Irish Life asserts the current valuations of Chinese equities reflect past challenges, anticipate continued GDP growth
This article is intended for an advisor audience.
This article was produced in partnership with Canada Life Investment Management.
While recent developments in China have understandably caused market unease, the investment team at Irish Life Investment Management (ILIM) continue to see the merits of including an allocation to Chinese equities as part of an investors’ overall equity allocation. Although there are arguments that support excluding Chinese equities from emerging markets exposure, ILIM is staying the course.
The nature of China's market is such that higher long-term return potential is often accompanied by volatility. Numerous investors and their advisors are opting not to invest directly in emerging markets, instead gaining exposure indirectly through commodities. Grasping the underlying dynamics can aid investors in managing these fluctuations more effectively.
Canada Life Investment Management adopts a simple yet effective approach combining the expertise of leading investment managers to assemble a collection of funds that is both diverse and relevant in providing exposure to unique assets. Each manager brings their own unique investment strategy, providing a breadth of knowledge and specialization. A key collaboration in this strategy involves ILIM, known for its seasoned team and impressive history in multi-asset investment, contributing a distinctive managed solution to the portfolio.
Chinese equities do not currently reflect their intrinsic value
Darragh O’Dowd, Head of Multi-Asset solutions at ILIM – raises a critical question, is now the moment to enter or exit the dragon?
On one side of the debate, O’Dowd argues that this downturn has positioned Chinese stocks as an excellent value proposition on the global stage, pointing to the steep decline in valuations as an unprecedented buying opportunity. This perspective hinges on the belief that the current prices of Chinese equities do not fully reflect the intrinsic value and growth potential of the underlying companies, especially considering China's role as a major player in the global economy.
On the opposite end of the spectrum, ILIM cautions against overly optimistic investments in this market, citing a host of enduring challenges that could continue to exert downward pressure on stocks.
The bear case: a value trap
The bearish perspective emphasizes the structural and cyclical challenges facing China's economy and, by extension, its stock market. O’Dowd notes, “One of the main reasons for considering the exclusion of China from investment portfolios is the anticipated deceleration in GDP growth, with projections indicating a decline to a range of three to five percent annually over the next decade, down from the six to 10 percent experienced during the 2010s.”
He further elaborates that this slowdown is fundamentally structural, driven by what's referred to as the “three Ds: demographics, debt and demand.”
China's population has reached its peak. The country's working-age population is expected to decrease by 19 percent by 2050, dropping from 864 million in 2023 to 700 million, while the segment aged 60 and over is projected to double to 500 million.
The total debt-to-GDP ratio has escalated to nearly 300 percent of GDP, with diminishing returns on additional debt in terms of its effectiveness in boosting nominal GDP. This indicates that significantly more debt would be required to achieve any notable growth stimulation.
The property sector, along with related services and infrastructure, represents 30 percent of China's GDP, a development that has been to the detriment of household consumption. As this sector experiences a slowdown due to policy restrictions, household consumption is unlikely to make up for the difference, leading to reduced overall economic growth.
The bull case: a golden moment
The principles guiding the case for China can be summarized by the acronym V.E.T.T.E.D (valuations, energy transition, the expansionary/pro-growth policies of China’s government, and de-risking).
O’Dowd notes, “Equity valuations in China appear to be appealing, as evidenced by the MSCI China’s 12-month forward price-to-earnings ratio of 8.5 times. This represents a 53 percent reduction compared to the MSCI World and is substantially below the usual discount rate of 23 percent by about 30 percentage points.
“Regarding the shift towards sustainable energy, China is leading with a significant investment, contributing to 32 percent of the world's expenditures on clean energy in 2022. This dovetails with its dominance in rare earth elements (REEs), where China was responsible for 70 percent of global production in 2022, positioning it well as this mega-trend plays out over the coming decade.”
Furthermore, China is enhancing its capabilities in manufacturing high-value products essential for the green transition. An example of this is the Chinese conglomerate BYD, which has become the top producer of electric vehicles globally based on sales.
From decoupling to derisking
The recent sentiment is being reshaped by the strategic recalibration of relations between China and the West, moving from the rhetoric of decoupling to a more pragmatic approach of de-risking. This shift reflects a growing recognition of the intricacies of global supply chains and the impracticality of severing economic ties with the world's second-largest economy. The nuanced stance adopted by Western officials, aimed at managing rather than severing ties, underscores the critical role of investment managers in navigating the geopolitical nuances that influence market dynamics.
“The Chinese New Year started on Feb. 10, 2024 – the year of the Wood Dragon is said to be a time to ‘build solid foundations for something new with long-term potential’. Only time will tell if this turns out to be correct in relation to Chinese equities, but there are V.E.T.T.E.D. reasons to stay the course,” says O’Dowd.
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Disclaimers:
The views expressed in this commentary are those of their respective fund managers and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice. Although we endeavour to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it.
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