Warming up to the potential of China’s equities

An overly cautious approach may mean missing out on fresh returns from the world's second-largest economy. Kate explains.

Powerful structural and cyclical forces make China’s equities attractive to investors. The key reasons? Global reflation and a domestic cyclical upswing should be supportive. See the BlackRock GPS for China. Progress on domestic structural reforms and undemanding valuations add to China’s attractiveness.

An increasing debt load, persistent capital outflows and a potential trade war with the U.S. under the new Trump administration have made investors wary of China. Yet trade is a smaller growth driver than in the past, and China is strengthening ties within Asia and making its economy more consumer-driven.

Performance conundrum

Chinese equity returns have trailed the nation’s spectacular growth since 2000, underperforming emerging markets such as India. Structural problems (resulting from the 2009 stimulus) and declining multiples have weighed on equity returns since the financial crisis.

Companies have enjoyed solid earnings growth, but high levels of investment have left little to distribute to shareholders. China H-shares—listed on foreign exchanges such as Hong Kong—have fared better than A-shares—listed on onshore exchanges. See the chart below.

chart-BII-investors-rewarded

These dynamics should change as policymakers in Beijing press ahead with reforms, domestic and offshore valuations converge, and China is admitted to global equity indexes.

“Old economy” sectors such as materials, industrials and financials are still overrepresented in the domestic A-share market, but “new economy” companies in consumption-driven sectors such as technology and services accounted for half of the IPOs in the A-share market in 2016, we calculate.

The eventual inclusion of domestic A-shares in indexes should expand the representation of China in global capital markets and attract a broader group of investors. China’s onshore and offshore markets are set to converge, attracting a more stable and less speculative investor base. This begs the question: Are Chinese equities investible? And where are the greatest opportunities today?

It may be tempting for investors to focus exclusively on “new economy” stocks given the high indebtedness and mature growth rates of some industrial and manufacturing companies. Yet we also see opportunities as the programs to reduce capacity and improve profitability in overbuilt heavy industries such as steel and coal are broadened to other industries over the coming years.

Trumped on exports?

The biggest immediate risk to Chinese equity markets is a breakdown in global trade. U.S. President Donald Trump has threatened to raise tariffs on imported goods from China, while a U.S. congressional proposal could result in a 20% border adjustment on imported products and components.

China has become less dependent on exports to the U.S. than in the past, and net exports’ contribution to gross domestic product (GDP) has also declined. Yet any curbs on Chinese exports could hurt the country’s technology and energy industries, which draw about one-fourth of their revenue from overseas. Other sectors such as consumer staples and utilities are less dependent on foreign sales.

China, meanwhile, is far from passive. Its leadership has been laying the groundwork for deeper ties with Asian trade partners through the Asian Infrastructure Investment Bank and the One Belt, One Road development program.

Bottom line

We see Chinese stocks supported by an accommodative and flexible policy that aims to stabilize growth ahead of the 19th Party Congress this fall. The near-term upside may be capped by trade tensions and the pace of structural reforms. There is also China’s ever-growing debt pile to monitor. But over the medium term, we believe Chinese equities are an attractive, and under-owned, asset.

Many of the challenges are discounted in market valuations, and profitability is improving thanks to supply-side reforms. The ongoing liberalization of the financial system will gradually make it easier for foreign investors to participate directly in China’s markets. Read more on this in my Global Equity Outlook.

Kate Moore is BlackRock’s chief equity strategist, and a member of the BlackRock Investment Institute. She is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal.

International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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