China's stealth rally

Author: Matthew Poterba, CFA

Although China has become one of the most polarizing stock markets in recent years, we believe there remain significant opportunities that investors should not write off. Many investors perceive China’s economy is in shambles, is plagued by geopolitical tensions, and incorporates overbearing regulatory crackdowns. This perception has led to near-record underweights in Chinese equities among global investors and huge valuation discounts relative to other markets.

Perception versus Reality

Contrary to this bleak view, Chinese stocks have staged a remarkable comeback this year and are outperforming most major markets since January (Chart 1).

The reality is that there are numerous positive developments that help explain Chinese stocks’ strong year-to-date performance:

1. China’s macroeconomic data has beaten expectations. PMIs, GDP growth, and exports have come in better than expected, suggesting growth is more resilient than anticipated (Chart 2).

2. China has pivoted away from restrictive policies toward a pro-growth and pro-markets stance. Recent challenges resulting from restrictive policies such as Zero Covid, forced property deleveraging, and the regulatory crackdown on internet companies have given way to increasing accommodation. Since the start of the year, significant monetary easing and rate cuts have been accompanied by heavy pro-growth rhetoric. China’s sovereign wealth fund directly intervened in markets, buying ETFs and stocks. And policymakers announced plans for shareholder-friendly reforms including stronger investor protections and more stringent capital markets supervision.

3. Icy sentiment toward China has started to thaw. A growing number of investors have begun to turn more constructive on Chinese stocks. Managers’ underweight China positions appear to have troughed. And stronger price momentum has driven some net buying by faster-moving quant and hedge funds. Although sentiment is only just beginning to recover off deeply negative levels, sustained outperformance may force managers to add China exposure to limit the drag from their large underweights.

Markets may be catching back up to fundamentals

Historically, Chinese stocks perform well when their earnings are accelerating, but this was not the case during the latest acceleration (Chart 3). The recent earnings recovery stands out as abnormal relative to accelerations in the prior two decades, and last year’s deteriorating investor sentiment may explain a lot of the weak 2023 performance. If accelerating Chinese earnings and policymakers’ continued easing drives a sustained improvement in sentiment, the near-record discounts on Chinese stocks may diminish in 2024 as the market catches up to improving fundamentals.

Looking Ahead

Despite negative headlines, reality paints a different picture. Focusing on China’s fundamentals reveals a resilient economy with accelerating corporate profits, more decisive policy action, and tepid improvements in sentiment. Investors’ enormous underweight to Chinese stocks this year despite it being one of the best-performing markets during 2024 has likely dragged on their performance. We continue to look beyond the perception of the Chinese market, staying anchored in fundamentals rather than swayed by headlines.