Chinese equity markets are having a terrible year with the MSCI China Index being one of the worst-performing global benchmarks currently. With the effects of the ongoing regulatory crackdown season still in play as of today, the stock market received the equivalent of a body slam again, thanks to jitters over an impending debt default from China Evergrande Group — one of the largest property developers in the country.
When the slow but inexorable Evergrande crisis suddenly fell into the public eye recently, Chinese stocks saw yet another plunge, pushing them into their furthest divergence in performance from Emerging Market (EM) stocks in modern history (See Charts 1 and 2).
Chinese stocks are increasingly widening the gap with Emerging Markets
After outperforming EM stocks for the better part of a decade, Chinese stocks have been decisively overtaken by EM stocks in the near-term, with the MSCI China Index delivering a “mere” 20% return as compared to the MSCI Emerging Market ex-China’s 80% gain since the stock market’s March 2020 lows.
Zooming out to a 20-year timeframe, this correction has been so severe that the difference in returns between EM equities and Chinese equities are actually now at their widest point in years (i.e. China’s stock market returns are now significantly lagging EM counterparts when using most timeframes), a remarkable development given China’s massive economic growth during this period.
Looking back even further, EM economies in past decades have seen their stocks (and economies) largely track rises and falls in China’s economy. This relationship however appears to be breaking down in recent times, with both markets now appearing to be going their own way.
From Table 1, we can see that the MSCI China tends to be heavier on technology-heavy mega-cap stocks such as Tencent and Alibaba as compared to the MSCI EM ex-China Index. The MSCI EM ex-China Index on the other hand, is rather geographically split, with significant exposure to Taiwan, India and Korea.
Quite notably, at least six of the 10 largest constituents in the MSCI China Index has been a recent target of Chinese regulators over the past few months (since last November for Alibaba), as part of a wider dragnet that has caught other companies such as Didi Chuxing, Bilibili, and Sohu in its wake.
This event alone has effectively plunged at least one-third of the index into turmoil over the past halfyear, and driven risk-off sentiment in the wider Chinese stock market as well, as investors remain wary of where the regulatory crosshairs will land next.
Has bearish momentum in Chinese stocks swung too far?
Besides EM stocks, Chinese stocks are now also trading at the biggest discount to global stock market benchmarks as well. Chinese tech giants such as Meituan and JD.com are also notably trading at tantalisingly low valuations — although they should arguably be compared to the likes of the US FAANG companies.
As can be seen from the company data above, Chinese technology mega-caps continue to record high growth on par with the likes of Amazon and Netflix and are even outperforming technology stalwarts such as Apple and Alphabet. However, their year-todate returns continue to greatly lag their US counterparts and have given pause to even the most cautious investor.
However, it remains unknown what the fair price of Chinese technology stocks will be, given the uncertainty surrounding the ongoing regulatory crackdown under President Xi Jinping’s recently declared “common prosperity” drive. Ultimately, this “political risk premium” may be too steep and too much of an unknown for many investors to think about.
Implications: So … what do we know?
1: Credit growth is likely to slow
China Evergrande’s woes will very likely have implications on China’s future credit growth, as this crisis is only one milestone in regulators’ ongoing fight to de-leverage the economy and reduce financial risks. Certainly, credit in China is likely to grow much slower in the coming years at least, given the signs of moral hazard in the credit market that has led China Evergrande to this juncture.
With the Chinese government now appearing to be unwilling to signal a bail out for Evergrande — as the market has tended to assume that it will do in the past, this is an implicit warning that lenders will have to assess their borrowers more stringently than in the past, with “non-productive” investments likely to fall out of favour. Xi has personally called out such investments as “fictional growth” as opposed to “genuine growth” and investors would do well to heed his thinly-veiled warning towards such lending behaviour.
2: Chinese technology/growth stocks may require a downgrade
With lower credit growth, one of the major implications will be a more-or-less inevitable decline in economic growth. While the scale of the decline is something that is hard to model in the current stage of the Evergrande crisis, one thing is certain — growth stocks tend to have priced-in expectations for future earnings into their fair value.
As Chinese economic growth forecasts take a hit in the coming months, it may be almost necessary to take another look at the Chinese technology companies again — particularly those with double-digit growth expectations and recognise that it will probably be necessary to realistically price in downward revisions in their fair value.
Mooris Tjioe is an investment analyst with Phillip Futures
Photo: Ralf Leineweber/Unsplash
