Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn


Chinese shares tipped to rebound after poor decade

Robert Mann and Trumann Du  |  08 Mar 2019Text size  Decrease  Increase  |  
Email to Friend

The sharp rebound in Chinese stocks so far this year has surprised many investors, given its main index, the Shanghai Shenzhen, has generally underperformed many of its global counterparts over the last decade.

Given the latest upturn, we believe Chinese stocks may finally start to perform in line with strong GDP growth.

We see an emergence of structural changes in the Chinese economy that would support the positive case for domestic equities.

Our reasons for this view include the following:

  • increasing flows of money from property assets to equities
  • improving quality of corporate earnings quality
  • increased participation of foreign companies and investors
  • the rise in stock market listings of innovative Chinese companies

But before we delve into why mainland China equities could see a sustainable uptick, let’s first look at some of the things that have weighed them down in recent years.

China’s economic growth model led to poor earnings quality

For many, it seems puzzling that China’s earnings per share and returns on equity – two of the main drivers of equity performance – didn’t match the country’s strong nominal and real economic growth over the past decade.

China's divergence in economic growth and stock market returns could have been indirectly caused by the global financial crisis in 2008.

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

The Chinese government, in November 2008, launched a massive RMB 4 trillion economic stimulus plan to invest in the country’s infrastructure, real estate and social welfare system – in an attempt mitigate the negative economic effect of the financial crisis.

This action significantly altered China’s economic growth model, which became largely driven by infrastructure and property investment over the past decade.

When a nation's GDP is driven by high levels of investment, it tends to push too much capital into less productive areas, resulting in a dip in overall economic efficiency.

This has occurred in China in recent years, where there is a potential property bubble and an overall real estate glut.

Beyond this, China's massive infrastructure construction and property investments delivered outsized benefits to mostly state-owned enterprises and government-linked organisations, spurred by government spending.

The increasing dominance of SOEs from 2008 onwards has come at the expense of privately owned Chinese companies, which have seen lacklustre share price performance for the following reasons:

  • declining return on equity
  • weaker EPS growth
  • poorer earning quality

The shadow banking problem

The investment-driven economic growth model of China after the financial crisis relied heavily on continuous financing from state-controlled banks and trust companies.

That caused China’s total debt ratio to swell dramatically, and also led to a precarious shadow banking problem in the world’s second-largest economy.

In China, the government sets the direction of bank lending and state-owned banks’ first priority is to facilitate the financing needs of government entities and SOEs.

As such, the costs of extending preferential loans, with artificially low borrowing rates, to government entities and SOEs tended to be lower than for banking loans.

This diluted the profitability of large state-controlled banks, whose shares are key components of China’s stock markets. The dominance of indirect financing in China in recent years was reducing the primary funding role of the A-Share stock platform.

De-rating of A-shares

Largely because of the overall weaker corporate governance of SOEs, they don't appeal to many domestic and foreign investors.

However, although there isn't a huge number of SOEs listed on the China A-share market, their profits could account for more than 40 per cent of the entire market’s profits.

The general lack of investor interest in China SOE-related stocks, which have seen dreary growth in earnings and profits in recent years, eventually led to a de-rating of these counters over the past decade.

This inevitably hurt the country’s stock market, as money started flowing out of China equities.

At the same time, as Chinese property prices soared in line with the country’s massive economic stimulus plan in late 2008, local investors have piled into the asset class. This trend has redirected money flows away from stocks to real estate.

Impetuses for China stocks to trend higher

Though China A-shares haven't performed particularly well over the past several years, we believe the recent rebound could be a sustainable trend upward, for the following reasons:

  • China’s property bubble could be nearing its peak. China’s top leaders realised the dangers of runaway property prices two years back and have since taken efforts to manage the country’s real estate prices more carefully
  • The country's over-reliance on debt financing from state-controlled banks is unlikely to continue. As such, the nation's businesses and economic growth plans have to rely more on direct financing via its equity and fixed income markets – a big positive for China’s equity market 
  • The growth of a Chinese institutional market and increasing foreign investor participation should lead to maturing domestic equity markets, reduced volatility and a better environment for good companies to outperform
  • China's more sustainable growth model, adopted after its 19th National Congress in October 2017, has turned to innovation and upgrading of its manufacturing and consumption sectors. This should improve earnings quality of listed private sector companies in China, potentially leading to higher valuations
  • Lastly, the US has proved that its equity market can provide the best funding platform for innovative companies

The next Tencent, Alibaba or other innovative Chinese firms are very likely to be listed on the country’s A-share market.

That's why we are confident that returns for onshore China equities will be much better going forward after underperforming over the past decade.

are senior portfolio managers at Nikko Asset Management.

This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. 

© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend