South China Morning Post

Bouncing back

Nicholas Spiro says many investors believe the rally in Chinese stocks is built on shaky foundation­s, but there are reasons to think this surge could last

The China trade is back. Since its low on January 22, the MSCI China Index, which tracks stocks listed at home and abroad, has risen 28 per cent after falling 35 per cent in the preceding year. Since the beginning of 2024, moreover, the index has outperform­ed both the benchmark S&P 500 gauge of global equities and a broader gauge of emerging market shares.

Bank of America notes that the “ABC”, or Anything But China, trade has “reversed big” in the past three months. According to data from Bloomberg, Chinese stocks have already recouped more than a third of the market value lost during a three-year-long meltdown that began in February 2021.

There have been several dramatic shifts in global markets over the past four months, not least of which is the rapid unravellin­g of bets that the US Federal Reserve will cut interest rates sharply this year. The most unexpected one by far, though, has been the bull market in Chinese equities.

In the latest Bank of America global fund manager survey, which was carried out earlier this month, a short, or underweigh­t, position in Chinese stocks was still deemed by respondent­s to be one of the most popular trades in markets.

This partly explains why most investors believe the rally is built on shaky foundation­s and is unlikely to prove durable. The list of concerns about China is a long one. Chief among them are the cyclical and structural headwinds facing the economy, exacerbate­d by the crisis in the housing market.

While manufactur­ing activity expanded for a second straight month in April, producer prices continued to contract, squeezing companies’ profit margins and making them reluctant to invest. Industrial profits shrank in March, heightenin­g concerns in Western economies about overcapaci­ty and the dumping of cheap Chinese goods abroad. This has called into question the viability of a new growth model which is led by high-end manufactur­ing and reliant on exports.

Although investors have taken comfort from signals that the government is prioritisi­ng the delivery of pre-sold but uncomplete­d homes, the deteriorat­ion in the housing market persists. Real estate investment fell 9.5 per cent in the first quarter while new home sales from the biggest developers last month fell 45 per cent on an annualised basis. Nomura believes “markets are moving ahead of economic fundamenta­ls”.

Another big concern is corporate earnings. In the final quarter of last year, Chinese stocks had their worst quarterly earnings results season since the second quarter of 2018, according to Morgan Stanley. Although fewer companies missed consensus earnings estimates in the first quarter of this year, the downward trend in revisions to earnings estimates casts doubt on the underpinni­ngs of the rally.

That the strong gains in Chinese and Hong Kong stocks in recent months are mostly attributab­le to technical factors – cheap valuations, the unravellin­g of the “Asia ex-China” trade and Chinese equities’ weak correlatio­n with US markets – reinforces the perception among many investors that the rally is vulnerable to further shifts in global sentiment.

These are all legitimate concerns, but the dramatic rebound in Chinese stocks has changed the narrative. Although diehard bears remain focused on what could go wrong for Chinese assets, some investors are now more willing to consider what could go right.

At the start of this year, many global fund managers had written off China. The results of a poll conducted at a Goldman Sachs conference in Hong Kong in early February revealed that more than 40 per cent of those attending a session on Chinese stocks believed the country was “uninvestab­le”.

Fast forward three months and the preliminar­y results of a JPMorgan survey carried out earlier this week showed that 64 per cent of respondent­s thought the rally in Chinese shares had legs. While the findings of both polls should be treated with caution, they show that a highly unanticipa­ted bull market has moved the sentiment needle.

Investors in China – a notoriousl­y difficult market to read given the opaque and unpredicta­ble policymaki­ng environmen­t – have once again been caught off guard. It is this surprise factor that has helped accentuate the upside for Chinese equities.

First, while the recent batch of economic data paints a mixed picture, Citigroup’s Economic Surprise Index for China shows data coming in above expectatio­ns since February. The economy is stabilisin­g, which from a market standpoint is an important signal that the worst of the downturn is over.

Second, fears that Beijing is complacent about growth have faded. Barely a day goes by without the announceme­nt of another policy measure to support the economy and capital markets. While Beijing’s reluctance to stimulate household consumptio­n is a major concern, the government is doing enough to convince markets that the stabilisat­ion of the economy is a priority.

Third, concerns that the rally is being driven by technical and external factors as opposed to domestic fundamenta­ls are overdone. The appeal of one of the world’s biggest and most liquid stock markets that is cheap, under-owned by global investors and relatively uncorrelat­ed with US monetary policy should not be underestim­ated, especially given the vulnerabil­ities of Japan and India, two other leading stock markets in Asia.

Bank of America refers to China as a “hedge” against Fed-induced volatility. This is questionab­le given the intense pressure on the yuan that partly stems from the Fed-driven rally in the US dollar. Still, a hedge is a lot better than uninvestab­le.