Considering China’s Capitulation

One of my favorite investment mantras is: “Have a plan and be patient”. Given cheap Chinese valuations it’s not a bad time to be ‘planning’ for investing in China. However, having the ‘patience’ to wait for green shoots in the economy will also be vital. 

The aftermath of the global financial crisis (2009) in the US markets presented a buying opportunity of a lifetime with the S&P 500 returning 549% since 2010 to date. The US market rebound was characterized by quality earnings growth, a highly liquid/open financial system as well as improving innovation. While this may not be the exact same setup for China as detailed below, the extremely attractive valuations for Chinese markets relative to US (see below graph) warrants further investigation to determine the size of the opportunity. 

Chinese markets are trading at a large discount to US markets

The US economy has been the jewel of the global growth crown over the last few years. This has led to the US stock market being quite richly valued. This month, I will to delve into the world’s second largest economy to bring some clarity on its equity market performance and identify if there is an investible market opportunity at this time.

China is cheaper than USA and Europe on many Valuation Metrics

China is cheaperChina has been experiencing a slowdown in economic growth over the last decade due to long term structural issues within its economy. The Covid-19 pandemic exacerbated these trends. Itimpacted economic supply chains, increased cautiousness in consumer spending and decreased global demand for Chinese goods leading to a fall in GDP and inward investment. than USA and Europe on many Valuation Metrics

China’s GDP Continues to Slow: 

We will first identify China’s problems, what policymakers need to do to fix it, provide some options for investing under different risk parameters and finally my recommendations on how to invest wisely:  

Long Term Structural Issues with China Economy: 

• Transition from a high growth Economy: For decades, China has experienced rapid economic growth, often exceeding 10% GDP annually. This growth was driven by factors such as large-scale investments in infrastructure, industrialization, urbanization, and mastering low-cost exporting. However, China’s economic base has grown so large that maintaining double-digit growth rates has become increasing challenging. This model has also led to high levels of debt and overcapacity in some sectors of the economy leading to recent and painful price resets in Chinese equity and property markets. 

Chinese Property Stocks Have Collapsed:

• Real Estate Market Dependency: President Xi’s comment in 2017 that “Houses are for living, not for speculation” was seen as the initial policy shift towards clamping down on the property markets unsustainable growth through tighter lending controls and regulation clampdown. China’s dependency on real estate and infrastructure projects has been a double-edged sword. On one hand, it has driven economic growth, urbanization, and job creation. On the other hand, it has led to high levels of debt, speculation, and financial risks, not only among property developers, but among local Chinese governments who had come to rely on land sales as a meaningful source of income. 

• Weakness in the Private Sector – Innovation in the private sector has been increasingly stifled by the Chinese Communist Party’s (CCP) favored status for state-owned enterprises (SOEs).  Preferential access to financing, government contracts, and regulatory approvals has created an unfair playing field, which is evidenced through the recent low foreign direct investment numbers. The Government has also shown a mistrust for Large Cap Tech’s growing market dominance by cracking down on the industry with antitrust regulations or fines, which has created an environment of business uncertainty and lower entrepreneurship levels.  

Large China Tech Stocks are down 71% from their all-time high in 2021. 

• Demographics:  China’s aging population and declining birth rates present a multifaceted problem with far-reaching implications for the economy, social services, and societal stability. The shrinking workforce, coupled with rising dependency ratios, threatens to slow economic growth and place significant strain on the pension and healthcare systems. Additionally, the persistent low birth rates suggest that these challenges will only intensify in the coming decades, requiring comprehensive policy responses and societal adjustments. Addressing these demographic issues is crucial for maintaining China’s economic vitality and social cohesion in the long term.

China is Plagued with a Concerning Demographic Issue – A Declining Population:

Recent Developments Creating Challenges

Recent developments are also creating significant challenges for China. Weak consumption post-pandemic is hindering the country’s economic recovery, as cautious consumer behavior and increased savings reduce domestic demand. Rising trade tensions, particularly with the U.S. and other Western nations (US semiconductor restrictions/future trade tariffs), are straining trade relationships, disrupting global supply chains, and complicating China’s efforts to access critical technologies. Additionally, policy uncertainty from the Chinese Communist Party (CCP), including regulatory crackdowns and shifting economic priorities, is creating an unpredictable business environment, discouraging investment, and contributing to slower economic growth. These factors together are undermining China’s ability to regain its previous growth momentum.

China Deflation is a Sign of a Weak Consumer and Slow Economic Growth:

The CCP is well aware of the slowing economic backdrop and has implemented the following measures in an attempt to stimulate its economy: cut the reserve ratio requirement, relaxed first time buyer criteria, lowered mortgage rates, issued special purpose local government bonds for infrastructure projects, launched policies to support SMEs and extended tax incentives for electric vehicle purchases. The government is navigating a delicate balance. It is weary of further increasing debt stimulus, given previous bad investments, and cutting current interest rates can lead to further capital outflows. Many analysts suggest however that current stimulus measures have not been enough to limit economic slowdown and more aggressive fiscal measures are needed for China to prevent further deterioration, including increased social welfare or more direct consumer support. 

Policy Changes to look out for: 

Given the challenges outlined, it makes it hard to consider a large allocation to Chinese assets at this time. We are patiently waiting on the sidelines for signs the Chinese markets are bottoming. Further and meaningful stimulus from the CCP will be crucial to better return outcomes. I would like to see policy improvements in the following areas: 

• Boosts to domestic consumption through better social safety nets in pensions, childcare, healthcare and affordable housing. Although this is likely to impact China’s competitive manufacturing base in the short term, in the long term it’s important for more sustainable GDP.  
• Deleveraging the economy (reducing debt) through restructuring corporate debt and improved regulation of shadow (unregulated) banking and real estate sectors. 
• Continual investment in innovation/R&D driving future growth, while providing clear and consistent policy messaging to build better confidence in private sector. 
• Financial incentives to encourage larger families to tackle demographic problem  

I wouldn’t suggest adding to Chinese exposure just yet. The market is still in a downtrend and risk averse investors should stay on the sidelines. Those investors who are more risk tolerant/adventurous should also remain on the sidelines but on lookout for a market bottom. The largest returns are usually captured when acting early. Signs of large stimulus efforts from the CCP as mentioned above or a more private sector friendly environment could be that trigger. 

How to Gain Exposure? 

Given the fundamental importance of government policy in China’s centrally planned economy, sticking to industries favored by government to excel would be a good place to start. E.g. electric vehicles, digital economy, e-commerce, high tech manufacturing and green technology. Maintaining an initially diversified positioning and looking for incremental improvements in the health of Chinese economy before adding to exposure would be a sensible approach.  

Here are some interesting ways to gain exposure to these markets:

• Ticker: EEM US – iShares MSCI Emerging Markets ETF: Ideal for investors seeking diversified exposure to China within a broader emerging markets context.
• Ticker: FXI US – iShares China Large-Cap ETF: Best for investors looking for targeted exposure to large-cap Chinese companies with strong market positions
• Ticker: MCHI US – iShares MSCI China ETF: Suitable for investors looking for broad exposure to Chinese stocks without broader emerging markets exposure.
• Ticker: KWEB US – KraneShares CSI China Internet ETF: Suitable for investors wanting concentrated exposure to China’s high-growth internet and technology sectors.
• Ticker: Individual Securities (e.g., BABA US (Alibaba), TCEHY US (Tencent), BYDDY US (BYD)) Allow for targeted investments in specific Chinese companies and are  suitable for investors who want concentrated exposure

My Recommendations: 

While I wouldn’t advocate for immediate allocating to Chinese names, there is optimism that emerging markets performance will improve as the FED lowers interest rates, the inflation scare dissipates and investors seek higher yielding returns outside already expensive US markets. A weaker dollar and lower cost of capital are very positive for emerging markets and we can see recent examples of lower rates from the FED leading to EM outperformance:

• 2001-2003 rate cuts: post dot-com bubble and Sept 11 attacks
• 2008-2009: Quantitative easing (US policy to boost growth through lower rates and injecting money into economy)
• 2016-2017: Dovish Federal reserve stance kept funds flowing to emerging markets

While rate cuts are a tailwind, having a plan and remaining patient to the evolving Chinese political policy landscape is essential for determining whether the Chinese trade will turn out to be a long term investment opportunity.  

Robert Whelan, ACA
Portfolio Manager
whelanrh@jncb.com
+1(345)324-2896