The outlook for Chinese equities is a subject of lively debate among Wellington’s multi-asset investment team and our regional specialists. Here, I present both the bull and bear sides of the debate to help inform investors’ decision making. I try to draw conclusions where possible, but the intention is to present both sides of the debate to inform investors in their own decision making.
In recent engagements with multi-asset investors and clients, the China question has been a recurring topic. Most recognise that given the pain of the past few years, coupled with compelling valuations and high volatility, Chinese equities will at some point (probably) experience a sharp relief rally that will have a big impact on benchmark-relative returns for investors who are underweight.
For those that are long, the pain has been tough to bear. Chinese equities have struggled relative to broader global equities in recent years. The narrative that Chinese companies would power the new industrial revolution centred around climate change and technology was alluring and led many to invest in Chinese equities.
There isn’t space here to do these arguments justice but, in my opinion, they were compelling and well based. “Europe doesn’t make solar panels; they import them from China” and “Technology and climate are aligned with China’s strategic objectives and will remain supported” were the mantras and Chinese growth stocks were the path.
Then came the US/China trade war followed by Covid. The pain was compounded by a regulatory crackdown on Chinese private education companies that spread into other sectors like health care and technology, followed by a property crisis — all underpinned by the belief that geopolitical tension between China and the US would escalate inevitably towards a generational geopolitical event.
Against this backdrop of near consistent headwinds, it is perhaps surprising that the performance of Chinese equities has not been even worse.
Vital global player
Of course, investors should take stock of what has happened and see where lessons can be learned. But looking forward, Chinese equities are attractively valued, represent about a quarter of the broad emerging markets index and, as the world’s second-largest economy, the outlook for China is a vital input into a global multi-asset investment process.
Beyond the bearish narrative, there is little doubt that this is a complex and unloved asset class facing several structural challenges. Yet the Chinese equity market is deep and full of opportunity, underpinned by an economy that, despite recent difficulties, is still moving up the value chain.
Growth
Let us start with the outlook for Chinese growth. China’s reopening in 2023 didn’t result in the economic boom that many had expected and the bears would argue that any recovery from here will be slow given low private sector confidence. Property market indicators point to prolonged weakness, and demographics and deleveraging remain headwinds for growth.
Yet while few investors think economic growth will meaningfully improve in the short term, there are nascent signs that China’s economy is bottoming out, and the end of US rate hikes could help to stimulate growth.
In addition, the financial system is stronger now and Chinese households are financially healthy. Importantly, China is moving away from infrastructure and real-estate-driven growth towards more sustainable and productivity-enhancing activities that offer the potential for long-term economic dynamism.
From my perspective, however, any positive cyclicality in the near term is likely to be overshadowed by broader deleveraging and prolonged weakness in the property sector. That isn’t to say that the Chinese economy won’t grow, just that growth may be capped by these headwinds.
Policy support
What about policy support? Efforts from policymakers have picked up recently, supporting the balance of risks to the upside. There is scope to do more, including easing regulatory restrictions across industries, supporting domestic consumption and further loosening property sector policy.
However, the underlying direction for regulatory policy remains much the same. For investors, the ideal regulatory environment is one where the private sector is appropriately rewarded for financial risks and governments can step in in the event of a systemic loss of confidence. However, Chinese regulators are facilitating the opposite dynamic by making an example of private sector firms to discourage moral hazard and curb excessive rent-seeking.
My view of the policy outlook for China is somewhat more positive. While it is difficult to predict the timing or scale of further policy support, the trajectory of policy should gradually improve from here.
Geopolitics
And then there is geopolitics. It is difficult to quantify geopolitical risk and, thus, how much is already priced at current valuations. Geopolitical tensions, specifically between the US and China, are unlikely to go away, and November’s US elections present further near-term risks.
However, China is an increasingly domestically-orientated economy, presenting opportunities for active managers to lean into more domestically-orientated sectors. Geopolitical risk represents the “unknowable” but from a portfolio management perspective, the high level of uncertainty, in my view, necessitates smaller position sizing given the potential for surprises.
Against all of this, investors must weigh the fundamentals. China is the least expensive major equity market, and low valuations typically tend to have a strong relationship with higher future returns. But cheap can stay cheap and lower multiples might be justified given the unquantifiable geopolitical risks and an unpredictable regulatory environment.
In addition, earnings-per-share dilution effects are unlikely to moderate given higher net stock issuance versus global equities. The upshot is that while depressed valuations increase potential future returns, being cheap alone is not, for me, a compelling reason to be overweight an asset class.
Active approach
Bringing it all together, with investors appearing to prefer the risk of being late rather than early to China, I would advocate a tactical underweight to Chinese equities. While many of the above arguments support a positive risk/reward profile, my view is that overweighting Chinese equities would require more evidence of a positive trajectory for some or all the above headwinds.
If possible, investors should consider separating Chinese equities from broader emerging markets allocations in their decision-making framework given the weakening relationship between China and broader emerging markets, or use an active manager who is able to balance China exposure in line with emerging dynamics.
Finally, if investors decide to allocate to Chinese equities, they should prioritise an active investment approach as high dispersion in China’s relatively inefficient equity market offers return opportunities for experienced stock pickers.
John Mullins is multi-asset investment director at Wellington Management
