Does it make good sense to increase equity exposure in markets such as China and Japan right now? BNP Paribas Asset Management’s chief strategist, Daniel Morris, certainly thinks so.
He points out that the poor returns for Chinese equities over the last year explain almost all of the underperformance of the MSCI Emerging Markets index relative to the MSCI World index.
“This lag in returns was not without cause,” he says. “The regulatory crackdown by the government on many sectors of the economy caught investors by surprise, and China’s zero Covid strategy, while keeping deaths to a very low level, has had economic consequences. The result was earnings growth last year of just 1% when EPS rose by 50% in the US and 60% in Europe.”
Turnaround in Chinese equities?
After such significant underperformance, Morris believes the conditions seem good for a turnaround.
“Earnings growth at 12% is expected to outpace most other regions this year. Recent government announcements promising support for economic growth, an easing of the regulatory crackdown and support for the property sector seem to signal a significant change in course.”
He argues that relative valuations also look attractive and he believes Chinese equities will perform better given the significant divergence in the outlook for monetary policy. “Markets anticipate policy rates rising by 240 basis points (bp) in the US, and by 111bp even in the eurozone over the next year. By contrast in China, they should drop by 90bp.”
Gergely Majoros, a member of the Investment Committee at Carmignac, also sees reasons to be positive on China over the US and Europe.
“The Chinese leadership could decide to launch a significant economic stimulus in the course of 2022. This would provide a divergent and more supportive economic backdrop for stocks as compared to the US and European economies, which are expected to face a significant slowdown in the coming quarters.”
He adds that a reversal of the economic policy mix in China, from the current tight one into a significantly more accommodating one, could become a main driver for these equity markets.
“Depending on the nature of the economic stimulus however, whether it is more geared to fiscal or to monetary policy, it will favour different market segments.”
Positive noises from Chinese
Majoros believes the speech by vice premier Liu He in March this year could probably be seen as an inflection point for the tech sector in the Chinese equity market.
“If concrete measures follow this strong political signal, then these segments of the Chinese equity market could experience a significant recovery. In particular, if the Chinese authorities find a way to comply with the SEC accounting board and keep the stock listings in the US stock exchange, then the ADRs would benefit significantly.
He adds: “The overall attractive valuation levels will be supported by the share buy backs recently announced by several Chinese companies. This practice has hardly been used by Chinese companies historically. It represents therefore a powerful additional factor to regain the confidence of international investors going forward.”
Grant Wilson, chief investment officer at Asset Risk Consultants, thinks investors need to be cautious regarding the strength of any support pledges from the Chinese government. “In our experience, investors (and their managers) are widely split on China. China looks cheap and has supportive economics but the government is not a liberal democracy.”
Wilson adds: “You might recall a savage change in government policy which hit the Chinese tech names in August last year. Many think a substantial discount needs to be applied and some just consider China un-investable because the normal rules just don’t apply. The failure to condemn Russia’s war is the most recent example, but the treatment of Uyghurs and other human rights abuses has been well documented.”
Toshiyuki Murai, Asian equities specialist at Sumitomo Mitsui DS Asset Management, argues that while profits for Chinese equities are likely to come under downward pressure in the near term, (particularly domestic demand-oriented stocks and manufacturers embedded in global supply chains due to the strict zero-Covid policy and lockdowns), he believes that the impact will only be temporary as seen in the examples of other countries around the world.
He points out that the Chinese market is mixed, with large disparities in the quality of individual stocks, so it is important to select the right stocks.
“In terms of the market as a whole, we believe that macroeconomic growth and the accompanying expansion of corporate earnings, as well as the inflow of foreign funds with an awareness of risk diversification between the US and China, will drive the market over the medium to long term.”
Murai believes that Chinese (and Japanese) equities will be attractive going forward, as stocks are relatively undervalued despite demonstrating solid corporate performance.
“The CSI 300, a leading [Chinese] index, has a current consensus earnings growth rate of +15.6% for 2022 and an expected price-to-earnings of 11.9 times. This is considered attractive as the US (MSCI US) has +9.6% growth rate and an expected price-to-earings of 19.9 times.”
Opportunities in Japan
Like Murai, BNP Paribas’ Morris sees reasons to be positive towards Japan. “A combination of looser monetary policy, currently negative sentiment and a strong earnings recovery could be a powerful driver of returns this year.”
According to Murai, tradditionally, Japanese equities have seen the weaker yen as a positive in light of the improved performance of exporters, but at present the impact of the exchange rate is becoming more complex.
“Whilst the economy as a whole remains sluggish and there are still concerns about a sustained rise in the stock market, it is considered important to identify individual companies with their own growth drivers. Rather than buying the entire index, active management is in a sense even more effective than with Chinese equities.”
Brett Moshal, portfolio manager at Orbis Investments, remains relatively circumspect on Japan. “What we find most interesting is that, for some time, valuations on the expensive side of the market had been stretched to ludicrous extremes. In recent months these stocks have sold off – a bit. Over the past year or so, speculative stocks have come under pressure amid fears of higher inflation and interest rates.”
Japanese inflation
Moshal points out that while inflation has been most striking in the US, where it has eclipsed 7%, even Japan hasn’t been immune. This year, inflation in Japan is likely to hit 2%, and 10-year Japanese Government Bond yields have risen to 0.2% for the first time since 2016, when the Bank of Japan first ventured into the era of negative interest rates.
“In our view, it is becoming clear that the next 10 years will not be the same as the last 10, and that the era of low rates and predictably low inflation is likely coming to an end. That could present risks to economic growth, consumer spending, and the profits of any business that depends on commodity inputs.
“The market is starting to share our view, but slowly. Some of the most egregious valuations have fallen a little. Yet when we look at the cheaper end of the market, valuations have barely moved.”
