Chinese stocks may be cheap but that doesn’t mean they’re a good buy

Sentiment has vastly improved, with investors drawn by low prices and assumptions of looser policy
Yet, Beijing’s regulatory crackdown, the threat of broader contagion from struggling developers and other factors should give them pause

Nicholas Spiro

Published: 3:15pm, 16 Dec 2021

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Sentiment towards mainland Chinese equities has undergone a perceptible shift in the past few months. Following a period of extreme bearishness which caused the benchmark CSI 300 index of large Shanghai- and Shenzen-listed shares to lose 18 per cent between February 9 and July 27, the mood among investors has improved noticeably.

Last week alone, foreign investors purchased US$7.7 billion of mainland stocks – a record amount since the start of the Covid-19 pandemic – via trading links with Hong Kong, according to Bloomberg data. The CSI 300, which is up almost 4 per cent this month, is close to erasing all its losses for the year.

Compared with the stellar performance of the FTSE All-World Index, a gauge of global equities that has risen around 15 per cent this year, Chinese shares remain in the tank. This is especially so for offshore stocks, which have suffered much steeper declines. Yet, as is often the case in markets, all it takes is a shift in expectations for asset prices to move in one direction or the other.

A growing number of investors believe Chinese macroeconomic policy has reached an inflection point. The combination of the severity of the shocks to the economy – a sharp property-driven downturn, growing signs of financial contagion, coal and power shortages and regular shutdowns amid the government’s unwavering “zero-Covid” policy – and a series of growth-friendly statements and measures has convinced some China-watchers that Beijing is leaning towards looser policy.

Markets have seized on a change in tone on the part of policymakers. Of particular significance to investors has been the government’s frequent use of the word “stability” when setting the policy direction for the next few years.

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Never mind that easing measures have so far been modest and accompanied by statements reiterating Beijing’s commitment to deleveraging and taking the heat out of the property market. The signal that the government is more concerned about the slowdown and plans to take steps to shore up demand has been enough to lift sentiment.

The perceived shift comes when Chinese equities are trading at discounts close to record highs versus their global peers. The forward price-to-earnings ratio – a popular valuation tool – of the CSI 300 stands at 15, while its equivalent for the MSCI China Index has dropped to 12.4. The benchmark S&P 500 index, on the other hand, stands at a lofty 21.2, not far below its level at the height of the dotcom bubble in the late 1990s.

In China’s beaten-down equity markets, most of the bad news is priced in. This provides significant scope for shares to rally, provided investors believe more easing measures are forthcoming.

In US stock markets, by contrast, valuations are extremely expensive. Investors have not even begun to price in the risks of a Federal Reserve that now expects to raise interest rates more aggressively, having fallen behind the curve on inflation.

The possibility of a negative surprise and the damage this could inflict on sentiment poses more of a threat in a market that is already priced for perfection. On those grounds alone, Chinese shares look like a compelling buying opportunity relative to their US peers.

Still, just because Chinese equities are attractively priced doesn’t necessarily mean they are a buy. First, while the main worry in US and European stock markets is the risk of a policy mistake, in China it is the entire policy regime that poses a threat to sentiment.

The fallout from Beijing’s sweeping regulatory overhaul of private companies is still ricocheting through the country’s equity and corporate bond markets as investors grapple with the consequences of President Xi Jinping’s new policy priorities. The uncertainty is compounded by the economic disruption caused by the government’s strict adherence to its zero-Covid policy and Beijing’s higher-than-expected pain threshold for maintaining restrictions in the property sector.

The threat of broader contagion from the liquidity crisis at China Evergrande Group is reason enough to be cautious on Chinese stocks. That the main source of concern right now is the financial position of Shimao Group Holdings, a higher-quality developer that has an investment-grade credit rating, demonstrates how far the turmoil has spread.

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Second, it is unlikely that an easing of monetary and fiscal policy will be sufficient to allay fears over Beijing’s relentless and broadening regulatory crackdown.

In September, Goldman Sachs predicted that policy in China would combine regulatory tightening with an easing of the government’s macroeconomic stance as growth continues to slow. It described the new policy mix as “micro takes, macro gives”.

The problem, however, is that macro is unlikely to give enough while micro will keep taking. Investors who are enticed by China’s cheap stocks should bear this in mind.

Nicholas Spiro is a partner at Lauressa Advisory

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