Will Federal Reserve Rate Cuts Trigger Outperformance for Chinese Equities?

No, Federal Reserve rate cuts alone are unlikely to trigger sustained outperformance for Chinese equities. While the start of Fed rate cuts may help support the RMB and allow the People’s Bank of China (PBOC) to modestly ease monetary policy, it is unlikely to reaccelerate China’s economy and ease current deflationary pressures, both of which are necessary for a sustained rally in Chinese equities. Rather, China needs a combination of increased fiscal and monetary stimulus, which appear less likely in the near term because of China’s economic policy priorities. Meanwhile, uncertainty over the US elections and future US policies toward China are keeping investors on the sideline. With these considerations in mind, investors should hold Chinese equities in line with their portfolio benchmark weight.

Chinese equities have suffered over the past three years, given concerns over geopolitics and China’s economy. Despite several short-lived rallies, the MSCI China All Shares Index remains down almost 50% from its February 2021 peak in US dollar terms. ¹ Fundamentally, for a sustained rally, China needs a rebound in domestic confidence and demand, particularly for the hard-hit real estate and consumer sectors. Although China has taken measures to contain financial risks in its property market, the government’s focus on controlling debt risks imply officials have been cautious in deploying large-scale stimulus to boost growth. Further, policy guidance following the Third Plenum re-emphasized “high-quality” growth as China seeks to build out its strategic industrial and technological sectors (green energy, advanced manufacturing, etc.), and suggests no urgency to tackle current depressed sentiments.

Meanwhile, weaker economic activity in China is translating to deflationary pressures, with July headline inflation only 0.5% year-over-year (YOY), while the GDP deflator was -0.7% YOY in the second quarter. Thus, while nominal interest rates in China appear low, real or inflation-adjusted rates have been high and restrictive on growth.

However, the desire for a stable RMB has limited the PBOC’s ability to ease monetary policy more aggressively. On the contrary, beginning in July, the central bank has taken measures to place a floor on Chinese government bond yields to support the currency, effectively tightening monetary policy. Impending Fed rate cuts may eventually ease pressure on the RMB, but uncertainty over the timing and magnitude of the PBOC’s response remains.

Weaker growth and inflation have impacted Chinese corporate earnings, although the declines seen in trailing earnings and return on equity (ROE) have bottomed out. Analysts’ expectations for Chinese corporate earnings growth in 2024 and 2025 have been revised down but remain healthy at 14.4% and 11.8%, respectively, versus estimates for global equities at 9.8% and 13.6%.

Current valuations for Chinese equities remain very low, especially relative to global equities. As of July, the MSCI China All Shares Index traded at around 10x earnings across the forward price-earnings (P/E), ROE-adjusted P/E, and normalized price–cash earnings ratios. A composite of these metrics is at the 14th percentile relative to history, while valuations relative to global equities have rarely been cheaper. Depressed equity valuations suggest negative sentiments and risks are largely priced in, thus offering significant upside potential should China’s growth outlook improve.

Overall, Chinese corporate fundamentals have stabilized, and equity valuations are attractively priced for significant upside gains. However, unlocking this value requires a rebound in China’s domestic sentiments and demand, which will take time absent additional policy support. The same was the case for Japanese equities during the 1990s and early 2000s; the market would meaningfully outperform global equities when government stimulus triggered growth rebounds in the absence of domestic demand. While China’s caution in deploying more aggressive stimulus is largely tied to its policy priorities, there are also views that the government may be saving firepower until after the US elections to adequately respond to any new policy actions (e.g., increased tariffs on Chinese exports to the United States). Yet, US policies toward China will not be clear until well after the election results and a new Congress takes over in early 2025. Given the uncertainties surrounding China, we recommend that investors be neutral on a tactical basis.

Aaron Costello, Head of Asia

Vivian Gan, Associate Investment Director, Capital Markets Research

Footnotes

1. Based on daily total net return data as of August 23, 2024.