Authors: Alex Wolf, Julia Wang, Timothy Fung , Weiheng Chen
What we think
Offshore Chinese equities rallied on the back of cheap valuations and optimism around policy. The valuation gap has now largely closed and policy is likely to remain focused on stability rather than stimulus. Importantly, the underlying growth momentum remains challenged.
Investment implications
We think the rally is unlikely to be sustained for long, and investors can consider tactically fading exposure at current levels. We would focus on onshore China for longer-term investors seeking exposure to structural growth themes in the economy, and very select blue-chip names going into the upcoming earnings season.
Since peak post-COVID reopening optimism in early 2023, Chinese equities lost over a third of their value, as investors digested worries around a worsening real estate downturn, persistent geopolitical risks and issues around longer-term growth prospects. Zooming out further, Chinese equities are down over 50% since their 2021 high. Recent rumors and headlines around potentially more substantive policy easing in the property sector, capital market support measures and technical dynamics, have coincided with a sharp rebound since mid-January this year. This has propelled the offshore MSCI China over 20% and the onshore CSI300 over 15%, outperforming regional markets like Japan and India – making the Chinese market among the best performers in the world over this time. This surge has captured the attention of global investors, with many wondering if they should “chase this rally”.
In this edition of Asia Strategy Focus we zoom in on exactly what factors are driving this rally, assess whether it can continue, and consider the upcoming policy catalysts that could move the market.
Chase the rally?
To understand whether the rally is sustainable (and worth chasing), one needs to know what has underpinned the market. Is it driven by fundamental factors such as growth and earnings upgrades? Are stable “long-only” equity funds increasing their allocations? Or has it been driven by retail investors chasing low valuations (or something else entirely)? The former would speak to this rally having further legs, while the latter might give pause.
Who is driving this rally?
1. Is it global fund managers “closing their short positions?”
There has been a lot of reporting on global fund managers “closing their short positions” by increasing their China exposure within actively managed equity funds, particularly those focused on Asia or emerging markets (EM).
However, the data is showing something different. While there is no comprehensive data on positioning, comparing China allocations in actively managed EM funds relative to passive EM exchange traded funds (ETFs) that follow the benchmark can give a sense of how global portfolio managers are positioned. Using this proxy, portfolio managers are indeed underweight. While they have slightly reduced the size of the underweight, it remains near multi-year lows. There has been no dramatic shift in fund manager positioning like what was seen in past market upturns in 2014 and 2017.
ACTIVE EMERGING MARKETS MANAGERS REMAIN UNDERWEIGHT CHINA
China over/underweight in active EM funds, %
The line chart shows China allocations in actively managed EM funds relative to passive EM exchange traded funds (ETFs) that follow the benchmark in percentage terms. Using this proxy, active EM funds were 1.13% overweight China in March 2009 as a starting point. From March 2009 to March 2010, it fell to -4.3% as portfolio managers reduced the size of their China allocation and turned underweight. It quickly rebounded back to ~1% overweight in April 2011 and remained relatively constant until February 2012 which we saw a decrease in their China allocation to -3.4% in February 2013. From February 2013 to January 2015, active EM funds increased their allocation to China and turned overweight again, reaching 4.1% in January 2015. From January 2015 to July 2016, active EM funds unwinded their overweight position in China with their positioning falling from 4.1% to -2.3% in August 2016. From August 2016, active EM funds’ allocations to China turned positive again as it rose to 2.7% in February 2018. However, there has been a decline in their allocations since then, with a decline from 2.7% to -1.6% as of March 2024, with portfolio managers now underweight China. While they have slightly reduced the size of their underweight in recent months, it remains near multi-year lows.
2. Are global investors finally turning more positive on China?
Beyond fund managers, has there been substantial flows from other global investors into Chinese equity funds and ETFs? Is changing global sentiment and the overall increase in money invested in offshore equities behind the rally? This is relevant in the context of Japan and India, which have seen some recent inflows coinciding with China outflows. Are these starting to reverse?
THE SHIFT IN FOREIGN FLOWS BETWEEN CHINA, JAPAN AND INDIA IS MORE APPARENT OVER THE LAST YEAR
Foreign inflows into equities, cumulative USD millions since May 2022
The line chart shows the foreign inflows into equities in cumulative USD millions since May 2022 for China, Japan and India. From May 2022, China’s cumulative foreign inflows into equities have generally increased from May 2022 to May 2023, hitting a peak of 24,500 USD millions in May 2023 despite a modest decline from Aug 2022 to January 2023. In contrast, India and Japan cumulative foreign inflows into equities remained in negative territory and was relatively flat from May 2022 to May 2023. The shift in foreign flows between China, Japan and India became more apparent over the last year. From August 2023 onwards, the trend reversed for China, with foreign inflows into equities falling from 23,705 USD millions to -822 USD millions as of May 2024. On the other hand, India and Japan saw an uptick in foreign inflows into equities during the same time period, which we saw some recent inflows coinciding with China outflows. India’s foreign inflows into equities rose from ~67 USD millions in May 2023 to 17,205 USD millions as of May 2024. Similarly, Japan’s foreign inflows into equities increased from -5589 USD millions to 13,057 USD millions as of May 2024.
Here the answers are also no. While there was a shift of global money leaving Chinese equities and generally adding to India and Japan from August 2023 onwards, recently there has been no major reversal. If anything, this trend has continued. The likely reason is that inflows into China during 2020 and 2021 were massive (totaling over $100 billion) relative to outflows experienced in India, and relatively subdued positioning in Japan. Some of the recent shifts can be seen as a normalizing of global China “overweights” in retail investor portfolios.
CUMULATIVE FOREIGN INFLOWS INTO CHINESE EQUITIES STILL DWARF THOSE OF JAPAN AND INDIA
Foreign inflows into equities, cumulative USD millions since 2020
The line chart shows the foreign inflows into equities in cumulative USD millions since 2020 for China, Japan and India. All 3 countries experienced foreign inflows into equities from January 2020 to May 2024. Japan’s cumulative foreign inflows into equities saw a modest increase to 50,731 USD millions in May 2024. Similarly, India’s cumulative foreign inflows into equities also rose to 16,163 USD millions in May 2024. Lastly, China experienced large foreign inflows into equities, with cumulative inflows rising to 115,082 USD millions in May 2024. Despite an increase of foreign equity inflows for both India and Japan since 2020, cumulative foreign inflows into Chinese equities still dwarf those of Japan and India.
There hasn’t been a reversal of this global shift towards Japan and India, and thus it’s unlikely to have driven the recent China market rally. So what happened?
3. Domestic Chinese investors
It’s likely that domestic Chinese investors are a major factor. Chinese investors net purchased more than HKD160 billion in stocks via southbound trading links with the Hong Kong exchange in March and April. The recent two months of southbound stock net purchases are some of the highest since the COVID reopening and a substantial increase over the trend of the last two years. Valuations were a significant factor – with the H-share discount relative to the A-share equivalents reaching a post-global financial crisis high in early February.
ONSHORE EQUITIES RECENTLY TRADED AT SOME OF THEIR HIGHEST PREMIUMS RELATIVE TO OFFSHORE SINCE THE FINANCIAL CRISIS
Hang Seng Stock Connect China A-H Premium Index
The line graph shows the Hang Seng Stock Connect China A-H Premium Index, which tracks the relative valuation of China A-shares to H-shares from 2008 to May 2024. A higher value of the index indicates that A-shares are trading at a higher premium to H-shares while a lower value of the index indicates that A-shares are trading at a lower premium to H-shares. The A-H Premium index was at 112 in January 2009 but spiked to a record high of 163 in February 2009 with the onset of the financial crisis. It then declined from 163 in February 2009 to 92 in October 2010 but bounced back to 141 in October 2011. From October 2011 to July 2014, China A-H premium index saw a sharp increase from 89 in July 2014 to 147 in January 2016. it fell to 113 in March 2017 but rebounded again to 137 in February 2018. From February 2018 to July 2018, the A-H premium index declined from 137 to 113. The trend reversed in August 2018, with the A-H premium index rising steadily from 116 in August 2018 to 142 as of May 2024, with onshore equities at some of their highest premiums relative to offshore since the financial crisis.
There are also domestic regulatory shifts aimed at promoting Hong Kong markets. Recent measures announced by the China Securities Regulatory Commission (CSRC) have increased accessibility between Hong Kong markets and mainland China. Trading has increased via the Connect scheme and mainland companies have been encouraged to list in Hong Kong. This increased accessibility has been a boost to Hong Kong stocks.
Another factor is the Hong Kong dollar itself. With a strong U.S. dollar putting downward pressure on Asian currencies, the HKD stands out for its USD peg and relative stability. With onshore investors increasingly turning to gold as a store of value and source of currency diversification, it’s not surprising that they are taking advantage of access to Hong Kong stocks as a means to convert liquidity into USD-pegged assets. Domestic investors’ desire for diversification coupled with a closed capital account could be channeling more funds into Hong Kong equities.
Are these flows sustainable?
They could continue but without an improvement in fundamentals it will likely be short-lived. Domestic bond yields are at all-time lows, house prices are expected to fall further, and valuations on offshore equities look undemanding relative to their domestic counterparts. Couple this with an increase in investable savings due to reduced spending on housing and concerns over continued currency depreciation, and it’s reasonable to expect some southbound flows to persist. However, in the past we’ve seen that such flows were volatile through cycles of boom and bust.
Flows: the bottom line
Most of the offshore Chinese equity rally was driven by liquidity flows and asset reallocation particularly from onshore investors, but these factors are unlikely to bring a meaningful earnings boost on the index level, nor a structural re-rating on multiples. Global investors have largely remained on the sidelines. The key catalyst for these investors tends to be fundamental factors around underlying nominal growth and corporate earnings. Geopolitics are often blamed but we find they have not had a measurable effect on positioning and can be a red herring. A key example is that outflows out of Chinese equities coincided exactly when growth expectations started being downgraded in August 2023. For a sustainable turnaround these fundamentals need to improve. The growth and policy outlook will likely have to take it from here…
Are policies turning more supportive of growth?
In our view, there has not been much change in the policy direction or underlying fundamentals. The bigger difference-maker now may be improving investor perceptions of tail risks, and there are some factors underpinning an ongoing change in assessment: the economy has continued to hold up, and as a result policymakers have the ability to stay the course.
We agree with the above points. Our base case for 2024 is stable below-trend growth. While actual Q1 headline GDP numbers were better than expected, most economic data continues to point to low household confidence and persistent deflation pressures, which are consistent with our view. For the rest of the year, our policy outlook is for stability rather than stimulus.
Below we outline our expectations on some policy aspects that could influence markets in the coming months.
1. Housing policy – can it spark a rebound?
There has been strong interest surrounding potential policy shifts in the housing market, given its continued decline. Several tier-one cities such as Hangzhou, Guangzhou, Beijing and Shenzhen have also continued to take steps to unwind home purchase restrictions. Many analysts cite the lack of funding and poor homebuyer confidence as reasons why the effectiveness of these policies may be limited. A further reason is that prices have yet to fall enough to attract buyers back into the market. We think further incremental easing is likely, but not a major policy reversal, and that the impact on growth will likely be modest.
CHINA’S HOUSING MARKET HAS CONTINUED TO COME UNDER PRESSURE
Daily housing sales, 10,000 square meters, 30 cities 7 day moving sum
The line chart shows the 7-day moving sum of China’s daily housing sales per 10,000 square meters in 30 cities for both 2023 and 2024. In 2023, China’s 7 day moving sum of daily housing sales was at 270 in January 2023, which later fell to 6.69 in February. From February 2023 to March 2023, daily housing sales spiked to 469 but this was quickly followed by a general decline of China’s daily housing sales which fell from 469 in March 2023 to 72 in October 2023. From October 2023 to December 2023, China’s daily housing sales rose from 72 to 379 by the end of the year. In 2024, China’s housing market has continued to come under pressure year to date, with daily housing sales for each month below 2023 levels, except for the last few weeks of January. China’s 7 day moving sum of daily housing sales were at 170 in January 2024 and remained relatively flat before plunging to 5.22 in February 2024. This was followed by a steep increase from 5.22 in February 2024 to 321 in April 2024, albeit still below 2023 daily housing sales from February to April. However, from April to May 2024, China’s daily housing sales continued to decline, from 331 to ~80 in May 2024.
2. Consumption support – can this reaccelerate the economy?
Household consumption finally got some attention at the March National People’s Congress (NPC) session. We wrote about the ‘upgrading’ initiatives as a small upside surprise in the NPC takeaways. Some local governments are giving incentives for consumers to upgrade home appliances – a tried and tested method that is yielding some results. A small amount of auto subsidies have also been announced, which could benefit lower-end consumers. There is no appetite for cash handouts on any meaningful scale, but further targeted measures to support consumption cannot be ruled out, which are incrementally supportive for growth.
3. Other policy catalysts
The delayed Third Plenum meeting is now scheduled to take place in July. By convention, the agenda is focused on economic reforms. Historically, the meeting has tended to coincide with positive equity market seasonality in Q4, but we doubt there will be a major policy shift this time around. Investor expectations also appear to be low, even as most see it as a positive policy signal. A reasonable guess at the agenda would include social security reforms, urbanization policies, education reform with a focus on promoting innovation, as well as industrial upgrading. A more systematic effort to defuse local government debt risk through fiscal reform could be a positive surprise.
Fade the bounce
Without a meaningful policy shift to revive investor confidence, we suspect this tactical bounce is close to an end. Valuations are already back to double digits and can no longer be considered distressed. Stretched technical indicators for the offshore market also suggest they are overbought.
CHINA EQUITY VALUATIONS NO LONGER LOOK DISTRESSED
MSCI China Index and valuations
The line chart shows the consensus next twelve months price-to-earnings (NTM P/E) ratio for the MSCI China Index over a 10-year period from 2014 to 2024. The 10-year average for MSCI China Index’s NTM P/E ratio is at 11.3x with a +1 standard deviation of 13.3x and -1 standard deviation of 9.3x. The shaded area represents the price movements of MSCI China Index over the same period, which moves closely in line with its’ NTM P/E ratio. Both NTM P/E ratio and share price of MSCI China was on an upward trend, albeit with some volatilities in between from 2014 to 2021. NTM P/E and price level starting values in Jan 2014 were 8.4x and 61.1 which saw a general increase before they hit a peak in Feb 2021 with NTM P/E at 18.8x and 122.9 for price level. This was followed by a sharp decline for both indicators where they fell from their peaks in Feb 2021 to 8.2x and 48.3 for NTM P/E ratio and price level in Oct 2022 due to China’s zero-Covid policy. NTM P/E ratio and price level of MSCI China then rebounded and increased to 11.8x and 69.4 respectively amid optimism on China’s reopening. However, that did not last for long as NTM P/E ratio and price level of MSCI China fell and was on a downward trend since Jan-23 due to harsh regulatory crackdowns and disappointing macroeconomic performance. Both price and NTM P/E has fell to ~50 and 8.4x in February 2024, with NTM P/E ratio below its’ -1 standard deviation of 9.3x. However, we have seen a reversal of China equity valuations from distressed levels, with both MSCI China price and NTM P/E increasing to 58 and 9.7 in the end of April.
As we enter the reporting season we see some potential for upward revisions given the continuous downgrades over the past few months. We are expecting 9-10% 2024 EPS growth for MSCI China, slightly below the consensus of 10.3%. We see the 20% rally as timely for trimming positions and keep our 2024 year-end outlook unchanged on both onshore (CSI300 at 3,700-3,790) and offshore (MSCI China 58-60) with little upside. Our focus remains on very select blue-chip names in the index. Onshore equities have underperformed and we prefer onshore over offshore at the moment.
What are the risks of not chasing the rally?
While we don’t recommend chasing this rally, momentum can be a powerful force in Chinese equities, particularly in onshore markets. Historically, there has been a noticeable divergence between onshore and offshore markets when it comes to sustaining a rally.
Historically, when markets are up 20% over a three month period, the onshore market has continued rising for some time, returning a further 20% more on average 6-12 months after the initial rally. This suggests that momentum plays a big role in the onshore market (likely a result of dominant retail participation). However, offshore equities were unable to keep going, ending flat or even negative in the next twelve months, seeing little of the momentum of onshore equities.
THE ONSHORE CHINA MARKET HAS SUSTAINED MOMENTUM RALLIES FOR A LOT LONGER THAN OFFSHORE MARKETS
Average index price performance by month after a 20% rally in 3 months, since 1995
The bar chart shows the average index price performance by month after a 20% rally in 3 months, since 1995 for MSCI China, Hang Seng Index and CSI 300 Index. We looked at how each of the indices performed 1 month, 3 months, 6 months and 12 months after the 20% rally. For offshore markets, MSCI China delivered 1.1% in 1 month, 0.8% in 3 months, 2.3% in 6 months and -6.7% in 12 months after the 20% rally while the Hang Seng Index delivered -0.3% in 1 month, -1.0% in 3 months, 5.0% in 6 months and 1.5% in 12 months after the 20% rally. On the other hand, the onshore China market has sustained momentum rallies for a lot longer than offshore markets. This can be seen in the case of CSI 300 Index which garnered a return of 4.0% in 1 month, 12.3% in 3 months, 26.6% in 6 months and 23.0% in 12 months after the initial 20% rally.
There is no saying how investor behavior could drive markets to perform in this cycle given the fundamentally changed economic environment in China today compared to the past two decades.
Technical explanations and historical experiences aside, a sustainable rally requires a sustainable improvement in nominal growth and earnings, which is dependent on an improving economic landscape and supportive policy environment. At the moment, that remains to be seen.
All market and economic data as of May 9, 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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Index definitions
The MSCI China Index is a free-float weighted equity index. It was developed with a base value of 100 as of December 31, 1992. This index is priced in HKD. Please refer to M3CN Index for USD.
The CSI 300 Index is a free-float weighted index that consists of 300 A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges. Index has a base level of 1000 on 12/31/2004. * Due to our agreement with CSI, shares in the index is restricted, please visit SSIS for more information and access. This ticker holds prices fed from Shenzhen Stock Exchange.
