China’s latest data suggest that the manufacturing sector outside of large state-owned industrial companies is holding up decently.
The Lunar New Year spending on travel is also expected to be strong, both domestically and internationally.
The housing correction continues, however. Chinese authorities have eased policy more forcefully, including cuts to the reserve requirement ratio and more long-term liquidity to banks. More easing is needed to reach around 5 per cent growth this year.
While the adjustment in the housing sector will continue, severely depressed equity market valuations and authorities’ increasing commitment to provide financial market support could lead to an improvement in sentiment and a short-term recovery.
However, those measures are unlikely to address structural issues weighing on the equity market, which is a lack of operational leverage and declining profitability. Thus, short-term attractiveness is unlikely to translate into long-term outperformance.
More easing measures since the beginning of the year
The Chinese government has been more forthcoming in supporting the economy since the beginning of the year. On the monetary side, it has cut the reserve requirement ratio by 50 basis points.
The People’s Bank of China has also lent more to the banking system through its liquidity facilities (medium-term lending facility and pledged supplementary lending).
It has also made an effort to stabilise the equity market. The market rout has been raised as an issue to policymakers at the highest level of government, implying its importance.
The measures include using state-owned entities to buy shares and exchange-traded funds.
Today’s actions are similar to the situation in 2015-16.
Chinese equities are now priced for one of the most downbeat scenarios in the past decade.At that time, it took a few months for the market to bottom out and turn around after the 'national team' started its action to prop up equity prices.
In fact, it is likely the central banks' strong injection of liquidity in 2016 helped turn around the housing downturn as well as supported the equity market.
The National People’s Congress meeting in March could boost confidence with concrete measures to address property developers’ and local governments’ finances.
What could be the next confidence booster for China’s financial markets?
The central banks' recent liquidity injection appears modest compared to what happened in 2016 (both PSL and MLF grew by 200-300 per cent then), and we do not expect the central bank to repeat its 2016 action.
Still, more liquidity could find its way into the stock market if confidence improves.
The next important policy meeting is on March 5 when the NPC will convene its annual meeting and set its 2024 economic policy and targets.
A steady 'around 5 per cent' growth target is likely (given recently announced provincial GDP targets), but it has to come with more policy easing to achieve such target.
More social spending in the near term, for example, could help boost consumption and households’ sentiment.
Valuations are back at their record lows on every measure
Is this justified? Earnings would suggest otherwise.
They have held up substantially better than the market itself, which has led to a sharp drop in price-to-earnings ratios.
The Chinese market’s private equity at 8.2x 12-month forward earnings per share is currently at levels only seen six times in the past 10 years. In five out of these six occurrences, Chinese equities rose over the following six months.
In addition, in four episodes, the rise was more than 20 per cent.
In our view, Chinese equities are now priced for one of the most downbeat scenarios in the past decade.
What has not sufficiently been addressed yet is the policy and geopolitical uncertainty that weighs on sentiment.Any improvement in the short to medium-term outlook would likely trigger a material repricing and bring valuations back in line with longer-term averages.
The dislocation in valuations relative to the rest of the world is even larger.
Even if US equities are excluded from the global aggregate, relative valuations of Chinese equities are trading at the largest discount to global equities in the past 20 years.
Recent efforts by authorities underline their commitment to halt the rout
What would be the trigger for this gap to close?
We think the macro policy easing is in place to deliver some upside potential in the short term.
What has not sufficiently been addressed yet is the policy and geopolitical uncertainty that weighs on sentiment.
However, while liquidity measures over recent weeks failed to stem the rout, the increasing commitment and reported direct involvement of President Xi Jinping indicates that authorities are willing to put a price floor, even if it comes at a cost.
While some short-term upside persists, long-term issues remain unresolved
This does not improve the long-term outlook for Chinese equities however.
In order to see Chinese equities outperform over coming years, either of the two (or both) would be required:
- China's GDP growth to remain at current levels or accelerate; or
- profitability in the private sector to improve.
The operational leverage of Chinese-listed firms has been substantially weaker than in other regions.
In past decades, Chinese earnings growth, for example, has only outpaced US earnings growth when China’s GDP growth was more than 5 percentage points above the US.
As this is unlikely to be the case on a sustained basis in the future, Chinese companies would have to become substantially more profitable to improve their outlook. The trend over recent years suggests the opposite.
The return on equity has been falling consistently over the past 5 years, countering the picture in other major markets while net income margins are trailing substantially.
Mali Chivakul is an emerging market strategist at J Safra Sarasin Sustainable Asset Management
