Happy Lunar New Year! The Lunar New Year started with a boom with the S&P500 reaching a new high and the global stock market continuing the bull run on the back of mild inflation and strong economic growth. With much optimism that the "Lucky Dragon" will spur the Chinese stock market, the optimism is misplaced for now. January proved to be a challenging month for Chinese stocks, with Hong Kong's Hang Seng index plummeting nearly 10%. The index now hovers around levels last seen in 1997, a time when industry giants Tencent and Alibaba had yet to emerge, and the territory had just returned to Chinese sovereignty.
What are the factors affecting the malaise in the Chinese Stock Market? Will there be hope that the Chinese stock market will reignite in the year of Dragon?
The China Economy In Jan 2024
The China central bank has projected a modest rebound in China's consumer prices for 2024 following recent deflation, deeming monetary conditions to be "reasonable and appropriate." However, the latest data on China's Consumer Price Index (CPI) revealed a larger-than-expected decline of -0.8% year-on-year, indicating persistent deflationary pressures.
In a notable shift, Mexico surpassed China last year to become the top supplier of imports to the U.S., marking a change unseen in over two decades. This development underscores the escalating tensions between Washington and Beijing, as well as American efforts to diversify import sources by sourcing more goods from nearby, allied nations.
Recent data from the Commerce Department reveals a nearly 5% increase in imports from Mexico to the U.S. from 2022 to 2023, totaling over $475 billion. Conversely, imports from China experienced a sharp decline of 20%, plummeting to $427 billion during the same period.
China has recently implemented measures to tighten restrictions on domestic institutional investors as part of efforts to address the ongoing stock rout. These measures include capping a cross-border method used for shorting Hong Kong stocks and advising offshore units against reducing mainland shareholdings. Additionally, certain quant hedge funds are now prohibited from placing sell orders, while others are barred from reducing positions in leveraged market-neutral funds.
In response to these actions, Chinese shares witnessed a notable surge after the a reduction in the reserve requirement ratio for banks by 0.5 percentage. This move, aimed at injecting approximately 1 trillion yuan ($140 billion) in long-term liquidity into the market, contributed to the positive market sentiment. Regulators have also introduced supplementary measures to bolster the struggling property and stock markets, including expanding the utilization of commercial property loans for developers to assist in debt repayment.
China's recent increase in stock purchases by state-affiliated funds and crackdown on short-selling, coupled with the replacement of the head of the China Securities Regulatory Commission, draw parallels to Japan's price-keeping operations of the 1990s. However, the effectiveness of these measures in restoring long-term confidence and stability remains uncertain without addressing underlying structural economic issues.
Are the efforts to prop up the stock market doomed to fail?
Despite these efforts, concerns persist regarding confidence in the Chinese economy. Both external investors and domestic savers continue to exhibit a lack of confidence, underscoring broader apprehensions about the stability and outlook of the Chinese economy.
Observing the Chinese government's repeated yet constrained attempts to boost share prices prompts questions about whether the country has drawn lessons from Japan's post-asset bubble burst struggles. With stock prices no longer serving as a signal for China's debt crisis, the world's second-largest economy appears to be teetering on the edge of its own "lost decade."
At a recent conference in Hong Kong, over 40% of participants expressed skepticism about Chinese equities, branding them as "uninvestable". Many strategists lamented that fund managers have turned a deaf ear, while disgruntled mainland investors have resorted to venting their frustrations on the US embassy's social media accounts, where they hope to evade censorship.
In the face of a generation marked by stagnant returns and market fatigue, the term "uninvestable" presents an intriguing opportunity. A value trade requires a level of pessimism that drives market prices below intrinsic value, and China's market certainly isn't short on pessimism. However, whether this presents a genuine value trade or a deceptive value trap remains uncertain.
For this potential opportunity to materialize, two critical factors must come into play. Firstly, Chinese companies need to act in accordance with their current status: as undervalued assets requiring tangible results to rebuild investor confidence, rather than relying on promises of future growth. This necessitates companies returning cash to shareholders through buybacks and dividends.
Secondly, Chinese domestic investors must rekindle trust in the market. While foreign investors might benefit from a market rebound, they cannot single-handedly drive it.
From a valuation perspective alone, Chinese stocks present an attractive proposition. The Hang Seng index boasts a forward price-to-earnings multiple of approximately eight, significantly lower than global equity valuations. Moreover, the price-to-book value ratio stands at less than one.
Despite these appealing metrics, low valuations stem from factors that have eroded confidence in the future profitability of Chinese companies. These include a sluggish economic recovery and Beijing's regulatory crackdowns, which have reshaped perceptions of profit potential in various sectors. To counteract this, companies operating in affected sectors should prioritize returning cash to investors, as evidenced by Tencent and Alibaba's dividends and share repurchases last year.
While Beijing's gradual relaxation of policies offers some hope, geopolitical tensions present a more formidable challenge. While geopolitical tensions may not directly impact corporate profits, they introduce an unpredictable risk of international investors losing access to earnings. This discount in valuation will persist until geopolitical tensions ease, making immediate returns to investors via buybacks and dividends all the more valuable.
The domestic investors the key to a China market rally?
Long story short, a sustainable market recovery hinges on domestic investors regaining confidence in a market that has previously disappointed them. While signs of official intervention briefly lifted stocks, sustained recovery requires structural changes, such as evaluations based on stock performance and stricter discipline for errant issuers.
However, the sluggish property market will restrict the ability of Chinese investors to move big into the stock market. The idea of owning a property is a central tenet of the Chinese wealth accumulation strategy. Owning a home is a priority and the stock market is viewed as a place to park the excess cash as a form of diversification. An unstable property market in China will force Chinese investors to set aside investible cash to pay for potential future mortgage payment in the case of retrenchment or a negative equity property. The Chinese property must stabilize first before the stock market can rally. However, if Chinese companies can return cash in forms of share buyback and dividends to the investors, changing the minds of the investors that the stock market is not just one big casino and is a sustainable investment to help fund their retirement, this may create a change in their investing mindset.
Ultimately, a Chinese market revival built on returning cash to investors may pose challenges for companies once hailed as global leaders. However, it also holds the potential to realize the long-awaited value trade, offering foreign investors a final opportunity to capitalize on the market's potential.
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