Time for a trade? – China edition

For three years, the price arrow on the Chinese equity market only knew one direction: down. Every recovery quickly fizzled out, and whoever bought countercyclically walked right into a trap. The recent trend reversal, however, may have a little more staying power because it comes on the heels of a classic capitulation by investors and public authorities. The odds of a cyclical rally are good, but whether China is worth more than just one trade remains an open question, the answer to which is largely in the hands of the country’s government.

A long list of concerns…

“The trend is your friend, until the end, when it bends.” This stock-market adage warns investors not to try to catch proverbial falling knives. At the same time, though, it is also a reminder that every (downward) trend ends at some point at least when it comes to an entire equity market (and not an individual stock). A trend reversal is usually almost inevitable when “weak hands” have sold their positions and all of the negative news and data are fully discounted in market prices. Since there has been plenty of grounds for pessimism in recent years, the Chinese equity market may have traced out a bottom inflection point of that kind on the charts over the past several weeks.

The following well-known problems top investors’ list of concerns: the crisis-wracked real estate market, disappointingly weak post-pandemic economic growth, geopolitical tensions with the West, the government of China’s confidence-rattling crackdown on technology companies, and the country’s longer-term demographic challenges. The government’s timid efforts until recently to get economic growth and sentiment back on track likewise turned out to be hardly confidence-inspiring. Instead of serving up stimulus with a giant ladle as it has done so often in the past, Beijing put emphasis on the quality rather than on the quantity of economic growth. The undesired side effect of this cautious soft approach was a slip into deflation and attendant high real interest rates, which exert a braking effect on growth. In view of this toxic cocktail, some institutional investors already consider the Chinese equity market to be uninvestable. More than a few of them by now are even viewing China as a standalone asset class separate from the rest of the emerging economies. This fact as well is merely a reflection of investors’ increasing exasperation with Chinese stocks and is a strong contraindicative signal for countercyclical investors.

Deflation averted? | One swallow does not make a summer

Inflation rate in China

Sources: Bloomberg, Kaiser Partner Privatbank

…and sheer exasperation

But the evolution of prices on the Chinese equity market has probably exerted the biggest single impact on investor psychology in recent years. After all, Chinese stock prices have been falling in almost a straight line since February 2021, and every intermittent rebound has consistently fizzled out quickly. The MSCI China index shed around 60% of its value during the three-year downtrend up until its recent low point at the start of February. The only time the last 30 years saw even bigger drawdowns was during two systemic crises (during the Asian crisis in 1997/98 and the global financial crisis in 2007/08). However, the absolute share-price declines in the current crisis have erased USD 6 trillion worth of market capitalization (equal to roughly 35% of China’s annual economic output) and are thus even worse than the plunges during the previous crises.

To catch the falling knife, Chinese authorities have been using all of the instruments in the intervention toolbox since autumn of last year, hesitantly at first, but then with increasing activism. For example, to enhance the attractiveness of investing in stocks, China’s securities regulator amended rules governing dividend payments and share buybacks. In addition, investment companies were instructed to stop acting as net sellers on the equity market. Then, after the turn of the year, Chinese authorities took aim at quantitative trading strategies and their “abnormal” trading behavior. To stop the net outflow of capital, they also restricted access to investment vehicles that invest in foreign markets. A ban on short-selling additionally followed shortly afterwards.

A burst without a bubble | Historical patterns match only in terms of price

Chinese equity market today vs. Japan bubble

Sources: Bloomberg, Kaiser Partner Privatbank

By January at the latest, the psychological strain had likely become so distressful even among politicians that the notorious “national team” of investors was deployed. This group of state-backed sovereign wealth funds, investment firms, and insurance companies provided massive support to the market by buying ETFs to the tune of almost USD 60 billion in the space of a few weeks. The only other time the “national team” had intervened to a comparable extent – and with success – was during the stock-market crash in 2015/16. Another parallel with the crash at that time – and another sign of capitulation by Chinese authorities – was the ousting of the head of the securities regulator in early February. However, a special form of capitulation on the part of Chinese retail investors had been observable beforehand: to evade censorship, they vented their anger on the US embassy’s account on Weibo (a platform similar to X (formerly Twitter)), posting over 100,000 critical comments full of frustration and sarcasm in view of the unremitting bear market. Amid a climate of abysmal pessimism and sheer exasperation, the interventions by the “national team” arguably delivered the clinching impetus for a turnaround. The major China indices have risen intermittently by around 15% since the start of February from a low which in all likelihood will stand for quite some time.

Good grounds for a (tactical) rally…

In the meantime, a technical selloff and depressed sentiment merely provide the necessary fertile ground. However, fundamental arguments are also needed to justify a trade. In the case of China, fundamental arguments are in place at the moment, and they relate to a stabilization in leading economic indicators and an easing of monetary policy by the People’s Bank of China, but especially to the Chinese stock market’s valuation. At the start of the descent at the beginning of 2021, China’s price-to-earnings multiple of 17x wasn’t necessarily at a bubble level. At its trough point, though, its P/E of 8x was at an absolute depression level and marked its lowest valuation in 20 years. China is currently trading at a massive discount even to emerging markets (MSCI Emerging Markets), which are already inexpensively valued in their own right. This means that the stock market is pricing in a full-blown economic disaster. If one doesn’t materialize (which we presume will be the case), the rally that commenced in February on the Chinese equity market could continue into the medium term.

Cheap, cheaper,… | …China

Comparison of CAPE ratios*

Sources: Research Affiliates, Kaiser Partner Privatbank

*Maximum/minimum = gray line; 2nd/3rd quartile = blue bar; current = orange triangle

We see three scenarios as alternatives to the worst case:

• Whatever it takes: Beijing gives up its hardline stance and resorts to the old playbook of unleashing massive economic stimulus. Given the ambitious, hard-to-reach targets for 2024 (economic growth of +5%, 12 million new jobs), the government will likely have fairly little tolerance for growth surprises on the downside. A “big bang” approach, though, is very unrealistic. Big-bang stimulus would certainly spark a small share-price explosion, but it’s questionable how sustainable it would be in the face of further mounting economic imbalances and risks in that event.
• Muddling through: Policymakers stay the course pursued in recent months and add further elements here and there to the colorful bouquet of select support measures. In this scenario, the growth path admittedly remains bumpy, but with time the stock market would acknowledge that reality is better than what’s priced in and would ditch its sense of doom and gloom. Developments in recent weeks suggest that the government of China is following exactly such a “muddling through” path. With a higher budget deficit than a year ago, Beijing plans, for example, to expedite key projects in strategically important sectors and to lend a financial hand to particularly feeble local governments. On the real estate market, instead of “red lines” there are now “white lists” bearing the names of property developers that are to be nursed back to health with generous loans. Xi Jinping’s declaration that “houses are for living in, not for speculation” did not turn up in Prime Minister Li Qiang’s recent government work report and appears to have been scrapped for the time being. Consumers, too, are to do their part to stabilize economic activity – cash-for-clunkers rebates are aimed at motivating consumers to make big-ticket purchases in order to boost growth with money tapped from household savings that have increased further in recent years.
• Structural reforms: In the third scenario, which brings with it not only a cyclical rally, but also a significantly higher long-term valuation rerating on the equity market, Beijing no longer confines itself to just handing out Band-Aids. Instead, the government presses the reboot button and structurally improves the country’s economic prospects. There is no clear sign yet that the government intends to move in this direction. The focus under the “Invest in China” slogan thus far has been on measures aimed at winning back lost trust (also outside China). Foreign capital, for instance, has recently been allowed to acquire wholly-owned interests in financial institutions in China. Chinese authorities also say they intend to better address foreign companies’ concerns about issues such as market access to the services sector, cross-border data flows, and fair and equal participation in public procurement tenders. The fact that China at least still captivates many captains of industry was evident in March at the China Development Forum, where there was a crowd of dozens of top-level managers from the West in attendance. Despite widespread misgivings, the lure of doing lucrative business in China is still powerful.

…and for caution in the longer term

However, in contrast to many a captain of industry, numerous investors are much more skeptical about China’s long-term ability to institute reforms. They therefore are more likely than not to interpret the Chinese government’s latest charm offensive, which in recent months has also included a further removal of restrictions on travel to the country and a more conciliatory tone toward the USA, as just another opportunistic short-term initiative of the sort that has so often been observable in the past. To regain the trust of foreign investors and domestic businesses, political consistency and market-oriented structural reforms are needed. Moreover, the government must create an environment in which property rights are protected. A new “private enterprise law” is aimed exactly at addressing this issue and establishing the same competition conditions for all companies. Formal legislation could possibly revive Chinese entrepreneurial spirit. However, the damage to confidence that has been inflicted in recent years is severe, and it is even graphically well visible in the Policy Uncertainty Index. From an investment strategy perspective, this huge political uncertainty – also with regard to the handling of long-term problems such as demographics – is what argues more in favor of just a China trade rather than a dedicated investment in China.

Just for a trade | Political uncertainty is a long-term risk factor

Economic Policy Uncertainty Indices

Sources: Economic Policy Uncertainty, Kaiser Partner Privatbank

How to play the trade

Regardless of which of the paths described above that Chinese policymakers tread in the months ahead, the motto “don’t fight the national team” applies from a tactical standpoint. There is considerable upside potential on the Chinese equity market even in a scenario of mediocre economic growth and unambitious reform efforts. Foreign investors have continually withdrawn capital from China and have cut their exposure to the country in half over the last three years and now are distinctly underpositioned there. Despite the recent stabilization of stock prices, China remains one of the most popular short bets, according to a survey of fund managers conducted by Bank of America. In the past, whenever the Chinese equity market was valued as cheaply as it is today (at a price-to-earnings multiple of less than 10x), it rose by over 20% on average over the next twelve months. The downside potential, on the other hand, appears limited to a retest of the February lows (and the subsequent establishment of a double bottom). Against this backdrop, structured products with capital protection and a barrier beneath the recent lows are suitable vehicles for a China trade.