Shoppers in the Guanqian Street shopping area in Suzhou, Jiangsu province, on January 25. China’s Lunar New Year travel and box office figures showed promising returns, adding to evidence that the country’s economic recovery could be around for the long haul. Photo: Bloomberg
Opinion
Macroscope
by Aidan Yao
Macroscope
by Aidan Yao
Never mind the dip, China’s reopening-driven stock market rally is the real deal
A pause for profit-taking after weeks of gains is not surprising, and the underpinnings of China’s equity market are solid enough to support further recovery
Markets might need confirmation of a genuine earnings recovery to continue the ascent, so investors should continue to monitor markets closely
After staging a powerful rally at the tail end of the Year of the Tiger, the Year of the Rabbit has so far not delivered the continued prosperity hoped for by equity market investors. However, remember that the Hang Seng Index and MSCI China Index gained almost 50 per cent in past three months, so some profit-taking leading to a pause in the breakneck rally is not entirely surprising.
Looking more broadly, the structural underpinning of the equity market rise remains intact. From a macro standpoint, the Chinese economy is on path to a solid recovery, supported by post-Covid reopening and a multitude of policy support. With accommodative monetary and fiscal policies safeguarding growth and easing property and regulatory crackdowns removing overhanging risks, the macroeconomic environment is unequivocally supportive of risky assets.
Equity markets have started to price in these improvements, but there is room for further rerating. Valuations of onshore and offshore markets have rebounded from multi-year lows but remain below their historical averages and peer markets.
The Hang Seng Index, for example, is currently trading at almost eight times earnings, making it one of the cheapest markets in the world. To get back to average valuation, the index has to gain another 50 per cent without any earnings upgrades.
The price-to-earnings ratios of the MSCI China Index is also below average, albeit with a smaller gap than the Hang Seng Index.
Market sentiment has also recovered. Fear indicators such as the CBOE volatility index and China’s credit default swap spreads have fallen substantially in recent months as investors grew confident the Chinese economy had turned the corner. However, the absolute levels of these indicators remain above their pre-pandemic norms, suggesting room for further improvement.
Finally, the aggressive downgrade of China in the last two years has left many global investors underexposed to the world’s second-largest market. While the recent rally has reversed some of these short positions, China remains a large underweight for many global funds.
Not everyone will be convinced of the China turnaround story. However, I imagine that many who thought China was “uninvestable” will readily change their minds as the market continues to deliver impressive performance. The unwinding of these underweights could trigger strong capital inflows that help keep this rally going in the coming months.
Overall, it appears the stars are broadly aligned for China’s equity markets to make a comeback after their horrendous performance in the last two years. This positive cyclical view is consistent with a careful analysis of long-term market trends.
Looking at the total returns of the MSCI China Index, with its performance breakdown into earnings and valuation changes, there are three major takeaways. First, the market exhibits clear and regular cycles in the past 20 years.
Futures data on a stock ticker in Pudong’s Lujiazui Financial District in Shanghai on January 30. Photo: Bloomberg
There are in total seven cycles since 1998, with each lasting three to three-and-a-half years. The last one started in 2019 and came to an end in late 2022, and a new cycle has just begun. The cyclical upturn of a cycle typically lasts for one-and-a-half to two years, which, if it is repeated, can take the current market rally well into 2024.
Second, a new cycle is usually kicked off by valuation rerating as the expectation of an earnings recovery often precedes the actual recovery itself. This is why the market is often seen as climbing a wall of worry.
Note that the MSCI China Index rallied about 35 per cent in final two months of 2022, during which the economy was hit by the biggest disruption since the onset of the pandemic. Those who think the current rally has gone ahead of fundamentals must be reminded that this is the norm at the start of a new cycle, not an exception.
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China's slow road to economic recovery after dropping its zero-Covid policies
China's slow road to economic recovery after dropping its zero-Covid policies
Finally, the strength of the earnings cycle usually determines the vigour of the market cycle. Strong gains in corporate earnings tend to amplify and elongate the rally, while cycles with weak earnings recoveries tend to be less impressive. The analysis shows that long-term returns of China’s equity market are driven mostly by earnings growth, with valuations merely oscillating around the mean.
The equity markets might have completed their first wave of gains supported by rerating and need the confirmation of a genuine earnings recovery to continue the ascent.
However, if China’s economic recovery fails to impress, the rally could quickly run out of steam, giving rise to renewed investor scepticism and market volatility. The pertinent downside risks for markets have therefore shifted back to the real economy and require the careful monitoring of investors.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers
