China’s Stocks Are Still Pricing In a Lot of Pain

Things are never as good or as bad as they seem. That adage has generally served investors well. Ignoring the extremes of optimism and pessimism can spare equity buyers some painful mistakes — such as piling into tech stocks at the height of the dotcom boom — and may signal lucrative opportunities for the brave, such as during the depths of the 2008 global financial crisis. It’s worth asking where China’s stocks currently lie on this perceptual continuum, and whether markets are correctly judging the risks that confront them.

March has been a landmark month for the nation’s equities, with a two-week rout that wiped out more than $1.5 trillion of value followed by a rebound that was almost as spectacular. Prices recovered so quickly (after top policy makers stepped in to pledge support) that the plunge now looks like a flash crash. Yet the rally has only returned Chinese stocks to the depressed levels where they stood before going into freefall, with upward momentum having stalled in the past two weeks.

There’s plenty to worry about, no doubt. Many if not all of the factors that helped drive the MSCI China Index to less than half its February 2021 peak remain in place. A campaign to tighten regulation of internet platform companies has yet to conclude (even if Vice Premier Liu He has promised it will end soon). The real estate sector continues to weaken. The Covid-19 pandemic is resurgent, darkening the prospects for economic and corporate earnings growth this year. Chinese companies are still at risk of being delisted from U.S. exchanges. And above all, perhaps, there is the threat of China being embroiled in secondary sanctions resulting from its stance on Russia’s invasion of Ukraine.

Even so, it’s fair to ask how much of this negative overhang is already priced in. On a range of measures, the MSCI China is close to its weakest relative to the MSCI All-Country World Index in five years or more. By price-to-book ratio, the Chinese gauge is at its cheapest compared to the global measure in more than two decades.

Cheap However You Slice It

Chinese stocks are at historically low valuations relative to global equities

Far from being tempted by such a valuation discount, international investors are behaving as if Chinese equities are radioactive. The country has been experiencing “unprecedented” capital outflows since late February, the Institute of International Finance said in a report last week. The exodus, shown in high-frequency data tracked by the IIF, is all the more notable because there has been no such move out of emerging markets as a whole.

It’s a picture reinforced by Hong Kong stock exchange trading figures. Net flows via exchange links with mainland bourses, which allow global investors to trade yuan-currency Chinese shares, turned sharply negative this month, data compiled by Bloomberg show.

Show Me the Exit

Outflows from local-currency stocks via China’s exchange links with Hong Kong have sharply accelerated this month

Russia’s war with Ukraine, which began on Feb. 24, is the obvious if unproven culprit. That’s understandable. Global fund managers, witnessing the effect on Russia’s markets and economy of U.S.-led sanctions, must blanch at the thought of China being drawn into a similar morass. How likely is this, though?

China has offered tacit support to Russia, refusing to criticize Moscow, declining to term its military action an invasion and blaming the U.S. for the conflict. However, the government has shown no appetite to defy Western sanctions and says it wants to avoid being impacted by them. More importantly, the feasibility of targeting China on any comparable scale must be in question. Russia accounts for less than 2% of global gross domestic product (based on 2020 figures); China is more than 17%, the world’s second-largest economy, and far more integral to global supply chains. It’s inconceivable that the U.S. and its allies could attempt similar sanctions on China without causing severe disruption to their own markets and economies.

That’s not to say it can’t happen. A vivid memory for this writer is hearing an investment analyst speak persuasively on the radio about the prospects for the Thai stock market in late 1996, citing cheap valuations after a one-third decline from the 1994 high. From there, the SET Index went on to lose close to 90% of its value in U.S. dollar terms, after the Asian financial crisis arrived the following year. Pricing the risk of once-in-a-generation cataclysmic events isn’t easy.

So, on rare occasions, perhaps things can be even worse than they seem. Still, the balance of probabilities suggests an accommodation will be found and China won’t be heading for Russia-style isolation. The near-term outlook for the stock market is probably still negative: The government still has to deliver on its market-supporting pledges, overcome the omicron wave and manage the property deflation. But these valuations are offering investors with patience a chunk of downside protection. They may be vindicated in time.

Author: Matthew Brooker, Bloomberg

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