Are Chinese Stocks Overvalued?

 In Market and Investment Insights

In this Q&A, Portfolio Manager Charlie Awdry shares his thoughts on the sustainability of the strength of Chinese equities, rising foreign inflows into the market and the 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 strong performance of highly liquid, large capitalization stocks suggests that foreign institutional investors may 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 toward 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.

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 as the current press headlines around the financially troubled HNA Group show. 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.

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Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.

Emerging market investments have historically been subject to significant gains and/or losses. As such, returns may be subject to volatility.

MSCI Emerging Markets IndexSM reflects the equity market performance of emerging markets.