Money

Contrarian opportunity or value trap?

Published

13 hours ago

September 19, 2024

If accolades were based on economic growth, the 21st century would belong to China.

It entered the new millennium with an economy smaller than Italy’s but, fast-forward a couple of decades, it now adds the equivalent of an economy the size of Italy’s to its growth every other year.

On a humanitarian level, China’s success story has been nothing short of remarkable, too. It has lifted almost all its population out of extreme poverty – a figure that stood at close to 50% in 1999.

The inner contrarian in me is twitching. Is this a multi-year buying opportunity?

Until recently, the equity market was rampant. In the years leading up to mid-2021, Chinese equities returned approximately two times the gains of their developed market counterparts.

The past three years have been an altogether different story, however, with Chinese equites underperforming the MSCI World index by a staggering 65%.

The inner contrarian in me is twitching. Is this now a multi-year buying opportunity?

Putting shareholders second

Corporates and investors alike have clamoured to enjoy a slice of China’s fruitful GDP pie, eagerly setting up businesses via joint operations or accessing capital markets, where possible. With such rampant growth, local equity markets would normally benefit through increased corporate profitability and investor flows.

However, while nominal aggregate earnings have increased a stellar 14% compound annual growth rate between 2007 and 2023, earnings per share have lagged considerably, growing at a meagre 4% p.a.

As China’s economy grew and corporates evolved into behemoths, so did their influence – a problematic development in a single-party political system

Chinese corporates have been mammoth issuers of shares, a policy move contrasting sharply with the share buyback policies of US technology giants and the de-equitisation of developed markets.

As such, as well as corporate governance, companies’ capital allocation strategies should be high on investors’ priorities when reviewing Chinese equities.

As China’s economy grew and corporates evolved into behemoths, so did their influence – a somewhat problematic development in a single-party political system. When the Chinese authorities reasserted their dominant position, investors proved flighty, with capital flows sharply reversing.

Foreign direct investment, once embraced by the authorities as an opportunity to drive liberalisation of the economy, is now increasingly treated as if it were a threat to sovereignty.

China now finds itself in a deleveraging spiral – the demand to borrow is falling faster than the cost of borrowing

However, perhaps more importantly superseding all this, the once seemingly unstoppable growth train has hit a speed restriction. Chinese property, the preferred investment asset of the burgeoning middle classes, is experiencing a painful period of price adjustment and forced deleveraging.

The People’s Bank of China has been cutting interest rates over the past three years, contrary to almost every other central bank globally, yet growth continues to slow. Chinese banks recently marked their first credit contraction in almost 20 years, despite bond yields close to secular lows, indicating cheap credit is not enough to stimulate the economy.

China now finds itself in a deleveraging spiral – the demand to borrow is falling faster than the cost of borrowing.

One antidote to monetary unresponsiveness would be a large fiscal impulse from the government to stimulate aggregate demand, yet no such splurge appears close, with China’s fiscal expenditure only marginally growing year-on-year.

When considering the correct multiple to apply to Chinese earnings, investors should be aware economic conditions have not yet fully stabilised

This dynamic is now beginning to reveal itself in many areas of US and European markets, too. And not just those solely sensitive to China’s industrial cycle. The spillover of a slowdown is also being felt in luxury goods multinationals, such as Burberry and Richemont, which have reported falling sales within China of 21% and 23% respectively. Western markets are not immune to China’s growth glitches.

Value closer to home

In May this year, after a bounce in performance, we took the opportunity to sell our only dedicated China A-shares focused fund. Chinese equities now trade at a similar multiple to the equally unloved UK market, yet UK corporates are increasingly recognising the need to unlock value in their companies through capital allocation polices, such as share buybacks.

Furthermore, contrasting to the Chinese slowdown, UK economic growth estimates are being revised higher and are expected to eclipse the pace of expansion in the US economy – a meaningful turnaround given the stagnant economy narrative.

For a contrarian craving, we contest the need to look far afield

In other developments, although perhaps not quite as stable as the Chinese Communist Party, the UK Labour Party now has at least five, possibly 10, years in power, given the size of its majority, putting the country on a more even-keeled political footing for the first time in a decade.

When considering the correct multiple to apply to Chinese earnings, investors should be aware that economic conditions have not yet fully stabilised.

Aggregate earnings remain vulnerable to further contraction, there’s little sign of corporates slowing issuance or turning to buybacks to recognise equity value and international investors are devoid of confidence.

Such a dynamic could mean both the price and earnings remain questionable. For a contrarian craving, we contest the need to look far afield.

Adam Norris is investment manager at Columbia Threadneedle Multi Manager

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