The Chinese market’s private equity at 8.2x 12-month forward earnings per share is currently at levels only seen six times in the past 10 years. In five out of these six occurrences, Chinese equities rose over the following six months.
In addition, in four episodes, the rise was more than 20 per cent.
In our view, Chinese equities are now priced for one of the most downbeat scenarios in the past decade.
Any improvement in the short to medium-term outlook would likely trigger a material repricing and bring valuations back in line with longer-term averages.
The dislocation in valuations relative to the rest of the world is even larger.
Even if US equities are excluded from the global aggregate, relative valuations of Chinese equities are trading at the largest discount to global equities in the past 20 years.
Recent efforts by authorities underline their commitment to halt the rout
What would be the trigger for this gap to close?
We think the macro policy easing is in place to deliver some upside potential in the short term.
What has not sufficiently been addressed yet is the policy and geopolitical uncertainty that weighs on sentiment.
However, while liquidity measures over recent weeks failed to stem the rout, the increasing commitment and reported direct involvement of President Xi Jinping indicates that authorities are willing to put a price floor, even if it comes at a cost.
While some short-term upside persists, long-term issues remain unresolved
This does not improve the long-term outlook for Chinese equities however.
In order to see Chinese equities outperform over coming years, either of the two (or both) would be required:
- China's GDP growth to remain at current levels or accelerate; or
- profitability in the private sector to improve.
The operational leverage of Chinese-listed firms has been substantially weaker than in other regions.
In past decades, Chinese earnings growth, for example, has only outpaced US earnings growth when China’s GDP growth was more than 5 percentage points above the US.
As this is unlikely to be the case on a sustained basis in the future, Chinese companies would have to become substantially more profitable to improve their outlook. The trend over recent years suggests the opposite.
The return on equity has been falling consistently over the past 5 years, countering the picture in other major markets while net income margins are trailing substantially.
Mali Chivakul is an emerging market strategist at J Safra Sarasin Sustainable Asset Management
