Economic Commentary - Can the rally in Chinese equity markets continue?

In this month’s commentary our Chief Economist, Colin Warren, looks at the prospects for the Chinese economy and equity markets following the recent announcements of coordinated stimulus measures from Beijing.

Investors in Chinese equities have waited a long time for a meaningful stimulus to shore up the economy, and in recent weeks they have finally got it. After months of disappointing economic data and growing concerns about deflation, the Chinese authorities have announced a series of monetary and fiscal measures aimed at reviving the country’s flagging economy, stabilising the ailing property sector, and lifting stock markets.

Coordinated stimulus

Up until recently, the Chinese authorities had adopted a piecemeal approach to supporting the economy. However, on 24^th September the People’s Bank of China (PBOC) announced a string of coordinated easing measures. These included cuts in interest rates and a reduction in the reserve requirements ratio, which will enable the banks to extend more loans.  There were also measures specifically targeted at boosting the beleaguered property market, including a 50-basis point cut for existing mortgage rates, a reduction in the minimum deposit required for buying a second home, and an extension of a scheme designed to encourage State Owned Enterprises (SOEs) to buy up unsold homes for use as affordable housing[i].  

In addition, the authorities unveiled initiatives to bolster the Chinese equity market, which has performed poorly in recent years. The PBOC announced two new facilities: one which would enable eligible institutional investors to access cash from the central bank to purchase equities, and another to provide funding for corporate buybacks. Reports indicate that these schemes could release Yuan800 billion (around £87 billion) into the market[ii]. There is also renewed talk of Beijing creating a state-backed stock market stabilisation fund, an idea that has been around for a while but which has not yet come to fruition. 

Equities bounce

Investors welcomed the news of more forceful stimulus by sending Chinese equity markets sharply higher. The iShares MSCI China ETF jumped over 35% during the two weeks following the PBOC’s announcement[iii], and other Chinese equity indices posted similar gains[iv]. However, equity markets have since fallen back (at the time of writing the iShares MSCI China ETF is currently around 13% below its early-October high) as Beijing has dragged its feet in announcing the big fiscal stimulus investors were hoping for.

Expectations were high that a Chinese Ministry of Finance press briefing on 12^th October would provide details of a big government spending package to support the economy. Measures were announced to support the property market, provide debt relief to local governments, recapitalise state banks and provide fiscal transfers to low-income groups[v]. However, while officials pledged to ‘significantly increase’ debt to boost economic activity, the detail on the overall size of the stimulus package was lacking. Indications are that investors will have to wait until any extra debt issuance is signed off by parliament before the details and the overall size of the package is made public.  

Investors are focused on fiscal policy because, as long as confidence remains depressed, consumers and businesses are unlikely to meaningfully respond to easier monetary policy. A reduction in interest rates and an increase in banks’ lending capacity is not much use if households do not want to take on more debt. Sure enough, Beijing is trying to boost consumer spending by subsidising purchases of new appliances and giving one-off cash handouts to the poor[vi]. However, such policies are only likely to provide a temporary boost to spending, and policies to incentivise consumption over the longer term have so far disappointed expectations.

Challenges remain

Arresting the downturn in the property market, where home sales[vii] and prices[viii] are still falling, is key in this regard. The opinion among most China watchers is that measures announced so far are insufficient to generate a significant turnaround in the property sector, which is plagued by a large inventory of unsold new homes and unfinished developments. As long as the property sector (which on some estimates makes up around 25% of Gross Domestic Product (GDP)[ix]) remains weak, it will undermine confidence in other parts of the economy. Home ownership is high in China and is estimated at around 90%[x]. As a result, consumer confidence, which has hovered near record lows in recent months, is unlikely to recover while home prices are still falling.

Other structural factors have contributed to lacklustre household spending. Compared with advanced economies, Chinese households save a disproportionately high share of their income (nearly 40%[xi]) and, partly as a result, consumer spending accounts for a lower share of GDP.  One factor that keeps households’ precautionary savings high is the lack of a comprehensive social welfare system, which means individuals need to save more for retirement, healthcare, and unforeseen expenses. From a cyclical perspective, the recent rise in unemployment[xii] will have further undermined confidence and made consumers wary of splashing out.

Against this backdrop, a more generous social security system could encourage households to spend more and save less, thereby boosting the economy. While there has been some limited progress in this direction, the impression is that a more expansive social safety net might run contrary to President Xi Jinping’s philosophy of promoting self-reliance.

The prospect of a more difficult environment for exports underlines the need for stronger domestic demand. With the property sector in the doldrums, Beijing has sought to boost growth by increasing foreign sales of high-tech products such as solar panels and Electric Vehicles (EVs). However, this strategy is encountering obstacles, with the US, the European Union and Canada all raising tariffs on Chinese exports of EVs in recent months. Moreover, the situation is likely to get worse if former President Trump, who has proposed an across-the-board 60% tariff on all US imports from China, wins the election in November (see our Commentary of September 2024[xiii]). Estimates from UBS, a Swiss bank, suggest that a 60% tariff on all Chinese exports to the US could knock 2.5 percentage points off GDP growth during the year following their implementation[xiv].

With this in mind, hopes for improved profitability hinge crucially on the outlook for domestic demand. Lacklustre economic growth and persistent deflation pressures have dampened Chinese corporate profits in recent years, and in turn this has weighed on equity market performance. For the coming year, analysts’ expectations for the earnings per share of the companies that comprise the MSCI China equity index are no higher than they were back in 2015[xv]. Stimulus measures should improve the profits outlook, but will take time to make an impact.

Grounds for optimism

This said, there are still grounds for optimism that the recent rally in Chinese equities could have further to run in the near term. Beijing has finally acknowledged that it needs to act more forcefully to boost the economy, and more policy announcements seem likely during the coming weeks and months.

This policy shift should in turn foster improved investor sentiment towards the Chinese market. After years of underperformance, investors have reduced their allocations to Chinese equities, leaving global fund managers’ allocation to the country underweight[xvi]. Even in the absence of outright optimism, a return to more neutral weightings could, along with the liquidity measures announced by the PBOC, lead to inflows that propel markets higher.

What’s more, even after the sharp rally seen in recent weeks, valuations are still relatively low, both historically and compared with other markets. The forward Price/Earnings (P/E) ratio for the MSCI China index currently stands around 10.5x[xvii], less than half the 23.9x of the MSCI India index[xviii] and the 21.9x of the MSCI US index[xix]. Previous bouts of stimulus have seen Chinese valuations peak at considerably higher levels than those currently prevailing. For example, stimulus-driven rallies took the forward P/E to highs of 14x in January 2018 and 19x in February 2021[xx].

In conclusion, there is little doubt that the Chinese economy will continue to face considerable challenges on both the domestic and external fronts. It is doubtful that measures announced so far will bring an end to the country’s property crisis and lead to a sustained upswing in consumer spending. Meanwhile, the prospect of a more protectionist administration in Washington looms on the horizon. However, the renewed sense of urgency on the part of Beijing and the expectation of further initiatives gives ground for optimism. Coupled with improved liquidity conditions, low valuations, and light positioning on the part of investors, this means that, from a macro perspective, there is potential for the recent rally in Chinese equities to continue a while yet.

15^th October 2024