Are Chinese stocks now overvalued?



In this Q&A, Charlie Awdry, China equities portfolio manager, shares his thoughts on the sustainability of the strength of Chinese equities, rising foreign inflows into the market, as well as the market pullback experienced in early February.

Following on from strong performance last year and into early 2018, are Chinese equities currently overvalued in your view?

Glamorous growth stocks are expensive but we still see a lot of value available in specific parts of the market, most notably mainland state-owned enterprises across a number of sectors such as energy, basic materials, property, banks and telecoms. 

Has there been a surge in inflows from foreign investors following China’s continued strength? Some commentators are suggesting that the inclusion of mainland A shares in the MSCI Emerging Markets Index this year may mean they will outperform other markets over the next five years – what is your view? 

The robust performance of many highly liquid, large capitalisation stocks suggests that foreign institutional investors could be closing long-held underweight positions in Chinese equities. The MSCI inclusion should give this a further boost. We believe that foreign investors have been very slow and reluctant to embrace this rally in Chinese equities but flows normally follow performance. 

Which market indicators are you monitoring that would make you adopt a more cautious outlook? 

We are keeping an eye on the vibrancy of the Hong Kong initial public offering (IPO) market for an early warning signal that investor sentiment is becoming overly exuberant. When the number of issuers rises and the quality falls then perhaps we can draw a general conclusion that we might be getting towards the end of the bull run. The spin-off of China Literature from internet group Tencent at the end of 2017 where we saw reports of more than 600 times’ oversubscription and the almost 90% rise in the shares on the first day of trading suggests the IPO market is now open and moving from a buyers’ market to a sellers’ market. Consequently, we expect Hong Kong’s industrious investment bankers to be working long hours raising capital for their corporate clients in 2018. Right now the capital raising market is certainly warming up and pipelines are probably full but we don’t think we are nearing a market bubble.   

You have long been a firm believer in the China consumer story; which other sectors are you finding attractive?
We still favour those consumer companies with strong competitive barriers to entry; essentially high quality growth stocks driven by consumer demand in China. While we still like consumer-driven stocks our largest sector overweight is currently to the banking sector which is unusual for us, and is a little contrarian, but one that is currently proving profitable. 

Since the global equity sell-off in early February China stocks have recovered somewhat accompanied by some market volatility. Has this changed your outlook? 

In early February Chinese equity markets sold-off just as hard as they rallied in early January. The sell-off appeared to be a global phenomenon and fortunately China’s lunar new year holiday over the second half of February means markets will be closed and everyone can draw breath, compose themselves and regain some objectivity on the markets. Chinese equities are continuing to outperform many other global equity markets so while the pullback may well slow the pace of inflows we believe the trend of investors reducing exposure to developed markets and allocating to developing markets is one that has further to run. 

We are entering the full-year reporting season and it will be helpful to see further upward profit estimate revisions on the back of these corporate updates. Chinese monetary conditions have been tightening for a few months as President Xi Jinping looks to deleverage the economy. This is unlikely to be an orderly process; the current press headlines around the financially troubled HNA Group is a case in point. We will keep an alert eye out for unexpected second and third order impacts from this process. 

Our view remains. We feel that the current upswing in corporate profitability and cash flows together with the return of reflation will keep the Chinese economy well supported in 2018. 


China A shares: stocks traded in the Shanghai and Shenzhen stock markets. 

Bull run: a financial market where the prices of securities are rising over an extended period of time.

IPO:  initial public offering; when shares in a private company are offered to the public for the first time
Highly liquid large capitalisation stocks: Larger companies as defined by market capitalisation (total market value of a company calculated by multiplying the number of shares in issue by the current price of the shares) tend to be easily bought or sold in the market (highly liquid).

Barriers to entry: factors hindering the ease of entering of an industry or business area such as high start-up costs, patents, brand loyalty etc

Growth stocks: stocks that are perceived to have strong growth potential in terms of earnings. Therefore there is an expectation that the share price will increase in value.

Tightening monetary conditions: refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Deleveraging: reduction of debt across many areas, usually measured as a decline of the total debt relative to the country’s gross domestic product (GDP - the value of all finished goods and services produced by a country).

Reflation: when governments aim to stimulate the economy by increasing the money supply or by reducing taxes to raise price levels back to the long-term trend.

Market bubble: when overly exuberant investors drive up stock prices to the extent their value in relation to stock valuations becomes irrational.

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