China also has deeper economic challenges to overcome, including still-fragile confidence, a worsening crisis in its property market, and potential troubles in its shadow banking industry.
CHINA’S monstrous reopening rally has fizzled out, with its stock market underperforming global equities by a massive margin this year. Are Chinese stocks finally too cheap to be ignored?
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.
Policymakers have recently pledged more forceful stimulus. However, policymakers have limited options in reality. Expectations for more large-scale stimulus could prove futile.
Beyond its near-term issues, China also has deeper economic challenges to overcome, including still-fragile confidence, a worsening crisis in its property market, and potential troubles in its shadow banking industry.
Besides, there are lingering long-term structural issues to worry about, such as China’s embrace of a top-down state-controlled economic growth model and shifting geopolitics.
While China’s equity market looks cheap by historical standards, we believe Chinese equities may be a “value trap” rather than a value opportunity.
Real cost of borrowing has been rising in China.
Gross domestic product (GDP) grew by 6.3 per cent 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.
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. 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.
Household savings continue to rise even after zero-Covid.
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.
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 per cent 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.
Home sales have resumed declines after a nascent recovery.
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 per cent year-to-date.
The index has also underperformed the global equity benchmark by a massive margin (the MSCI AC World Index has delivered returns of 16.2 per cent over the same period).
To be sure, China’s equity market looks cheap by historical standards. Chinese companies are currently valued at about 12 times their estimated FY23 earnings – that’s way below the peak of near 22 times back in 2021. Chinese equities are also trading at their steepest discount relative 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.