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China’s equity market today has many notable qualities. Among the most striking is that it is the least expensive major equity market in the world (Figure 1). Not only is it inexpensive relative to other markets, but it is also at the bottom of its own long-term valuation range.
We know from extensive research over lengthy periods of time that valuations matter — they are reliably a key driver of future relative performance for both stocks and markets, with lower starting-point valuations having a strong and consistent relationship with higher future returns.
Not only is China attractively valued today, but investors’ expectations are at depressed levels. Investor sentiment, having been worn down by both geopolitical concerns and the weak performance of the Chinese domestic economy since the end of the zero-COVID policy, does not price in any significant likelihood of improvement in either overall economic growth or company-level fundamentals. However, to paraphrase Warren Buffet, “the time to be greedy is when others are fearful.”
Against market expectations, I believe it is within scope for China to surprise investors on the upside. The good news is that the primary ways in which this surprise could happen are either in the hands of domestic Chinese authorities or potential developments in the Chinese domestic economy. To summarize, we do not need a lessening of geopolitical tensions, or an improvement in international investor sentiment to unlock material return potential in Chinese equities. As we saw in July of this year, even the hint of a more constructive fiscal or monetary stance from the Chinese authorities is enough to bolster strong returns.
What could potentially catalyze a rebound in performance? There are three things I am keeping an eye on:
Any or all of these factors could materially support domestic sentiment within China on top of improving the country’s economic outlook.
Where do I see the greatest opportunity? Without question, in domestic consumption-related plays and companies that are not reliant on either imports from or exports to the West. While it is unlikely geopolitical tensions between the West and China will dissipate soon, there is, in my view, far more to the Chinese economy beyond its perceived reliance on being an export-driven manufacturer for developed economies. Although few investors seemingly recognize this, China is one of the least trades-driven economies in the world (Figure 2). Put another way, China is among the world’s most domestically oriented economies. For this reason, I see compelling opportunities today in high-quality companies catering to domestic demand in food, household goods, media and entertainment, and logistics industries.
While I would not describe myself as being strongly “bullish” on China today, I do think it’s fair to say that there is a reason for optimism, and that the concerns held by many international investors are based more on negative news headlines rather than underlying economic realities.
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