Special Report
Highlights Our market-based China growth indicator has risen meaningfully since mid-December, but mostly due to the equity components. For now, we regard this as a mixed signal, rather than a green light for Chinese stocks. Our research suggests that the odds of a serious earnings contraction for Chinese investable stocks over the coming year are high. Stocks are only likely to bottom near the end of the earnings adjustment process, if the 2014-2015 episode is a guide. Despite reasonable relative valuation, the long-term downtrend in sales-to-GDP suggests that Chinese stocks may be a “value trap” even over a multi-year time horizon. Feature Over the past several months BCA’s China Investment Strategy service has focused heavily on the cyclical condition of China’s economy, and whether any “green shoots” are evident from the key indicators that we track. We noted in last week’s report that our leading indicator for China’s old economy continues to point to slower growth over the coming months,1 a conclusion that is generally supported by the December trade, money, and credit data. In today's special report we address six questions concerning the outlook for Chinese stocks in light of passive outperformance versus the global benchmark over the past 3 months. We highlighted in last week’s report that investors should not view recent outperformance as a positive cyclical sign for Chinese stocks, and our answers to the questions below will hopefully provide readers with a fuller understanding of our neutral stance over a 6- to 12-month time horizon. The bottom line of our analysis is that a cyclical (6-12 month) overweight stance toward Chinese investable stocks versus the global benchmark remains uncompelling until the earnings contraction that is likely to occur this year is well underway. Chinese stocks offer reasonable-to-good valuation relative to global stocks, but may be cheap for a reason even over a multi-year time horizon. We remain tactically overweight Chinese investable stocks in recognition of the fact that investors may bid up the market in the lead-up to a possible trade deal with the U.S., but a legitimate improvement in domestic fundamentals is likely needed before we recommend investors upgrade their medium-term equity allocation to China. Q: Are the market signals from China-related assets bullish or bearish for Chinese stocks? A: Our market-based China growth indicator has risen meaningfully since mid-December, but mostly due to the equity components. For now, we regard this as a mixed signal, rather than a green light for Chinese stocks. Chart 1 presents our market-based China growth indicator, its four asset class subcomponents, and the range between the strongest and weakest components. Table 1 shows the change in the indicator and its 17 individual components since December 10, when the indicator clearly broke out. Chart 1Largely Driven By EM Equity Relative Performance Both the chart and the table make it clear that the recent rise in the indicator is not uniform. While it is true that most of the individual components have improved over the past month, the equity components and two currency measures (the inverse of the dollar and Asian currencies), especially CNY-USD have accounted for most of the gains. Table 1(Anomalous) Equity Relative Performance Has Driven The Recent Improvement In Our MBCGI As we noted in last week’s report, the Q4 outperformance of Chinese / emerging market stocks has been passive in nature, meaning that they have outperformed simply because developed market equities have collapsed. This, in combination with the fact that the strongest currency components have been linked to declining interest rate expectations in the U.S., tell us that the aggregate indicator has largely risen due to a 1) generalized selloff in global risk assets, 2) perceptions of easier Fed policy, and 3) a modest improvement in sentiment concerning the U.S.-China trade war. While it would not normally be the case that a global equity selloff would cause the equity component of our indicator to rise, December was atypical because many China-related assets had already declined in advance of the selloff. Are the latter two factors noted above reason enough move to an overweight stance towards Chinese stocks over the coming 6- to 12-months? In our view, the answer is “not yet”. While easier U.S. monetary policy is certainly welcome (particularly given our view that a recession is unlikely), it is not yet clear that either of the negative factors waiting on Chinese stocks in absolute terms will be resolved over the coming year. The first factor is the trade war with the U.S. We agree that the odds of some sort of a deal that avoids further tariff imposition have risen significantly over the past two months, more than we anticipated in the lead-up to the G20 meeting in Argentina. However, given the deep, structural nature of the dispute between the U.S. and China, we think it is dangerous to pre-emptively act on an agreement that may not come or may take much longer to be reached than investors currently hope. This risk is in addition to what is likely to be a deceleration in export growth over the coming few months regardless of the outcome of negotiations, as the export front-running effect that has boosted trade volume over the past several months wanes. But as we address in the next question, the second negative factor impacting Chinese stocks is the upcoming impact of a slowing domestic economy on Chinese earnings, an effect that is not likely to be impacted by the changes in the global economy implied by financial markets since mid-December. Q: What is the outlook for Chinese earnings growth over the coming year? A: Our research suggests that the odds of a serious earnings contraction over the coming year are high. Chart 2 presents an update to a model for Chinese ex-tech (or “old economy”) earnings growth that is part of our analytical toolkit.2 The model paints a rosy outlook for earnings growth, suggesting that it is set to decelerate over the coming year but will continue to grow at a double-digit rate. Chart 2The Li Keqiang Index Suggests Ex-Tech Earnings Growth Will Stay Positive... However, one problem with the approach used in Chart 2 is the fact that we have used the Li Keqiang index (LKI) as the independent variable in the model. Historically the LKI has reliably led ex-tech earnings growth, but we have highlighted several times over the past few months that the index is currently being supported by trade front-running activity that is very likely to wane, a view that is strongly consistent with the very negative December trade data that was released earlier this week. Chart 3 presents a different approach, namely the prediction of the odds of a serious investable equity earnings contraction over the coming 12-months (defined as earnings growth falling below -5%). The statistical approach taken in Chart 3 (logistic regression) is similar to that often employed by researchers attempting to predict the odds of a recession, and the chart shows that the model successfully warned of the two major earnings contractions over the past decade. Crucially, the odds of a major contraction did not rise about the 50% mark in 2012, when investable earnings growth decelerated significantly and fell briefly into negative territory. Chart 3...But Other Measures Imply High Odds Of An Outright Contraction The current message from the model is clear: the odds of a significant earnings contraction over the coming 12-months are as high as 70%, implying that the deceleration in 12-onth trailing earnings growth shown in panel 2 of Chart 3 is likely to continue. Q: If earnings are set to contract, when will investors anticipate a recovery? A: Near the end of the earnings adjustment process (for investable stocks), if the 2014-2015 episode is any guide. Chart 4 presents some perspective on the issue of when investors are likely to anticipate an eventual bottom in earnings if a contraction does indeed occur. The chart shows the level of 12-month forward earnings for investable and domestic stocks, and circles at what point stocks in each market bottomed during the massive selloff in the Chinese equity market from 2014-2015. Chart 4The Forward Earnings Adjustment Process Has Yet To Begin The chart shows that the domestic market bottomed roughly halfway through the earnings adjustment process, whereas the investable market bottomed almost at the end of the process. The chart also shows that this adjustment process has barely begun, which (in combination with Chart 3) currently argues against a cyclically overweight stance towards global stocks. Q: In the developed world (particularly the U.S.), elevated profit margins are viewed as a potential risk to earnings over the coming few years. Is profit margin mean-reversion a risk in China? A: Based on the absolute level of profit margins, no. Relative to the history of poor profitability for Chinese stocks, yes. Chart 5 shows the 12-month trailing profit margins for global and investable Chinese stocks. It shows how global margins have now moved past their previous cycle highs, a circumstance that is even more extreme in the case of the U.S. Chart 5Chinese Profit Margins Are Very Low, But Very Elevated Relative To Their History Investable Chinese margins are very low, which at first blush implies less risk of a mean-reversion assuming a common mean. However, panel 2 shows that Chinese investable margins are as high relative to their own history as they are for global stocks, and they have followed a similar pattern over the past few years. This suggests that the central tendency for Chinese margins is indeed significantly lower than it is for the global benchmark, and that the risk of mean reversion is similarly elevated in the face of a major economic shock. How is it possible that Chinese investable ROE has been similar or even higher than that of the global benchmark, but that profit margins are substantially lower? The answer, with very high likelihood, is leverage. Panel 1 of Chart 6 shows ROE for both markets, whereas panel 2 shows ROE divided by the profit margins shown in Chart 5. Using the DuPont approach to decomposing ROE, ROE divided by profit margins is equal to sales over equity, or the product of the asset turnover (sales/assets) and leverage (assets/equity) ratios. Panel 2 shows that product of turnover and leverage is more than twice that of global stocks, implying that Chinese companies are either extremely efficient in the use of their assets to generate sales, or they are very highly levered compared with global stocks. Chart 6High Chinese ROE The Result Of High Leverage The latter is overwhelmingly more likely. We presented evidence in our August 29 Special Report suggesting that Chinese state-owned enterprises (SOEs) now have a negative net return on borrowed funds,3 a situation that has been caused by persistent leveraging since 2010. Not only does this explain the low profitability of Chinese stocks, it also magnifies the risk of significant mean reversion beyond a 6-12 month time horizon if Chinese policymakers panic and aggressively stimulate credit to stabilize a slowing economy. Q: Are Chinese stocks relatively cheap? A: The domestic equity market, yes. The investable market, somewhat. We presented Charts 7 and 8 in our final report of 2018,4 which showed the following: The forward P/E ratio for both domestic and investable Chinese stocks has improved substantially over the past several months. In relative terms, Chinese stocks are not as cheap as they have ever been but, depending on the measure employed, usually haven’t been cheaper (at least over the past decade). The A-share market particularly stands out, with all four relative valuation measures near, at, or above their 2014 levels. Chart 7Chinese Stocks Have Become Cheaper In Absolute Terms… Chart 8…And Relative To Global Stocks Since we published our December report, global stocks sold off severely, which has somewhat diminished the relative cheapness of investable Chinese stocks. But the bottom line for investors is that Chinese stocks are not expensive in absolute terms, relative to global stocks, or compared with the history of relative valuation. Q: Given reasonable-to-good valuation, are Chinese stocks a good long-term buy? A: Not necessarily. It is distinctly possible that Chinese investable stocks are an example of a “value trap”. When discussing equity valuations in our last report of the year, we also mused about whether Chinese stocks are a great long-term buy. We noted that valuation is normally a powerful predictor of 10-year future performance, but that deviations from this relationship can exist. Chart 9 shows a vivid example of such a deviation, by presenting the profile of investable and domestic equities versus U.S. and global stocks, all rebased to the start of the U.S. recession in December 2007. The chart shows that for every $100 invested in equities at the end of 2007, local currency prices have fallen to $52 for domestic stocks and $86 for investable stocks. This is in sharp contrast to $128 for global equities, and a whopping $176 for the S&P 500. Chart 9A (Largely) Lost Decade For Chinese Stocks Excessive Chinese stock market valuation at the end of the last economic cycle has certainly contributed to the divergence shown in Chart 9. But Chart 10 shows another, less discussed factor: Chinese fundamental performance has not kept up with GDP growth, in contrast to developed markets. The chart shows the indexed ratio of sales per share to nominal GDP growth for the U.S. and China, and highlights that the latter has not only trended downward over time but has collapsed over the past four years. Chart 10Are Chinese Stocks Really A Play On Higher Chinese Growth? At root, the secularly bullish narrative surrounding Chinese stocks is based on the fact that China’s rate of economic growth is considerably higher than that of the developed world. But if the fundamental performance of China’s listed equities cannot keep pace with the economy, are they such a compelling buy simply because they are not expensive? An alternative view is that Chinese stocks are cheap for a reason, i.e. that they are a value trap. In combination with the sizeable risks facing the Chinese economy from extremely elevated levels of corporate debt, the best answer that we can give investors looking out over a multi-year horizon is that Chinese stocks are a great long-term buy for those who do not share our structural concerns. On a risk-adjusted basis, we do not yet find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report “Monitoring The (Weak) Pulse Of The Data”, dated January 9, 2019, available at cis.bcaresearch.com. 2 Owing to the recent changes to the global industrial classification system (GICS), the chart shows Chinese earnings growth excluding the information technology and communication services sectors. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report “Legacies of 2018”, dated December 19, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
