Is there opportunity left in Chinese stocks?

We are positive on China’s stock market, even after this year’s rally, but favor a selective approach amid growth and trade risks. Richard explains.

The Chinese stock market has rallied sharply this year, becoming a top performer among global markets after finishing 2018 near the bottom. Is there still opportunity left? We have a positive view on China’s stock market, but see rising risks and reason for greater selectivity.

Price o earnings ratios of China A-shares and EM equities, 2010-2019

The mainland China market–the world’s second-largest by market capitalization–includes shares (called A-shares) of Chinese companies trading in yuan. A-shares became more accessible to global investors last year when MSCI incorporated eligible A-shares into its indexes. The chart shows how A-share valuations took a big hit in 2018, when they experienced their largest annual percentage drop since 2010. Behind the derating: the U.S.-China trade conflict compounding a growth slowdown and ongoing Fed policy tightening. Some of those factors have turned supportive: Chinese monetary stimulus is arriving, hopes are running high for a trade deal and the Fed has hit the pause button. Yet A-shares still trade at a hefty discount to other emerging market (EM) equities, as the chart shows, and to their own history. This suggests potential for further gains.

Behind the turnaround

We see three drivers of the turnaround in China A-shares after a tough 2018. First, international flows into A-shares have accelerated amid improving sentiment toward China–and EMs more broadly. Second, the policy environment has become more supportive. Material policy easing in China, including ample credit growth and fiscal stimulus, is particularly helpful for A-shares given issuers’ domestic consumer focus. The Fed’s pause on policy tightening has stabilized the U.S. dollar, and other major central banks have taken on a dovish tone. Third, our indicator shows market concerns around U.S.-China trade tensions have eased. Reports suggest progress in meetings between U.S. and Chinese officials, with a planned delay of a significant tariff increase at the end of this week.

We see these drivers persisting in the near term and remain positive on the A-share equity market. Global investor positioning in China is still light. Official data suggest international investors hold only 3% of A-shares, and we could see this figure increasing. An upcoming change by index provider MSCI could quadruple the weighting of A-shares in its EM equity index to nearly 3% from 0.7%. Finally, valuations are still attractive, though a large unwind of negative sentiment means the value isn’t as big as it was in late 2018.

Two risks

We see two risks: First, China’s economic and earnings momentum are weak. We see scope for consensus growth expectations to drop further in the near term, but expect economic and earnings growth to both bottom out next quarter at levels still above those of many developed markets. Investors are currently looking through such downgrades, but fundamentals will need to turn for a sustained rally. The second risk: a significant escalation in the U.S.-China conflict. A meeting between the countries’ leaders may be required for a meaningful trade deal. There is a danger of market complacency over the prospects for such a deal, even as we see a low near-term risk of a flare-up.

Bottom line

We see potential for positive returns for Chinese stocks, but would be more selective. In the short term, we favor market segments likely to benefit from further local policy easing such as brokers and companies related to the domestic consumer.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves special risks including, but not limited to currency fluctuations, illiquidity and volatility. These risks may be heightened for investments in emerging markets.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of February 2019 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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