Written by Julian Howard, lead investment director of multi-asset solutions at GAM Investments
2023 has been surprisingly good for world stockmarkets despite geopolitical conflict and higher interest rates. The MSCI AC World index has generated a healthy 8.2% in local currency terms to the end of October.
But it’s been a very different picture in China, where the year-to-date underperformance of equities has been significant; in local currency net terms, the broad-based MSCI China index has fallen by 10.9% and the MSCI China A index of onshore shares by 6.7%.
The gap is easy enough in itself to explain – but its persistence is getting harder to.
2023 was supposed to herald the biggest economic event of the year in the form of China’s re-opening. But consumers have proven cautious amid the distress in the real estate market, and the threat of deflation persists.
And that’s all before we even get onto the geopolitics. Across the world economy, a (wholly unrealistic) desire for strategic economic autonomy has arisen following the shocks of the pandemic, ensuing inflation and war in Ukraine. In the US in particular this has taken the form of a zeal for protectionism and economic nationalism, with China framed as a key threat.
Under the current administration not only has there been no meaningful reversal of President Trump’s import tariffs, but huge amounts of subsidies have also been unleashed to promote an economic agenda that favours and stimulates domestic US industries to produce their own semiconductors and execute the green transition independent of ‘other economies’.
The barely concealed target here is of course China and this, along with mounting geopolitical concerns of a showdown in the South China Sea, and in Taiwan particularly, is weighing on global investor sentiment towards China.
But things may have gone too far, too quickly.
Today the emerging and contrarian case for China rests in part on valuation. The forward price-to-earnings ratio for the MSCI China index suggests that China is trading at almost ‘half price’ versus the US.
Clearly, there are drivers behind the valuation difference but this sort of gap is rarely seen. Cheap valuations are often cited as a reason in itself to invest in any given market, but there still needs to be a catalyst to light the metaphorical match and see price appreciation.
China’s most recent economic data might serve in this regard. Its economy grew by 4.9% on the previous year, just shy of the official state growth target of around 5% for 2023. Unemployment has fallen a touch, from 5.2% to 5% in September, and household debt has also dropped slightly.
While it would be unrealistic to expect the huge stimulus packages of old, help has nonetheless been forthcoming in a targeted way. The interest rate on existing mortgages was loosened by nearly 0.75%, while government-issued refinancing paper is helping suppliers to the distressed real estate sector.
But the long-term case for China surely transcends the ‘now’. While the country accounts for fully 18% of world GDP according to the World Bank, its stocks represent barely over 3% of the MSCI AC World equity index. While there is no iron law of economics to say that an economy’s equity market weighting should perfectly match its GDP weighting, China’s is surely one of the more extreme examples of underrepresentation.
Furthermore, Chinese authorities are keen to harness the stockmarket to drive investment in new areas such as semiconductor manufacturing, biotechnology and electric vehicles rather than the ailing property and infrastructure sectors.
Assuming the case outlined above is sufficiently persuasive, there is then the small issue of how investors should access China in the first place.
There is a strong case for individual stock selection, but for many investors a top-down index-level exposure may well be sufficient within a long-term portfolio context.
There is then a choice between MSCI China, ‘H’ Shares listed in Hong Kong, MSCI China A and a variety of technology-based indices.
China A shares offer a more direct allocation to China’s structural story given that they are onshore and more sensitive to domestic growth. This could be particularly advantageous for a globally minded investor who is likely already exposed to consumer technology stocks via an existing US allocation.
And, unlike the broader MSCI China index, China A skips the likes of Alibaba, Baidu and Tencent with their more inflated valuations.
It also arguably offers the approved domestic growth story, with a lower allocation to real estate than its MSCI China counterpart, but higher allocations to the pure technology and healthcare sectors most likely to benefit from state-infused ‘guidance capital’ in order to meet China’s aims of equitable modernisation.
Bubbles, manias, interventions and unwinds have been an inevitable part of China’s equity journey given that its stock market internationalisation only really began in the wake of its entry into the World Trade Organisation in 2001. But beyond the continued growing pains lies a compelling story about a still fast-growing economy rapidly learning how to harness capital markets to facilitate resource allocation.
For the former holders of the $14.9bn-worth of Chinese equities that were sold in September, the real question those investors need to answer is not whether they could risk staying invested but whether they can now risk not being so.
