Portfolio manager May Ling Wee discusses why, following a period of market weakness, Chinese stocks are now looking more appealing to investors.

  Key takeaways

• Bucking the global tightening trend, China’s policy easing could sustain market outperformance into the remainder of the year. However, this could be thwarted by monetary tightening in developed markets and weak global demand, exacerbated by higher energy prices and input costs.
• Investors should be heartened by signs of economic reopening, policy easing and softer private sector regulation, which should hopefully entice fund flows back to China.

Chinese stocks have suffered since the start of 2022 following the Chinese government’s insistence on continuing with its ‘Zero COVID’ policy, which caused significant economic fallout. The slowdown has been acute, manifested in weaker employment, weak consumer spending, and a property market still in the doldrums.

But looking at the numbers, after a poor first quarter, China’s equity market outperformed developed markets as a whole as well as emerging markets in the second quarter of the year¹. Is investor sentiment towards China turning a corner?

Reasons for optimism

China’s strict COVID regulations put a significant strain on the economy and policymakers are now facing up to the economic reality of lockdowns. Bucking the global tightening trend, China’s policy easing could sustain market outperformance into the remainder of 2022. The government’s deployment of fiscal and monetary policy appears to be in earnest. Financial institutions have been urged to lend again, funding for infrastructure projects is being ramped up, while various tax initiatives have been announced, eg. purchase sales tax has been halved for passenger vehicles, and social insurance payments have been deferred for small and medium-sized enterprises (SMEs).

Other incrementally positive signs for investors include the refining of COVID guidelines with shorter quarantine periods, the simplification of the travel QR code system and continuing to ensure supply chains and production are given priority. The technology sector, which bore the brunt of the China market sell-off since early 2021, has seen some reprieve, with the government shift to managing growth and stability instead of preventing the “disorderly expansion of capital”.

Long-term investment case still valid

China’s huge domestic market remains a key reason for investors to invest in the region. Consumer sentiment should improve when COVID restrictions ease further. This improvement in mobility should eventually lead to an improving services and SME sector, which would help employment. Among the segments that could benefit include internet platforms, small-ticket consumer discretionary segments such as food & beverage, domestic travel, and hotel stays. Market weakness this year has led to some value opportunities in select large internet platforms, life insurers, consumer-focused banks, infrastructure-related companies, and specific healthcare companies.

While macroeconomic data is stabilising, current company earnings and guidance will likely be revised when first-half earnings reports are released in August. The chart shows the return for the MSCI China Index by calendar year, which is driven by a combination of forward earnings per share (EPS) revisions and the change (either expansion or contraction) in the price-to-earnings (P/E) multiple of companies within the index. The P/E multiple can be thought of as what the market is prepared to pay to access earnings, typically affording a higher multiple when sentiment towards equities is more positive and financing costs are lower. Investors should take note that any rebound this year is likely to be comparatively weaker than the post-COVID period in 2020 or the growth spurt in 2017, given the current backdrop of monetary tightening in developed markets and weak global demand, exacerbated by higher energy prices and input costs.

First half of 2022 saw downward revisions for earnings and valuations of Chinese stocks

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Nonetheless, we are heartened by signs of economic reopening, policy easing and softer private sector regulation, which we believe could entice investment flows back to China.

 

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