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Chinese stocks don’t look as cheap on a valuation basis as they did in January 2019 before a 60 percentage point gain in the CSI 300 Index. As we explain below, China’s equity market valuation rose as currency risk shrank.
We are a long way from August 2015, when the People’s Bank of China less than adroitly devalued the RMB, settling months of worry about a currency crisis. China’s monetary policy is now in a sweet spot and China’s currency is more stable than it has been in years, with considerable remaining upside.
Unlike the US stock market, where the price/earnings ratio moves in lockstep with Federal Reserve policy, China’s equity market valuation reflects diminished risk and monetary stability. On a valuation basis, China’s market remains the cheapest among the world’s major stock exchanges, and it is supported by strong GDP and profit growth.
We continue to like the best of Big Tech, for example Tencent and Alibaba, and see value in underperformers like the better-quality financials, among them China Construction Bank, China Life Insurance, and Ping an Insurance, as well as the mobile service providers China Telecom and China Unicom.
Parallel but mutually supportive trends in A-shares (the Shenzhen 300 Index) and H-shares (the Hang Seng Index and the Hong Seng China Enterprises Index) point toward further strength in Chinese equities.
The two cities are a dozen minutes apart by fast train, but widely separated by China’s exchange controls. Shenzhen has become a center of entrepreneurial flourishing where ambitious and capable challengers become market-capitalization locomotives.
Hong Kong has reaffirmed its position as China’s window to the world with a currency freely convertible into both Chinese RMB and Western currencies, and the financial center where large-capitalization, established companies float multi-billion-dollar offerings to global investors. Hong Kong’s strength lies in its ability to capitalize on the previous round of entrepreneurship.
The inclusion in the HSCEI (starting September 7) of Alibaba, smartphone maker Xiaomi and delivery-service Meituan Dianping helps transform a vehicle dominated by state-owned enterprises in energy, finance and infrastructure into an index that better reflects China’s economic transformation of the past ten years.
The Shenzhen 300 Index, meanwhile, mirrors the fast-growing market capitalization of new companies that are becoming industry giants.
The risk that didn’t rattle the market this year was Washington’s sanctions against some Chinese companies and the larger threat of Iran-style sanctions against Chinese financial institutions. In part this is the result of American overreach; a dozen top US companies inveighed against a proposed ban on WeChat in a conference call with the White House last week because the ubiquitous Chinese app is essential to doing business in China.
Nothing succeeds like success: China’s economy is expected to grow by 2.5 – 3.0% in 2020 while America’s shrinks by 6%. Under normal circumstances a growth imbalance this extreme would shrink the Chinese trade deficit with the US, but the opposite has occurred.
China’s exports to the US are almost back up to the 2018 peak, largely due to US demand for consumer electronics. For all the rhetoric, the US can’t do without China. Even so, China’s total exports to the US represent less than 3% of GDP.
Chinese President Xi Xinping rolled out an economic strategy more focused on domestic consumption than on exports in a set of speeches to senior officials during the past three months.
Translated as “dual circulation,” the initiative is represented in the Western media as a response to restrictions on China’s international activity. But it also reflects China’s observation that the Western world and the US, in particular, may not recover from the Covid-19 pandemic for a long time and that China thus has to generate its own growth.
We view “dual circulation” as a continuation of a policy that reduced China’s exports from 36% of GDP in 2005 to just 18% in 2019.
The domestic focus of China’s policy bodes well for consumer industries, for example China’s automobile companies. But something qualitatively new is at work. What we observe in China’s economy today is what Nobel Laureate Edmund Phelps called “mass flourishing” in a 2015 book. Extraordinary spurts of growth, Phelps argued, occur when all elements of a society embrace innovation.
The best performers in the HSCEI last week were China’s two main mobile service providers, China Telecom and China Unicom, up respectively by 36% and 22%. They have long been market laggards, but reported stronger than expected earnings due to rapid adoption of 5G smartphones by Chinese consumers. 33% of all smartphones sold in China during the second quarter were 5G enabled, compared to just 16% in the second quarter.
That’s nearly 30 million 5G phones in a single quarter, or nearly ten times as many 5G smartphones as the four big American carriers have sold since the product became available last year.
China is building three times as many 5G base stations per capita as the US, according to a Deloitte report. What is even more impressive, though, is the speed at which Chinese consumers are adopting the new technology.
China’s CSI 300 has generated a total return of 59% since the beginning of 2019 and of 15% during 2020 to date, compared to the S&P’s 38% return since the start of 2019 and a 5.5% return during 2020. Nonetheless the CSI 300 still looks cheaper than the S&P as well as most other major markets, and far more dynamic and diversified.
S&P returns depended on a handful of popular tech names (Amazon, Facebook, Microsoft, Netflix, and Google). By contrast, most of the CSI’s returns during 2020 came from companies that most foreigners have never heard of.
Except for Kweichei Moutai and Wuliangye, China’s leading spirits producers, the biggest contributors to CSI total returns were a diverse set of companies shown in the chart below.
Luxshare makes electronic components. Chongqing Zhifei makes vaccines. East Money Information is a popular consumer financial platform. Changchun Technology is a diversified pharmaceutical and technoloy holdin company. Goertek make components for wireless communications. Myuan producers pork and animal feeds.
The chart below shows the normalized performance of the US, European, Korean , Brazilian and cinese broad equity markets.
The relative valuation of markets is more pertinent. The Shenzhen 300’s price-earnings ratio has risen from 12x to 16x, while the S&P 500 is trading at 25x earnings. The valuation difference between Chinese and US stocks, that is, has risen from between 4 and 6 percentage points to 9 percentage points.
Relative to US stocks, Chinese stocks are cheaper than ever. The KOSPI is only slightly more expensive than the Chinese market; Europe is only slightly cheaper than the American market.
Another way to look at the data is to calculate the so-called Z-score, that is, the difference between each day’s value and the long-term average, divided by the long-term standard deviation. Shown below are Z-scores for several major markets calculated over a rolling 5-year horizon.
We observe that the P/E of the Shenzhen 300 is two standard deviations above its 5-year average. That seems rich by historical standards. But the other three markets shown (US, Europe and S. Korea) are four standard deviations above their long-term mean.
What drives the lofty valuation of the S&P 500? There isn’t a lot of mystery to the high price-earnings ratio. It has risen and fallen with the real yields on Treasury bonds, a reflection of expected Federal Reserve policy.
Money market futures pointed towards zero or negative rates next year, which pushes investors into equities. They have been buying the new monopolies (Microsoft, Apple, Facebook and Google) rather than the old monopolies (e.g., utilities), but valuation of the US equity market clearly is a monetary phenomenon.
What should investors buy now?
1. Big Tech: Tencent and Alibaba will continue to generate strong earnings as China moves to a digital, AI-driven economy.
2. Telecoms: Last week’s strong performance by China’s mobile service providers only begins to recoup losses over the past year. They should continue to benefit as the 5G rollout generates revenues.
3. Financials: As we noted last week, Chinese banks are trading at their lowest valuations in years, and the financial sector has lagged the Shenzhen 300 Index. The credit cycle is improving with China’s economic recovery.
We expect to see a reduction in banks’ provisions for loan losses starting the second quarter of 2021. This is a patient investors’ trade; it may take some time for the improvement to be reflected in equity prices, but we expect the financial sector to outperform next year.