Key reasons for the sell-off in Chinese equities and why you should stay the course

By iFAST Research Team

 

AMID the meltdown in global markets witnessed lately, Chinese equities were not spared. The MSCI China Index, a representative benchmark for both onshore and offshore Chinese equities, saw a significant decline in February and March.

Like other major equity markets, growth-oriented sectors such as consumer discretionary & technology saw the biggest drawdowns.  The peak-to-trough for Chinese equity indices as well as some of the growth-oriented funds does not look pretty.

So what’s next for Chinese equities? Will the selling continue?

Valuations are not often the catalyst for major moves in financial markets. Expensive assets may become even more so, and vice versa.

Rather, frothy valuations were the metaphorical tinder-dry that set up the conditions for the sell-off. Many investors were expecting 2021 to be a big year for China (due to their effective handling of the coronavirus situation) as they piled onto Chinese equities which consequently became a crowded positioning.

Chart 1: A big rebound in GDP growth is expected for China in 2021

 

Erosion of confidence

One probable catalyst, aside from the selling momentum experienced globally, could have been due to investors’ realisation of Chinese policymakers’ desire to keep its house in order.

Reducing leverage, and improving the use of capital within its economy and the financial system, remain one of the country’s top priority. Since the start of the year, China’s top policymakers have issued statements and actions that have done little to assuage market participants.

The series of events highlighted in the articles above suggest that policymakers are pre-empting to remove some of the froth that is forming around its property and financial markets.

When taken all into account (property tightening measures, peaking growth of broad money supply growth, and rising interbank bank repo rate), it does not provide confidence to investors regarding the timeline of which China’s policymakers plan on tightening its monetary policy.

Firstly, valuations of the tech sector have become extremely expensive as a result of the massive run up in stock prices since March last year.

Even after accounting for the sell-off, the MSCI China Information Technology index continues to trade at a forward P/E (price-to-earnings ratio) of 29 times, implying that it would take approximately 29 years for the company to earn back the amount paid for each share.

Such long duration growth assets are naturally more sensitive to changes in interest rate expectations, making it a prime target for a sell-off.

Sustainable recovery

Secondly, with the current economic recovery resilience, we opine that market participants are rotating out of growth oriented names into cyclical and cheaper sectors such as financials as the reflation trade narrative shifts a gear higher.

On the contrary, the drawdown in Chinese equities is a positive development for Chinese equity markets over the longer term.

The removal in valuation froth ensures that the bull market in China remains in check. We continue to favour Chinese equities moving ahead as we see three main reasons that will drive growth in the country’s equities.

Strong earnings growth trajectory: China corporates (gauged by the MSCI China index) has a revenue exposure of roughly 87% derived domestically, a staggering concentration when comparing to other major Emerging Markets (EMs) and Developed Markets (DMs).

Therefore, we think a robust economic growth for China translates into relatively stronger broad-based improvements in earnings for Chinese companies. In the current environment where growth is healthy, we believe that domestic demand will continue to thrive and consumption should remain strong.

Gradual pivot towards an economic model driven more by consumption and tech: With China’s dual circulation strategy, we expect the theme of ‘Consumption Upgrade’ and ‘Technology’ to serve as one of the twin engines for China’s long-term economic growth momentum.

Therefore, sectors (ie technology and consumer discretionary) providing exposure to these long-term growth themes in China are slated to benefit from China’s long term growth strategy.

Chart 2: Chinese companies have high domestic revenue exposure; its strong domestic growth should keep earnings growth healthy

 

China remains on track to be the largest economy by the end of this decade: Peering ahead, our team’s forecast for China’s real GDP (gross domestic product) growth for 2021 is +8.5% – the highest among major economies.

Such robust growth prospects are stacked on top of over 2% growth in 2020, while the rest of the world contracted due to COVID-19.

Based on our calculations, our bold prediction is that China’s GDP will surpass the US in 2026 – potentially taking over the mantle as the world’s largest economy within the next five years. This is expected to bode well for corporate earnings in the years ahead.

We think new investors are mistaken if they decide to sell and take a loss now. Regardless of what happens in the interim, Chinese equity markets remain a bright spark over the long term given their current economic trajectory. – April 6, 2021

 

iFAST Capital Sdn Bhd provides a comprehensive range of services such as assisting in dealing, investment administration, research support, IT services and backroom functions to financial planners.

The views expressed are solely of the author and do not necessarily reflect those of Focus Malaysia.

 

Photo credit: Investor’s Business Daily

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