How Chinese stocks are turning around

The raft of announcements that came out of China in late 2024 sound seemingly ambitious, leading to volatile swings as markets reacted aggressively. Are these stimulus packages genuine or simply lip service? One only needs to look at the recent past for answers.

After hitting a high in early 2021, Chinese equities have been on a gradual decline with no meaningful rebound. The post-pandemic rally widely seen in other financial markets was very short-lived for Chinese stocks, contained at near-trough levels for an extended period until a recent turnaround.

Declining valuations also hounded Chinese stocks in the past couple of years. Valuations, indicated by forward price-to-earnings ratio of Chinese equities, came down to below 8x at the beginning of 2024, which was nearly two standard deviations lower than the five-year average and trailing counterpart indices. The October spike took stock values back to the mean level only briefly.

If we compare Chinese equities with that of other developed or developing markets as in Graph 1, they exhibit significantly lower valuations. However, China’s relative economic strength, rapid growth, and solid fundamentals of public companies do not justify cheap stock prices. 

Regaining lost sentiment

Why was a sooner turnaround not possible for Chinese equities? As one of the world’s most liquid markets, stocks within a bear market have historically shown a pattern of lost sentiment and dwindling participation that contribute to a downward spiral.

The two trend lines in Graph 2 show that the last two bear market episodes in the past decade led to a plunge in trading values. Usually, it would take some drastic catalysts to change prevailing market sentiment. The last four years saw investors grasping onto unfulfilled hopes that the Chinese government would intervene. It is, after all, important to assure market participants that their prayers will be answered. 

Building hope

We do not believe the Chinese economy is at its worst. There is negative news coverage about China, but the reality is that consumers are still spending and economic growth is not falling off a cliff. However, China should not wait until it is too late.

The Chinese government has announced incentives and policy changes in September-October 2024, some already implemented while others await execution. The near-term objectives are straightforward: to build confidence in China’s growth story, boost the economy despite aging demographics, and improve the profitability of Chinese companies to aid employment.

This time, China means it.

To recap: on the monetary front, the central bank cut bank reserve requirements, leaving more cash to lend to businesses and individuals. It also cut interest rates, reduced mortgage rates, and slashed downpayments on second homes to spur demand. These will provide liquidity support for markets and help local governments spur job creation and household consumption. By January, the central bank said it is adopting a “moderately loose” monetary policy to further support an economic resurgence. On the fiscal front, China will issue more government bonds to support local government property purchases, fortify bank capital to increase lending, and aid vulnerable groups. Some were disappointed that the Finance Ministry did not disclose the details and sizes of these measures, but that is because these plans needed the approval of the National People’s Congress.

We are at the definitive turning point in China’s attempt to reverse deflation. The countercyclical adjustment will go beyond what has already been announced. Beijing will, without a doubt, march to its own beat in terms of timing and communication, but we remain convinced that further interventions will be forthcoming – and with it, a steady recovery for China’s economy. Future monetary policy easing will leave the private sector doing the heavy lifting while implicitly backstopped by the central government. 

Two factors to watch

We think the property and stock markets must be paid attention to in the short term.

The best days of Chinese developers are over. Massive urbanization and the resulting property development boom in the past contributed to fiscal gold through land sales, economic prosperity with property and appliance purchases, and optimistic sentiment through wealth creation. These benefits were halted in 2018-2019 and have not been restored. The announced incentives will be helpful in repairing the balance sheets of local governments, setting a floor to property prices after a freefall, and regaining investor confidence.

It is likely that the effects of these incentives might not last, let alone be enough to revamp the entire property market, but this is not the aim. Rather, it is meant to stop the bleeding and rebuild confidence in this deflated market that has completely discounted the value of home ownership. Ideally, the end goal is a normalized property market in China with ample liquidity and better living conditions. 

Meanwhile, the stock market is singled out in the stimulus for the first time ever. Previously, the Chinese government was always only “supportive of the capital markets,” but this time, several measures are specifically meant to lift equities. This should boost market sentiment.

We have already seen signs that forward earnings of Chinese companies have stopped falling. Coupled with share buybacks, shareholder value will be further enhanced, making Chinese equities more appealing. 

Outlook

Do we need more stimulus? Yes. Do we expect it will come? Yes.

Stocks have cheered up. The MSCI China Index, having declined by some 60 per cent from 2021 to March 2024, has soared by nearly 40 per cent between mid-September to early October and ended the year with a 16.3 per cent gain from 2023’s close. Sizable gains have been given back in recent days, but this is more optimal in our view. Should the market quickly double in the near term, it will turn out to be a one-off bounce but fall short of a new bull market.

Of course, risks lie ahead. However, we believe Chinese stocks are ripe for a sustainable turnaround towards a bull run. Meanwhile, China’s economic performance and pro-growth policies are largely out of sync with the rest of the world. When correlations among other investment assets are high, Chinese equities can offer invaluable diversification benefits to an investor’s portfolio.