Is China's rally real?

When I launched Woodford Views, I said I would write about events relevant to our everyday lives and have since focused on UK economic and market issues. But of course, as much as events close to home preoccupy our thoughts around these subjects, we live in a globalised world in which events in other geographies can also impact us all. Consequently, this week, I decided to write about a topic that has divided expert opinion in recent months and about which my views have evolved: the Chinese equity market.

I am not an expert on China, but I have been an interested observer of this modern economic miracle for over two decades. When I was writing about this economy and market some years ago, I was cautious for a number of reasons. I highlighted then what I saw as an excessive reliance on debt-funded property and infrastructure investment to drive economic growth and a valuation basis for the equity market that reflected excessive optimism. Now, more than five years on from those observations, I can tell you that I was wrong and then broadly right, in that the Chinese equity market (as represented by the CSI 300 index) continued to perform well even while China's growth slowed and shifted away from its reliance on an overheated property market but eventually succumbed to a very significant correction (see below).

This correction was even more dramatic in Hong Kong (see below), where the Hang Seng index halved from its peak in early 2021 and, even after a significant rally that started early this year, remains well below its 2014 level.

This dramatic market correction has many causes that include the travails of the property sector, the Chinese Government's regulatory clampdown on several popular sectors, trade and diplomatic tensions with the EU and the US and an international consensus perspective that the authorities in China need to do more to stimulate domestic consumption. These concerns and the market's underperformance, echoing what has happened in the UK equity market, have also caused an exodus of foreign investors.

However, after a significant and dramatic three-year bear market, has the time come for a different perspective? The charts above show that after bottoming in the early months of this year, both markets have rallied in recent months, prompting the question: Is this the start of a sustained recovery in these two linked markets, or is it a false dawn?

As ever, there are many conflicting opinions, but it is certainly true that the fundamental economic challenges confronting the Chinese authorities have not gone away. For example, economists' concerns about the fundamental structure of the Chinese economy and its high saving and low consumption share of GDP continue to loom large, as does the legacy of the property sector's problems.

However, for many reasons, it is now clear that the authorities in China are placing their long-term bets on a broad industrial strategy to revitalise the economy and, indirectly, the stock market. Central to this strategy is a desire to ensure self-sufficiency for the Chinese economy and help drive Chinese manufacturers up the value chain with the ambition that they should dominate their domestic market and grow global market shares from this strong base. Ultimately, the leadership aims to continue establishing China as the dominant global manufacturer across a broad range of targeted industry sectors. Inevitably, this strategy will lead to further international trade tensions, which, unsurprisingly, will likely result in the imposition of significant tariffs as countries around the world look to protect their domestic industries from what they perceive as unfair competition. But what are the near-term implications of this long-term industrial strategy for the Chinese equity market, and can the rally of recent months be sustained?

This question inevitably attracts many different opinions among the cohort of experts who follow the Chinese market. Some stress the importance of these longer-term economic challenges and ambitions, and others focus on shorter-term considerations. My own, non-expert opinion is driven by the investment disciplines I have always deployed when looking at more familiar markets and companies and is centred, in the first instance, on valuation.

Aside from these longer-term strategic considerations, the Chinese economy does appear to be recovering from the prolonged pandemic disruptions that endured for significantly longer than in other major developed economies, and important variables such as electricity consumption, exports, manufacturing PMIs, airline passenger volumes, and retail sales all appear to be trending up, albeit not yet decisively. However, more compelling, in my opinion, are the valuation arguments for both Chinese markets. The price-earnings ratios of the CSI 300 and the Hang Seng are both more than one standard deviation below the average of the last decade, as are both markets' price-to-book, and the dividend yield in both cases is one standard deviation above the average of the previous decade. So, relative to recent history, the market is cheap, but arguably, the absolute numbers are, if anything, more compelling. The PE multiple on the CSI 300 is 11.6x this year's earnings, and the Hang Seng an even more depressed 8.6x. These are very low not just in comparison to the history of the Chinese market but very low in an international context.

In my experience, these multiples are inconsistent with the economic outlook most economists expect to see in China and the returns leading Chinese businesses are generating on invested capital. My guess is that in their rush to exit the Chinese equity market, international investors have driven the market down to an excessively depressed level, which discounts not just a significantly worse economic outlook than forecast but also declining corporate profits, which are growing strongly across many leading sectors.

As I said, I am no Chinese market expert, but the universal rules of valuation and return that can be consistently applied worldwide seem to indicate that the market is now very cheap, with the bonus of an attractive and growing dividend yield of over 3% on the CSI 300 and well over 4% from the Hang Seng.