Cheap but risky: the case for being brave in China

China has been a grim place to be invested in over the past three years. The MSCI China lost over 20% in both 2021 and 2022, and another 11% in 2023*. A toxic combination of a property crisis, sliding growth, and geopolitical tensions have left investors cold. However, a stimulus package in November, plus stronger signs from the economy, have piqued investor interest again and halted the long run of declines.

The weakness of China has weighed on performance not just for dedicated China funds, but also for emerging markets and Asia Pacific funds. Many active managers are clear that Chinese stocks are cheap, but the risks are significant. However, there have been signs of a revival in sentiment, with the MSCI China index up 16.5% for the year to date*.

Active managers have not participated fully in the recovery, with the average China/Greater China fund up 14.2% for the year to date**. Many adopted a more defensive positioning during the recent rout, while active managers naturally swerve the state-owned enterprises that form a large share of the index.

Continued strength?

The real question is whether the recovery can continue or whether it is just a temporary blip in a long-term structural decline for China. There are a range of factors to consider. From January, the Chinese authorities will have to contend with Donald Trump in the White House, who is promising to impose onerous tariffs on imports from China. There are also worries over deflationary forces, including the country’s weakening demographics. The long-term impact of the one-child policy has been to leave an ever-smaller workforce supporting a larger older population.

This needs to be weighed against the potential impact from the stimulus. Also, investors expect very little from China, with valuations still at low levels in spite of the recent rally.

The good news is that the stimulus package appears to have brought domestic retail investors back to the market, reinvigorating the A-share market. Shao Ping Guan, manager on the Allianz China A-Shares fund, says: “Trading volumes have picked up. And the level of margin trading, a good real-time sentiment indicator, has increased significantly back to levels last seen three years ago. This suggests that retail investors are now far more highly engaged.” Retail investors have always been an important source of demand for the domestic market.

He adds: “Retail cash levels are close to record high levels – household deposits in banks have reached the equivalent of two times the entire market capitalisation of China A-shares. The last time they were at this level was in the second half of 2014, which presaged a strong market rally when interest rates were cut and retail investors flocked to equities.”

However, the success – or otherwise – of the stimulus package, is still open to question. Shao Ping Guan says that its effect on the property market is the swing factor: “Much of the reason for the higher savings rate in recent years, in our view, is related to fears on future income prospects and the erosion of wealth as housing prices have fallen. Stabilising housing prices, or even seeing some modest gains, would help to start rebuilding confidence and ultimately reverse this cycle.” It points out that national new home sales volumes in October expanded for the first time in more than a year, with big cities such as Shanghai and Shenzhen taking the lead.

Anthony Srom, manager of the Fidelity Asia Pacific Opportunities fund, is more sceptical on the impact of the stimulus. He says the measures are too small, and fail to address some of the structural imbalances in the Chinese economy, including consumer confidence and low growth. “The market’s anticipation for further stimulus suggests a level of optimism that may not be justified. The lack of movement in foreign exchange and bond markets signals scepticism about the adequacy of these measures.”

More stimulus to come?

However, there is a chance that the government extends its stimulus, particularly if it needs to counter the impact of Trump’s tariffs, according to Edmund Harriss, co-manager on the Guinness Asian Equity Income fund. He says: “If the government does scale up its support, this could mark an end to the negative earnings and valuation de-rating cycle in China…In valuation terms, China remains very cheap on a price-earnings basis.”

While the stimulus measures are necessary, they may not solve the main problem – the lack of demand for credit rather than the supply of credit. Sharukh Malik from the Guinness team says: “It’s the support for the consumer through fiscal policy that is going to help China address the transition its economy is undergoing.

“The intention is to help the consumer have extra income and potentially increase the demand for property, but then when you look into each individual measure, the impact is fairly limited.”

He says Chinese consumers have been through a lot. Household wealth has fallen as property prices have declined. The pandemic led to a savage drop in consumer confidence and it may take more than these limited stimulus measures to revive it.

However, his view is that this represents an important change in intent, and asset allocators across the globe need to take note. It has been fine to ignore China, but that response seems inadequate now. Sharukh says: “Even with the spike in performance in China at the end of September and early October, that actually there’s a lot of room for China to catch up with the rest of Asia, and emerging markets. China’s valuations are still trading very cheaply relative to other major markets.”

If this picture feels confusing, it is. If the outlook for China was clear, valuations would be far higher. They are low because there are a range of significant risks. However, China remains the second largest economy in the world, home to a range of highly innovative and successful companies, and its outlook is notably better than it was a year ago. For the brave investor, it has its appeal.

*Source: MSCI index factsheet, 29 November 2024

**Source: FE fundinfo, 10 December 2024