Chinese equities: a leap of faith

Chinese equities have become increasingly hard to ignore for international investors. However, difficulties to properly assess implied risks makes them a complex, and risky, investment.

Chinese stocks are unavoidable, but tricky

Chinese equities have delivered robust returns for investors over the long term, both in local currency (CNY) and in US dollar terms.

It is true, however, that the pace of gains has significantly slowed in the past decade, with a further deceleration since 2018 due to the conjunction of the US-China trade war, major turmoil in China’s real estate sector after the fall of Evergrande, the threat of delisting for Chinese firms who issued shares in the US and a sweeping regulatory reset in China.

We also note that onshore equities (represented by the CSI 300 index), have delivered superior returns compared with offshore stocks (represented by the MSCI China index) as they are generally better aligned with the government’s strategic priorities (e.g. ‘dual circulation’ and ‘common prosperity’) and shielded from the vagaries of foreign investors due to their limited accessibility.

For illustration purposes only. Past performance should not be taken as a guide to or guarantee of future performance. Performances and returns may increase or decrease as a result of currency fluctuations.

Chart 1: Inflation (CPI) in advanced economies since 1960

Despite the significant risks and complexity involved in holding Chinese equities, they remain unavoidable for emerging market investors due to the unparalleled size and depth of the Chinese market. China currently accounts for 30% of the MSCI EM market’s capitalisation, although onshore shares are only included at 20% of their actual value. Domestic (onshore) equity markets alone represent more than USD3 trn of market capitalisation, which is roughly three times the size of the entire Indian stock market (and one-tenth of the US market). For completeness’ sake, one would also need to add Hong Kong’s market capitalisation (USD500 bn). Beyond pure size, Chinese equities also exhibit more diversity across sectors than any other emerging country. And given China’s economic and political clout, Chinese assets are increasingly hard to ignore for international investors.

For illustration purposes only. Past performance should not be taken as a guide to or guarantee of future performance. Performances and returns may increase or decrease as a result of currency fluctuations. There can be no assurance that these projections, forecasts or expected returns will be achieved. The projection is not based on simulated past performance.

Chart 2: Country breakdown within the MSCI emerging markets index

High return, high risk

If Chinese equities do indeed belong in a long-term investor’s asset allocation, one could argue that current valuations offer an attractive entry point. The 12-month forward price-to-earnings ratio of Chinese onshore stocks has fallen significantly in the past year and thus offer re-rating potential. Note that given the high likelihood that US-China tensions will persist, potentially leading to financial and technological decoupling, we have cut our expectations for valuation convergence over time. While economic growth has undoubtedly slowed since last year’s projections because of the travails of China’s real estate sector, growth remains high by developed-markets standards, hence supporting companies’ top-line projections. While we are wary of the risk of an erosion in margins, and equity dilution is likely to continue, these headwinds should be more than compensated by revenue growth and valuation expansion. In addition, we expect the renminbi to appreciate over time against the USD, hence providing some support to returns in hard currency terms.

Overall, we expect 10-year expected returns for Chinese equities of 7.5% per annum in local currency, slightly higher than last year thanks to a better entry point. Such prospective returns compare favourably with our average annual forecast of 6.0% for US equities and 5.7% for euro area equities, yet come with a significant geopolitical premium. The counterparty to such high expected returns is the difficulty to properly assess implied risks; more than ever, investing in Chinese equities requires a leap of faith.

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