. To be sure, the chances of a war are low at this junction, but it is no longer a remote possibility.

Beware, China is a value trap

China’s shift away from its draconian zero-Covid policy was supposed to be the biggest trade of the year. However, the monstrous reopening rally has since fizzled out, with the MSCI China Index registering a decline of -1.6% year-to-date (in SGD terms as of 14 August 2023). The index has also underperformed the global equity benchmark by a massive margin (the MSCI AC World Index has delivered returns of 16.2% over the same period).

To be sure, China’s equity market looks cheap by historical standards. Chinese companies are currently valued at about 12X their estimated FY2023 earnings – that’s way below the peak of near 22X back in 2021. Chinese equities are also trading at their steepest discount relative to US equities since at least 2006 (Chart 4).

Chart 4: Steepest discount to US equities since at least 2006

However, there are no positive catalysts on the horizon. China’s export boom is over, but its deep economic issues are not. The longer-term structural issues afflicting China also means Chinese equities now warrant a significantly higher country risk premium and investors may need more of a margin of safety. In other words, beware, as we believe China is a “value trap”.

As such, we reiterate our view that China is no longer an attractive market to invest in. We maintain our Star Ratings for Chinese equities at 2.0 Star “Not Attractive”, and recommend investors to underweight China in their portfolios.

Chart 5: Earnings forecast and price performance of the MSCI China Index

Table 1: EPS and upside projection for the MSCI China Index

Where should investors redeploy their capital then?

For investors who still wish to invest in China, it is now more important than ever to align their portfolios with China’s priorities: that means investing more in SOEs and companies that operate in favoured industries (e.g. green energy, electric vehicles, and advanced manufacturing). Most of these companies are found in the A-shares market, which should be relatively more resilient compared to the offshore market where foreign investor confidence remains fragile. Investors who wish to gain exposure to A-shares can consider either the E-Fund CSI 300 ETF (SSE:510310) or the Allianz China A Shares Fund.

Table 2: Recommended products

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.