Making the case for investing in Chinese equities has not been easy in recent years. The market has fallen sharply from its peak in early 2021, undermined by a post-Covid economic slowdown and property market slump, while efforts by the Chinese authorities to shore up confidence have so far been disjointed and underwhelming. However, there are signs that things may be starting to change, with the large, coordinated stimulus package unveiled at the end of September demonstrating to investors that the Chinese government will do what it takes to support the economy. While there is no easy fix to China’s problems, we ask whether the intensifying policy response is the signal investors need to re-engage with the world’s second largest stock market.
China’s economic outlook remains challenging
China’s real GDP growth has slowed sharply in recent years to around 4%. Deflationary pressures mean that nominal growth is even lower, standing at around 3% according to official figures, although in reality it may actually be closer to zero. The slowdown represents a big change from the double-digit nominal growth rates that investors had become used to over the previous decade.
In many ways, China’s current situation is a good example of the structural economic imbalances that are caused by long-term government interference in the free functioning of market pricing mechanisms – interest rates, exchange rates and inflation. Weak growth and deflation stem from years of over investment, exacerbated by China’s supply-side focus on production capacity, which has created excess capacity in many industries and has resulted in downward pressure on prices and profits.
Dealing with overinvestment and oversupply issues in the property market has had a particularly negative impact on the economy, and investor sentiment. Property-related losses in the banking sector have caused credit conditions to tighten, and with almost two thirds of Chinese household wealth tied up in property, falling property prices have contributed to weak levels of consumer confidence. Interest rates are falling to provide support, but the more they fall the less incentive there is for banks to fund credit growth.
With property making up 63% of total household assets, falling house prices have created a negative wealth effect
Putting a floor under China’s growth
Working through the excess capacity in the Chinese economy will take time. In the interim, the risk is that weak growth turns into a more severe downturn, which explains investors’ disappointment with the piecemeal nature of the stimulus measures announced over the last few years. It also explains why September’s large, coordinated stimulus package is a potential game changer, as it serves to demonstrate the determination of the Chinese authorities to put a floor under the economy and minimise economic tail risks.
September’s stimulus announcement is significant. The measures include a half percentage point reduction in the Reserve Requirement Ratio (RRR) to free up about RMB 1 trillion of liquidity in the banking system and make more funds available for lending and investment, a reduction in interest rates for existing mortgages, a lowering of minimum down payments on homes to help support the property market, and new liquidity facilities to help stabilise the stock market and encourage investment.
Cuts to the Reserve Requirement Ratio have historically supported credit growth
The Ministry of Finance has followed up with an additional package of fiscal measures, announced on 12 October, which are designed to prevent the proliferation of financial risks in the economy. While the exact scale of the fiscal package was not specified, and a lack of detail on the measures to boost consumption may have disappointed some investors, this latest fiscal announcement further shows the government’s willingness to support growth. More stimulus measures are expected, with the National People’s Congress Standing Committee meeting on 4-8 November the next potential signpost to look out for.
Muddling through can still be positive for the Chinese stock market
While these stimulus measure are not a magic bullet to revive growth, they are significant, as they demonstrate the willingness of the Chinese authorities to step in to remove tail risks from the economy. As a result, we think a best-case scenario might be a "muddle-through" situation, similar to Japan's protracted economic stagnation.
A muddle through economy may not seem very exciting for investors, but Beijing’s determination to put a floor under growth should help to restore investor confidence and support the Chinese stock market, particularly with valuations at, or around, multi-year lows and trailing earnings growth now starting to show signs of picking up. Investor sentiment would be expected to be further boosted by any additional policy responses over the coming months, particularly if part of a targeted and measured response designed to avoid the creation of further bubbles in the economy.
However, while investor sentiment towards China may be expected to continue to improve, navigating China’s complex markets and identifying the companies that can perform well even in a challenging economic environment will be key to unlocking long-term value. With over 1,000 liquid stocks to choose from, we believe China holds attractive opportunities for active stock pickers that understand the market’s complex dynamics, and have the research resources to identify companies with the resilience and adaptability to thrive in various market conditions.
Equity market valuations have fallen sharply in recent years
Understanding the differences between the state-owned sector and the private sector, and the fundamental tension that exists in the market between government control and free market forces, is particularly important. Many Chinese companies are state-owned enterprises, or SOEs. These companies benefit from easy access to capital at low borrowing rates, but because they are often insulated from market pressures, they can struggle to generate attractive returns on capital.
China’s private sector, on the other hand, is more entrepreneurial and has nurtured many globally competitive companies across a broad range of sectors, from manufacturing to ecommerce and technology. Private companies offer higher potential returns, but face intense competition, while success can also attract regulatory attention from the Chinese authorities.
This distinction between public and private can have a significant influence on returns. For example, while government support for the property market could help to stabilise earnings more widely across the real estate sector, investors looking to gain exposure may prefer to look at SOEs rather than private developers, as they are better able to secure funding for new projects in top-tier cities where demand is holding up better.
Slower growth doesn’t necessarily mean lower returns
China’s economic growth rate may have slowed, but investors buy equities, not GDP. We see no real connection over long periods of time between economic growth and earnings growth in a globalised world. One only has to look at Europe and Japan, where markets are at or close to all-time highs despite weak GDP growth over many years. The important thing is to be able to differentiate between the companies that are adapting to the growth environment and growing their earnings over time, and those that are being left behind.
Many Chinese companies are already adapting to the slower growth environment by improving their capital allocation and by looking to boost shareholder returns. The government is playing a role, encouraging SOEs to emphasise dividends and set return-on-capital targets. Major state-owned companies have a track record of paying dividends to minority shareholders, with China Construction Bank, for instance, consistently able to provide a stable income stream for its shareholders. Also, Sinopec, which is one of the largest oil and gas companies in China, has maintained an attractive dividend payout for many years.
Private companies are also now focusing much more on shareholder value to attract investment as the economy slows. In the ecommerce sector, for example, Alibaba has implemented its first regular dividend and a significant share buyback programme, reflecting a broader trend among Chinese companies to focus on shareholder returns rather than aggressive reinvestment. Alibaba’s dividend yield, combined with its buyback programme and future earnings growth, offers attractive total return potential for investors.
Another example is dairy producer Mengniu, which has announced its first buyback programme, reflecting its strong balance sheet and commitment to returning capital to shareholders. The company has been focusing on improving its product mix and expanding its market share, which should support its long-term growth prospects. And in the energy sector, the gas distributor China Resources Gas has significantly increased its interim dividend, highlighting its strong cash flow generation and shareholder-friendly policies. The company has been expanding its customer base and investing in infrastructure to support future growth. Its focus on operational efficiency and cost control has also helped improve profitability.
Conclusion: Navigating China’s complex landscape
The Chinese government is taking steps to stabilise the economy, which should help to support investor sentiment and boost the long-term investment case for Chinese equities at today’s valuation levels. At the same time, Chinese companies are increasingly adapting their businesses to the new economic reality, and are looking to attract new investment by improving capital allocation and boosting shareholder returns. All of which is creating attractive opportunities for active stock pickers.
While there are still reasons to be cautious, given China’s well-documented structural economic challenges, the threat of government intervention, and the complexity of the Chinese stock market, we believe that by carefully navigating these challenges and focusing on companies with strong fundamentals and shareholder-friendly policies, investors can find attractive long-term opportunities. From a portfolio perspective, it’s all about the alpha, not the beta.