Is the Decline in Chinese Equities Justified by Market Fundamentals?
We don’t think so, as the markets are pricing in more severe conditions than we believe are warranted. The MSCI China Index, which tracks Chinese stocks listed in both Hong Kong and the United States, has sold off sharply thus far in March and is down roughly 25% year-to-date, and over 50% from its February 2021 peak. This marks the worst drawdown since the 2008 Global Financial Crisis when the index fell over 70%. Onshore A-shares have fared better but are still down about 15% year-to-date and over 20% since February 2021.
Chinese equities are being hit by three different issues: US-delisting concerns, the impact from increased COVID-19 lockdowns, and risks surrounding global sanctions on China related to support for Russia. Much of the risk is likely priced in given that some of these concerns are either overblown (US delisting), temporary (COVID-19 restrictions), or unlikely (global sanctions). Holding onto Chinese assets now provides optionality should the worst-case scenario not occur, given China’s economic interests and long-term strategic goals suggest avoiding global sanctions is more important than supporting Russia.
US-listed Chinese stocks have been under heavy selling pressure since March 10, when the Securities and Exchange Commission notified five companies that they will be delisted in early 2024 unless they submit their underlying audit papers to US regulators, per the Holding Foreign Companies Accountable Act (HFCAA) passed in December 2020. Concerns around US delisting are an overblown reaction to headlines, as 90% of US-listed China stocks (by market cap) already have secondary HK listings or are eligible for one. Given the shares are fungible, institutional investors can easily switch from US to HK listings, and many investment managers and index providers have already done so. Furthermore, the March 10 SEC notice reaffirmed that Chinese companies still have two years to comply with the HFCAA. In other words, the risk that investors will be stuck with illiquid, delisted American depositary receipts is overblown, and the SEC notifications last week provided no new information.
This week’s market action is more likely being driven by concerns that a worsening COVID-19 outbreak in mainland China could result in widespread lockdowns and a hit to economic activity. The major cities of Shenzhen and Shanghai are already facing COVID-19 restrictions. Given China’s “Zero-COVID” policy, further spreading of the virus could have a large impact on the economy. While this risk does pressure fundamentals, justifying some market decline, ultimately the economic impact will be temporary, just as the impact of COVID-19 on global markets in 2020 was short lived. Further, slowing growth could prompt the People’s Bank of China (PBOC) and Chinese authorities to launch additional monetary and fiscal stimulus to offset the impact, conditions already anticipated following China’s recently announced 2022 GDP growth target of 5.5%. Selling Tuesday may have been amplified by the PBOC disappointing markets by not cutting lending rates but only injecting additional liquidity into repo markets. This was perhaps due to economic data showing an economic acceleration is already underway.
The third factor driving the selling is concerns over potential sanctions on China, should China decide to support Russia either militarily or economically related to the war in Ukraine. The United States has raised concerns that China may do this, and US and Chinese representatives met yesterday to discuss the situation. Today, China’s foreign minister stated China wants to be a neutral party in the Ukraine crisis and avoid any global sanctions, but also threatened to retaliate if sanctions were imposed on China, increasing investor concerns. Global sanctions on China would hurt both trade and economic growth in China and hit global supply chains and profits. Sanctions could also result in global investors being forced to divest Chinese assets, similar to the situation with Russian assets. However, such conjecture is premature, and the economic realities suggest that China would not risk aiding Russia. Chinese exports to the United States and EMU dwarf those to Russia by about 15:1. Furthermore, China would risk losing access to key technology imports and access to USD assets/banking systems before meeting its long-run strategic goals of becoming technologically and monetarily independent of the United States. Thus, for China the risks outweigh the benefits of aiding Russia, and China will likely seek to avoid global sanctions. Yet China’s actions deserve close watching.
Chinese equities have already fallen over 50% from their recent high. Momentum is at extreme oversold levels and valuations have hit record lows in absolute and relative terms. Among the three risk factors disrupting Chinese equities, the risk of sanctions has likely most unnerved investors and is hardest to calibrate. Furthermore, the war in Ukraine also puts pressure on Chinese growth prospects stemming from higher commodity prices and slowing global growth. Longer term, prospects for global businesses to revisit the benefits of offshoring production could also weigh on China’s growth prospects. While near-term volatility will likely remain high, long-term returns from Chinese equities at these valuations should be compelling assuming global sanctions are avoided, and US and European investors maintain access to Chinese assets. Given China’s economic interests and long-term strategic goals suggest avoiding global sanctions is more important than supporting Russia, we see the worst-case scenario as unlikely. Arguably Chinese equities have never offered a larger risk premium than now for investors that can tolerate the volatility.
Aaron Costello, Managing Director, Capital Markets Research