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Chinese equities outpacing the S&P500 – what’s driving the rally?

16 mai 2024

Female engineer using a tablet computer at an electronics factory, monitoring the progress through online software.

Profiting as an investor occurs in the delta between expectations and reality. One example is the boom in enthusiasm for AI stocks being fuelled by blockbuster earnings of industry monopolies such as Nvidia consistently outpacing consensus forecasts.

In emerging markets, India’s bull market stands out as the obvious example of this. India has long appeared perpetually expensive to investors relying on mean reversion tables. The problem with this approach is that expectations may be out of kilter with reality when there is structural change occurring – much like in the new AI frontier and the domain of the economy is expanding. The chart from Jefferies below illustrates this structural shift.

India is climbing the development ladder – on track to be the 3rd-largest economy globally
Bar graph showing India’s GDP growth from 2000 projected to 2027.
Source: Jefferies, Q1 2024.

A succession of reforms in Modi’s India is unlocking a virtuous circle of development, including:

  • Sanitation in every village empowering women in rural areas to become economic agents.
  • Establishing a nationwide digital payments network accessed through biometric identification, allowing even the illiterate to transact and access welfare payments.
  • That network allows the government to accurately calculate what taxes citizens owe, which has seen the state tax take double in around five years.
  • Higher government revenues alongside private investment are helping to fuel a new capex cycle, targeting electrification, ports, freight and telecommunications infrastructure.

The self-reinforcing nature of these reforms fuels the growth of what will become an enormous Indian middle class, whose consumption habits will evolve as they become wealthier. This surge in new wealth is also fuelling the rise of domestic pension funds, which are biased to equities given India’s young population and long investment horizon.

Careful relying on mean reversion when there is structural change
Bar graph showing net inflows into equity mutual funds from 2016 to 2023.
Source: Jefferies, Q1 2024.

Local allocators are more incentivised than foreigners to drive Indian corporates to improve corporate governance and returns for minority shareholders. This feeds into improving domestic liquidity, where it is increasingly local allocators that set the price in Indian equities, not fund managers in London or New York.

As investment strategist Keith Woolcock pointed out a few months ago commenting on the AI boom, there are times when valuation is the “alpha and omega of investing but most often it is not.” The same applies to India, where simple mean reversion can mean that investors miss the potential for upside surprise when positive structural change is occurring.

Is the bear market over in China?

China presents us with the flipside of the above – 1) longer-run structural risks as institutional quality deteriorates under Xi Jinping, which risks the country getting stuck in the middle-income trap; 2) this deterioration depressing the animal spirits of consumers and entrepreneurs who are less confident about the future; and 3) the rigid commitment of authorities to fiscal and monetary orthodoxy even at the risk of a deflationary bust.

This gloomy backdrop has seen foreign investors abandon the market, with Chinese equities halving since 2021. At 10x CAPE, China now trades at a record discount to the rest of EM, pricing in a dire economic outlook.

China now trades at a record discount to the rest of EM
Line graph comparing the MSCI China Index price/book and forward P/E ratios to the MSCI EM ex China Index from 2000 to 2024.
Source: NS Partners, LSEG Datastream.

However, prices being driven to such depressed levels eventually exhausts the sellers to the point that a market can rebound even before a recovery in the economy or corporate earnings gain real steam.

Are we starting to see this in China?

Chinese equities have outpaced even the S&P500 this year
Line graph comparing the performance of the S&P 500 Index, MSCI China Index, MSCI EM Index and MSCI EM ex China Index from January to May 2024.
Source: NS Partners, LSEG Datastream.

Chinese equities have so far outpaced even the US, including an S&P500 Index dominated by the Magnificent-7 tech giants.

We have been writing to our investors for some time about the gradual economic recovery taking place in China, the steady improvement in earnings growth among corporates, and ratcheting up of fiscal and monetary support (but without the stimulus bazooka). Animal spirits remain broadly depressed, and risks lurk within property and the banks. However, with much of this pain priced in and with positioning in China at such depressed levels, all it takes is for a slight pick up ahead of expectations to ignite a rally.

Short positioning in Chinese equities has begun to unwind (falling by a third in China A-shares over the period), while GEM managers tentatively reduce underweight positioning. Indeed, April was a record month for foreign flows into Chinese equities.

Foreign buying of China stocks tops record

Foreign flows into China equities from 2017 to 2024.
Source: Bloomberg.

There are a number of reasons to think that the rally can be sustained:

  • Positioning across GEM and global equity portfolios remains light, leaving plenty of headroom for allocators to add exposure and chase the positive momentum (forming a virtuous circle).
  • Policymakers, and most importantly Xi Jinping, have acknowledged the severity of the economic malaise and have pledged more aggressive measures to avoid a bust.
  • Company earnings are strengthening across several industries including travel, exporters and names aligned with key policy aims such as energy security, automation and import substitution.
  • The market is (finally) beginning to reward earnings beats.

This rally could carry on for some time. However, in contrast to India where we are more willing to run winners given the positive structural tailwinds driving the market, our bias is to be more conservative in China as the longer-term structural story remains negative.

China risks getting stuck in the middle-income trap so long as Xi continues to favour greater state control over rekindling the animal spirits and creative dynamism of entrepreneurs. However, much like in Japan’s lost decades, there were opportunities to take advantage of that delta between reality and depressed expectations, which precipitated sharp trading rallies. Also much like Japan, China’s deep universe of companies will offer up a rich opportunity set for active managers to generate alpha, even when running structurally lower exposure to the market.

Groupe financier Connor, Clark & Lunn Ltée
mai 16th, 2024