Time to revisit Chinese stocks?

It is now a year since we quit the Chinese stock market. The hyper-activity of policy makers has deterred us from returning but recent data flows suggest it is time to take another look.

After a “risk-on” week in financial markets, the mood darkened on Friday as hopes faded of any meaningful agreement among oil producers. No matter what they agree, we doubt that it will prevent oil eventually bottoming at around $20 (see Will oil stop at $20?). The G-20 meeting was equally uneventful.

There was little this week to shake the Fed out of its reluctance to hike rates. Though weekly jobless claims were the lowest since 1973 and the NY Fed Manufacturing survey rebounded to the highest level in more than a year, retail sales weakness in March suggests the consumer will have made little contribution to GDP growth during Q1, while a 0.3% dip in manufacturing production was disappointing after the recent rebound in surveys. The icing on the cake was the dip in University of Michigan consumer sentiment (hopefully, just another delayed reaction to financial market turmoil).

The data set from China was more encouraging. At 6.7%, Q1 GDP growth was a touch below the 6.8% of the previous quarter but suggests the much feared collapse has not occurred. Even better, after plenty of evidence that the property market is recovering, there were signs that other parts of the economy are accelerating, including growth of 10.7% in investment spending, 6.8% in industrial production and 10.5% in retail sales (all y-o-y in March). Even more impressive, aggregate financing was CNY 6.5trn in Q1, up from CNY 4.6trn a year ago. The PBOC is easing and the new funds are being used.

Figure 1 shows what has happened since we quit the Chinese A-share market a year ago. The most notable feature is the derating of the stock market (from a CAPE of 15.6 to 9.1).

The change in economic backdrop seems insufficient to justify such a movement. GDP growth has slipped from 7.0% in 2015 Q1 to 6.7% in 2016 Q1 and investment spending growth has eased from 13.5% to 10.7% but all other economic indicators have improved. The easing by the PBOC has stimulated monetary growth, reduced bond yields and weakened the yuan, all of which should be supportive of local equities, in our opinion.

We abandoned the market a year ago for a number of reasons: first, the preceding rally had reduced five year return potential to mid-single digits (annualised), which did not seem enough given the risks (the growth of debt etc.); second, the authorities had just started to do something about the perceived excessive equity market rally and, finally, there is a tendency for the market to perform poorly in the middle part of the year.

Concerning that last point, May to August has been the worst performing third in 11 of the last 17 years (using the FTSE China A50 index). In the last 10 years, the returns in that middle part of the year have been negative six times, with an average return of -4% across the 10 years (versus +9% and +15% for the first and last thirds). The returns during 2015 followed that template, with +23% in the first four months and -31% and +9% in the second and third periods, respectively.

The 43% top-to-bottom decline in the FTSE A50 index during the June-August period could have been viewed as an opportunity. However, the manic stabilisation efforts of the Chinese authorities, which at one stage seemed to mimic the daily initiatives of the US authorities during the financial crisis, acted as a deterrent.

Thankfully, things have settled down – there are still lots of new initiatives but they do not seem so panicked.
The market is up 13% since that August low and has been making steady progress since the end of January.
From a valuation perspective, Figure 2 shows that a cyclically adjusted price earnings ratio of 9.1 is as low as it has been over the period available (by definition, the first 10 years of data were lost in order to create the 10-year moving average of earnings). This is less than half the historical average 20.3 and well below the current US multiple of 25 (the emerging market average is around 12). This modest valuation explains why our five year FTSE A50 target (17,000) is so far above the current level (9,723). That suggests an annualised five year return of nearly 12%, even before dividends are included (the yield is close to 3%).

The above calculations do not allow for what might happen when MSCI and other index providers include A shares in their emerging market indices (according to this FT article, it will likely happen this year or next, perhaps as early as June). There currently seems little enthusiasm for Chinese stocks among either foreign or domestic investors but that could quickly change. As outlined above, a mid-year dip would not be unusual; however, we would use that as an opportunity to buy Chinese equities even more cheaply, rather than a reason to run away

Paul Jackson – Head of Research – Source
András Vig – Research Director – Source