Chinese equities have suffered more than a 20% drawdown on 47% of the days in the past five years.1 In comparison, US equities have experienced a 20% drawdown just 2% of the time.2
So when will the poor performance of Chinese stocks finally be fully reflected in the price, making them impossible for investors to ignore? That time may be soon.
Two Years of Losses Historically Precede Gains in Year Three
Chinese stocks have already fallen 25% in 2022, on the heels of a 20% decline in 2021.3 And with losses extending from H-shares to Red Chips,4 it’s difficult to imagine anything positive in 2023. But historically, Chinese stocks have posted solid gains after two calendar years of declines.
Over the past 30 years, Chinese stocks have returned an average of 32% following five periods of two consecutive years of losses (2021 and 2022 will likely be the sixth such period). Dating back to 1993, there was only one period (2001 to 2003) when Chinese equities had a third year of losses.
After Two Years of Losses, Chinese Equities Historically See Gains in Year Three
Subpar Chinese Stock Returns Have Improved Valuations
Looking at five fundamental metrics collectively, Chinese equities now trade in the lower 15th percentile relative to US stocks, and the 20th percentile relative to their own history dating back to 1995. And no single metric is above the 40th percentile.
Chinese Stock Valuations Are Inexpensive
Historically, when both valuation screens have been in the lower 20th percentile, subsequent 12-month returns averaged 9.4%, beating the average overall 12-month return of 5.9%.5 And the performance of Chinese equities has historically outpaced US stocks by an average 4.5% when valuations have been as inexpensive as they are now.6
Below-Target Growth Could Mean China Is Cheap for a Reason
Earnings sentiment in China has been extremely weak, as the analyst upgrade-to-downgrade ratio for full-year 2022 earnings has been below one (meaning more downgrades) every month for the past year. Notably, the US also has an upgrade-to-downgrade ratio below one — but valuations for US stocks are still above their historical median.
China’s 2022 earnings growth is now projected to be just +0.17%, revised all the way down from +13% at the beginning of the year.7 If China’s economy grows by the expected 3.2%, well below the government’s targeted 5.5% growth rate, it would be the economy’s largest miss relative to the targeted growth rate — and pose a challenge to 2023’s 5.2% expected growth rate.8
Despite downward revisions for 2022, China’s 2023 median growth forecast has remained steady,9 likely supported by stimulus plans that include:
Central bank rate cuts
1 trillion yuan ($146 billion) growth package
6.8 trillion yuan ($1 trillion) of government funds appropriated for large infrastructure projects, from renewable energy to high-speed rail development.10
China’s steady 2023 growth forecast coincides with the China Credit Impulse Index, a measure of new financing in the region, having risen every month for the past seven months — and finally turning positive for the first time since March 2021 in the past two months.11
Historically, the index rises as the economy begins to recover. Positive readings have historically coincided with above market returns for Chinese equities over three subsequent time horizons, as shown below.
Positive Readings of China Credit Impulse Index Have Historically Benefited Returns
Complex Risks Could Undermine the Case for China
These four interrelated risks could make the compelling valuation case moot:
President Xi Jinping’s potential unprecedented third term: It’s uncertain what Xi’s re-election means for local policies and geopolitical actions, but the October election should bring some clarity as we head into 2023.
Geopolitical concerns: Headline risks around Taiwan, tech-related regulation, and tariffs are likely to persist given that relations with China will be a natural talking point during the US midterm election cycle.
Zero-Covid policy: China’s strict policy has crimped growth across many dimensions and faces new criticism.
Slow growth in the property sector: China’s property sector, a segment that accounts for one third of the national GDP, is suffering a severe downturn. Prices have fallen by over 24% this year, causing some developers to default on their debts and struggle to complete projects. Homeowners also have threatened to stop making payments. Home prices are expected to steady, but sales are expected to fall 15% due to ongoing sluggish demand, according to a Reuters poll.12
Given these risks are likely to continue to spark volatility that challenges recovery, the case for China hinges on valuations and a revival of economic activity back to trendline figures —making it a contrarian case at the moment.
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1 Bloomberg Finance, L.P. based on the daily return of the S&P China BMI Index as of September 20, 2022 2 Bloomberg Finance, L.P. based on the daily return of the S&P 500 Index as of September 20, 2022 3 Bloomberg Finance, L.P. based on the daily return of the S&P China BMI Index as of September 20, 2022 4 Bloomberg Finance, L.P., A-shares = Shanghai Shenzhen CSI 300 Index, H-Shares = Hang Seng Index, Red Chips = MSCI China Red Chip Index, and ADRs = S&P China ADR Index as of September 20, 2022 5 Bloomberg Finance L.P. as of September 19, 2022 based on SPDR Americas Research calculations based the S&P 500 and the S&P China BMI Index fundamental metrics from 1995 to 2022. 6 Bloomberg Finance, L.P. as of September 19, 2022 based on SPDR Americas Research calculations based the S&P 500 and the S&P China BMI Index fundamental metrics from 1995 to 2022. 7 FactSet as of August 31, 2022 8 “China’s Growth Prospects Weaken as Economists Cut 2023 Forecasts”, Bloomberg August 28, 2022 9 “China’s Growth Prospects Weaken as Economists Cut 2023 Forecasts”, Bloomberg August 28, 2022 10 “China’s Next Megaprojects Are Key to Reviving Flailing Economy”, Bloomberg August 25, 2022 11 Bloomberg Finance. L.P. as of September 20, 2022 12 “China's 2022 property sector outlook worsens, home prices seen falling”, Reuters September 6, 2022
China Credit Impulse Index Credit impulse index = new loans / GDP Credit impulse index measures the credit cycle in a market. When the economy recovers, the index rises
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S&P China BMI Index The S&P China BMI Index is a market capitalization weighted index that defines and measures the investable universe of publicly traded companies domiciled in China, but legally available to foreign investors.
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