This article first appeared in Capital, The Edge Malaysia Weekly on October 14, 2024 - October 20, 2024

CHINESE stocks recorded their biggest drop in a day in over four years last Wednesday, when this article was written, with the domestic benchmark CSI 300 Index falling 7.1% to erase the gains it made on Tuesday after the mainland markets reopened following the Golden Week holidays.

This came after investors’ optimism hit a speed bump following a hotly anticipated briefing on Tuesday by the state planner — China’s National Development and Reform Commission (NDRC) — that underwhelmed, with no new stimulus measures announced. Selling pressure ensued, with the Hang Seng Index cratering 9.4% that day while the broader MSCI China Index sank 7.8%.

The drop came after Chinese stocks staged one of the most remarkable turnarounds that started at end-September, when China unveiled its most aggressive stimulus since the pandemic, which led to the CSI 300 gaining more than 30% in a matter of days.

The cooling equity surge lends weight to the warning sounded by JPMorgan, Nomura and Invesco, which had flagged that Beijing needs to back up its stimulus pledges with real money to keep the rally going, and that much will depend on the size and implementation of the measures it plans to undertake to support the economy.

As it is, the Chinese market has entered “overbought” territory, says JPMorgan’s chief Asia and China equity strategist Wendy Liu. Goldman Sachs, HSBC and BlackRock, meanwhile, think Chinese equities still have legs as they believe the Chinese government will do whatever it takes to stimulate its economy this round.

JPMorgan’s house view is that China’s stimulus package will total about RMB2 trillion (RM1.22 trillion), says Liu, citing a research report by JPMorgan’s chief economist for greater China, Haibin Zhu. “Among the buy-siders, I think there is expectation for a higher amount of stimulus,” Liu notes.

China plans to issue special sovereign bonds worth about RMB2 trillion this year as part of a fresh fiscal stimulus, according to a Sept 26 report by Reuters. That figure has since been seen as the minimum benchmark for the stimulus package, while larger figures have been speculated, from RMB3 trillion to as much as RMB10 trillion.

Some think half of the stimulus will be for consumption-boosting measures, while the other half will go to local government financing vehicles (LGFVs) to alleviate the debt burden of local governments.

JPMorgan, however, thinks most will end up with the LGFVs.

JPMorgan was also one of the few to downgrade its stance on Chinese stocks to “neutral” from “overweight” in early September — before the mega stimulus came into the picture. At the time, it cited heightened volatility due to the upcoming US elections, growth headwinds and tepid policy support.

“The market is quite hopeful and anticipating something bigger — a ‘bazooka’, as some call it. We haven’t seen that and we’re not forecasting that. We think the measures are meant to set enough floor in growth.

“Therefore, the near term could be something of a slight disappointment. But you know, if you have a slight disappointment and the markets have been overbought, you would get a bit of a healthy correction,” Liu tells The Edge after delivering a keynote speech at the Khazanah Megatrends Forum 2024 last week.

Asset management firm Value Partners Group’s deputy chief investment officer (equities) Yu Chen Jun concurs, saying there may be volatility after such a rapid surge in the market. Nevertheless, he thinks a correction could present buying opportunities for stocks with upside potential.

“Currently, the MSCI China Index is trading at approximately 12.5 times forward PER [price-earnings ratio], with a risk premium of around 4.6%, both close to their 10-year historical averages,” says Yu, pointing to the broader index that covers both domestically traded large-cap A-shares (listed on both the Shanghai and Shenzhen stock exchanges) and shares of mainland Chinese companies listed in Hong Kong.

However, compared to its peak valuation of 14.2 times during the last major policy shift, which was China’s reopening in the second half of 2022, there is still room for growth.

“Additionally, we expect earnings forecasts to be revised upward, in line with significant policy easing. So we continue to see potential upside for the market. We believe that if policy support continues, the economy will eventually recover to its potential GDP [gross domestic product] growth rate,” Yu explains in an email response.

The CSI 300 and Hang Seng traded at more than 19 times and 13 times forward PER, respectively, during the previous peak cycles in 2015 and 2007, compared to their current levels of 14.7 times and 10.9 times.

What was disappointing about Tuesday’s NDRC briefing was how officials mainly reiterated the existing policy stance on structural rebalancing instead of laying out new, concrete measures, says JPMorgan’s Zhu in an economic note shortly after the briefing.

Still, the lack of fiscal measures does not mean such measures will be absent, Zhu notes.

“The Ministry of Finance (MoF) is in charge of fiscal policy, so it is worth watching whether the MoF will hold a press conference in the coming days, or [if] the NPC Standing Committee meeting in late October will approve additional fiscal measures involving lifting the fiscal deficit or additional government bond beyond the debt ceiling,” he says.

On Wednesday, the MoF announced it will hold a press briefing on Saturday for an update on its measures to strengthen fiscal policy to boost growth and to answer reporters’ questions.

Liu says the Chinese equity market, on average, takes 12 to 20 days to price in the maximum upside from domestic events.

“On the Fed rate cut cycle, the [duration] for equity prices to reach the maximum following the day after the first [rate] cut, very consistently, is 30 calendar days. So, we are in a very favourable period,” says Liu, given the Sept 18 rate cut announcement by the US Federal Reserve, which was followed by China’s stimulus announcement on Sept 24. “But the upside [so far] has been quite significant and exceeded what we would normally see in the [same] duration.”

There were reports that the sharp market rally was also because global investors, who had been shorting China, were scrambling to rebalance their portfolios to prevent further short squeeze.

Liu acknowledges global portfolio positioning in China has been light, but thinks a flow reversal may not be that imminent.

“Based on EPFR [data], if there is only a 25-basis-point narrowing in the underweights by all the funds tracked, the aggregate will come up to about RMB278 billion or US$40 billion [RM172 billion], which is significant.

“But it is not going to happen overnight. I think investors will want to see the actual amount of fiscal stimulus, the reform measures and how the earnings will come through, whether housing has stabilised, the impairments made during the current non-performing loans cycle, and if any recapitalisation needs to be done,” Liu says.

Value Partners’ Yu, on the other hand, believes foreign funds will be shifting back to China due to improving fundamentals and undemanding valuations. “While hedge funds have already moved quickly to reallocate, investor exposure to Chinese stocks remains low with hedge funds and mutual funds holding just 9.2% and 5%, respectively — both at the lower end of their historical ranges.”

Chinese equities also tend to trade a little better than emerging markets (EM) from Sept 1 to the US presidential election day, based on the previous three cycles, Liu observes.

“Then from the election results day to the end of the year, it tends to trade less well. Perhaps it’s because people need to price in and understand what the new presidency would mean for the US-China relationship ... and this year, we also have the Fed rate cut decision on Nov 8. Beyond year end to the following spring, China equities tend to outperform EM,” Liu says, adding this phenomenon may partly be due to seasonality like the spring spurt, but also likely reflects that by then, people would have a better understanding of what the policy would be, especially the country’s growth agenda.

“There is a sort of wave-like pattern, where closer to the end of the year, post-US election, things would clarify for Chinese equities. What the US may do in terms of tariffs has [also] yet to be priced in, so I think things would clarify more towards the end of the year, especially how it may impact 2025 growth.”

Liu says China’s macroeconomic cycle peaked in the first quarter of 2021 and is now in the fourth year of a five-year asset price adjustment period. “So far, the economy is improving year over year, but it hasn’t improved to a very strong level, so it’s getting better but not very fast.”

China is now undergoing what she calls a non-performing loans cycle, something that has yet to play out completely.

“We are starting to see more consumer credit becoming a little bit worse; there are also receivables that have lengthened in duration, particularly among companies that do business with the government. The governments are delaying payment to corporates because they are in a difficult fiscal situation.

“So, as this process goes on, we think there will be more business exits, there will be impairments, there will be write-offs and, ultimately, there will be capital injections for some of the financial institutions, which is part of the initial financial stimulus combo,” Liu adds.

Through this process, JPMorgan hopes to see more consolidation in fragmented sectors that have been overly competitive.

“The ideal result is that you get bigger companies with better market share and then higher returns on equity,” Liu says.

Liu also compared China’s equities market with Japan’s, which peaked in 1989 even though its PER multiple did not peak until 1994.

“If I were to pick the peak of equity multiple by standard deviation to historical average, vis-à-vis China, the meeting point of Japan’s TOPIX and MSCI China would be 1994 and 2021.

“Right now, MSCI China would be in the October 1997 equivalent of TOPIX. That was the final year where TOPIX had to deal with financial institution failures, recapitalisation of the banks before it emerged about a year later with an 81% upside in the next 15 months.”

As to whether China equities can expect a similar up cycle time frame, Liu says no two markets trade exactly alike.

“It almost appears like China is doing [Shinzo] Abe’s ‘three arrows’ at this moment. I think the parallel may diverge, but we don’t know,” she says, referring to the former Japanese prime minister’s three-pronged approach to revitalising Japan’s economy, which comprised aggressive quantitative easing to stimulate spending and investment, increased government spending to boost economic activities, and the implementation of structural reforms to make the economy more efficient and competitive.

“Economies go through cycles. Overly pricey asset prices will get corrected, but as that process completes, you also have a resumption of growth or normalisation of growth and normalisation of asset valuation,” she explains.

In terms of earnings growth, she says “things are getting less bad for CSI 300 and better for MSCI China”.

“If I look at earnings [growth], MSCI China last year was 11%, this year 15%, next year [likely] 11%, it’s sort of recovered. For CSI 300, last year was (a contraction of) 3%, this year (a growth of) 8%, next year (possibly) 13%. So, earnings are favourable.”

Meanwhile, corporates are increasingly using their free cash flow to buy back shares and pay higher dividends.

“I think the corporate mentality through the earnings cycle and the cash flow transition has changed, particularly among big private enterprises like the internet companies,” Liu says.

For the property sector, Liu expects it to pick up in 2025 and 2026, driven by the upgraders population, which is estimated to be 1.4 million in 2025 and two million in 2026, and viewed as significant numbers.

“I’ve been a little bit more optimistic; I think property prices could stabilise by the end of the year and then certainly by the first half of next year. Once that happens, it will help restore confidence,” she says.

Value Partners’ Yu also thinks China’s property sector appears to be nearing its bottom, with a gradually diminishing impact on GDP growth. In addition, local government debt and risks tied to the property sector have also been effectively managed, he says.

While Chinese consumer confidence remains weak, Yu says incentives such as offering subsidies of up to RMB2,000 for the trade-in of home appliances, to encourage consumers to replace old ones to boost domestic demand, are beginning to show some positive effects.

“In our view, China is likely to sustain a GDP growth of around 4% to 5% in the medium to long term, which remains faster than most of the top 10 largest economies globally. We maintain our positive outlook on the China and Hong Kong markets,” Yu says.

Liu says events to watch out for include China’s monetary policy committee sessions in late October, the US election and Fed rate decision in early November as well as China’s Central Economic Work Forum in late November or early December. The last one will be crucial for understanding China’s growth or development objectives and targets for 2025.

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