China: The case for a rebound

China has been the world’s unloved market since 2020, with 2023 marking the fourth consecutive year of losses for the Hang Seng Index. The U.S., by contrast, is hitting all-time highs.

Whisper it quietly but, despite a sea of negative sentiment, equities in the world’s second-largest economy have held their ground in recent months. The MSCI China Index traded flat in the first quarter overall, but was well off its early-quarter lows, gaining roughly 26% since the end of January and outperforming most developed and emerging markets. Valuations are compelling, and many individual stocks trade at single digit price-to-earnings multiples with unusually high dividend yields. Our conviction has grown as short-term uncertainties, while real, have faded in importance relative to the rarity of the long-term opportunity.

What changed in China’s macro picture to drive up stock prices?

Perhaps it is the beginning of the unwinding of the negative expectations and relentlessly bearish sentiment that dominated the market earlier this year. The initial rebound may have been triggered by economic data and policy measures which support the "less bad" economic situation. For example:

• A resilient economy that grew faster than expected in the first quarter of 2024, expanding at an annual pace of 5.3% and beating growth expectations thanks to strong performance in the industrial and services sectors.
• China's Manufacturing Purchasing Managers Index, a leading indicator, moving to expansion in March and April.
• Government-mandated purchases of large-cap stocks by state-owned funds to boost the benchmarks.
• China pledging continued support for the economy at April’s Politburo meeting.
• A ramp up in special bond issuance and the newly announced ultra-long dated government bonds. 
• The State Council’s national ninth article strengthening supervision and risk prevention to promote high-quality development of capital markets.
• The risk of renminbi (RMB) devaluation looks to be averted and, as the U.S. Federal Reserve moves to an easing cycle, the downward pressure on the currency should diminish.

New housing policy measures announced to alleviate the property sector’s drag on the economy and revive the property market:

• Lowering mortgage rates and downpayments for first-time buyers to a record low 15%, lifting home purchase restrictions in major cities.
• Absorbing some of the excess inventory, local government buying unsold homes for social housing, backed by RMB 300bn lending scheme.
• Further easing liquidity squeeze among developers, special projects eligible for commercial funding.

Forecasting anything in the short term is a fool’s game. The fundamental bottom of China’s bear market may only come with clear signs of life in the property market. China has been throwing everything at solving its property problem. Intervention by government and regulators is also beginning to provide a backstop for markets. Most notably, the monetary easing and selective fiscal provision put in place from the end of 2023 have started to take effect and there are signs of sequential improvement in the macro data. Growth indicators have exceeded expectations in recent months, bolstered by manufacturing activity and a recovery in exports.

The rally in Chinese stocks has gained momentum, with the MSCI China having broken above key technical resistance levels above the 200-day moving average. But Chinese equities are still trading at depressed multiples, with near-record large discounts relative to their historical averages, and to their emerging and developed market counterparts. Attractive valuations may have more appeal if earnings accelerate as consumer and business confidence recovers and growth conditions improve.

Shareholder returns provide a floor

A key factor driving China’s comeback story has been the recent increase in shareholder returns through dividends and buybacks, initially at state-owned enterprises but increasingly at privately-owned companies too. Not only do these provide strong valuation support, but they also make a compelling case for equity investment in a rate-cut environment. It’s worth bearing in mind that while other countries are facing inflation, China is witnessing deflation. This makes equities attractive for domestic investors when compared against low interest rates offered by bank accounts and could provide additional future support for the market.

After three years in a bear market, few believe in China, and it remains a consensus underweight, despite the attractive valuations. Sustained market moves higher may convince more people to buy and eventually real money may come. Time will tell.