What prospects for China’s economy and equity market?
5 April 2019
Craig Mackenzie, senior investment strategist, Aberdeen Standard Investments looks at the issues for China’s economy and A share market
With a solid earnings outlook and cheap valuations, we hold a positive view of China’s onshore A share market. Importantly, however, we think the current opportunity is a tactical rather than a long-term strategic one.
The A share market enjoys a more attractive earnings and valuation profile than most developed and many emerging markets. Under normal circumstances, this would likely merit an overweight position in a strategic portfolio. However, the A share market is no normal market and its idiosyncratic nature makes it more suited to a tactical rather than a strategic allocation.
If we consider the market from the perspective of it fundamentals it undoubtedly stacks up well relative to other global equity markets. But there are other drivers that need to be considered when forming a definitive view of the role of A shares in a broader portfolio.
At present, the outlook for revenue growth is more positive than it is for the developed world and many emerging economies. Over the long-term, projected corporate revenue growth in China is similar to that for the economy as a whole: lower than in the past, but high by global standards. While structural forces, such as a shrinking labour force and reduced scope for catch-up growth, will prevent a return to the extremely rapid growth of the past, at 6.9% per annum our 10-year revenue growth forecast is well above much of the global economy. Meanwhile, while the outlook for profit margins is negative in the short-term, it is broadly neutral in the long-run.
However, a peculiarity of the market has been the propensity of Chinese companies to issue new equity. This high level of share issuance has long been a source of weakness for onshore Chinese equities. It has had the effect of diluting existing shareholders and has detracted hugely from earnings per share over the last 30 years. While we are encouraged by a slowdown in share issuance in recent years, even this more modest rate is likely to dilute shareholders by some 3% per year. This stands in contrast to the US market, where net buybacks increase returns by some 1% per annum.
Taken together, these three factors – revenue growth, profit margins and share count – generate an earnings-per-share growth forecast of 3% per year, a solid figure although somewhat below the 5% we have seen over the past few years. That said, 3% beats the forecasts for most developed equity markets.
Undoubtedly, the most attractive thing about China A shares is that they are very cheap. By our reckoning, the market is around 25% below fair value. If, as history suggests, valuations tend towards fair value in the long run, then A shares should benefit from a strong tailwind as the index reverts to fair value. This could add 3% to annual returns over 10 years. If we then add in dividends, we can expect returns of around 8% per annum in local currency terms. Compare this figure to the expected returns of under 5% for global equities and the attraction of the A share market becomes clear, even if its higher risk profile renders the story marginally less compelling on a risk-adjusted basis.
However, over the long-term A share returns have been disappointing when compared with other markets and when put in the context of China’s huge economic success. Since 2000, the market has returned just 3.7% per year, a figure which pales in comparison to the 6.3% annual return of the US market. For much of the last twenty years the market has moved sideways.
This longer-term picture obscures some years of exceptionally high returns, however. For example, in 2007 the index grew by over 290% and by some 130% in 2015. These anomalous years speak to an important characteristic of the A share market. The market is dominated by retail investors, who tend to be swept up in periods of speculative fervour, only to jump ship when markets crash. Prosaic factors such as earnings expectations play little role in this market.
This is why we view China A shares as more of a tactical momentum trade than a conventional, fundamentals-driven strategic asset allocation opportunity. A tactical approach that involved buying during the early stages of a boom and exiting in a disciplined manner when momentum fades would have produced exceptional results. But, as the returns of the last twenty years show, a long-term strategic holding would have disappointed.
Today’s cheap valuations provide fertile ground for a speculative momentum rally but there needs to be a catalyst to reignite retail sentiment. That catalyst may be an increase in the supply of credit. There is strong historical evidence that price momentum in China A shares gain pace when credit growth accelerates. When the central bank is easing monetary policy and loosening credit conditions, China A share prices surge.
The sharp slowdown in Chinese activity in the last 12 months has prompted exactly these conditions. The 25% rally in China A share prices this year is consistent with renewed flow of liquidity. The PBOC is unlikely to unleash a huge wave of credit this time – it is worried that the economy has become too heavily indebted. However, economic news has continued to disappoint, so the trend for looser credit looks set to continue for a while. This provides a promising backdrop for the momentum rally to continue for a while longer.
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