By Reshma Kapadia
The economic news out of China remains glum, but a soft landing in the U.S. and a September rate cut by the Federal Reserve could give beaten-down Chinese stocks a lift.
The iShares MSCI China ETF is down 40% from three-years ago, making the Chinese market one of the cheapest places to shop.
There are lots of reasons for that discount, including a deteriorating U.S.-China relationship and a new wave of trade pressures that has prompted some investors to steer clear. Plus, China's economy is still sputtering, with its battered property market still showing little sign of an upturn. Consumer and business sentiment remains depressed.
But the changing global economic backdrop could nudge some investors to take a look, especially if the U.S. dollar continues to weaken and encourages investors to take some of their money elsewhere.
In a note to clients, Gavekal Research founding partner Louis Gave writes Fed Chair Jerome Powell's recent signaling that a rate cut was coming and the Fed now sees 2% as the floor for inflation rather than a target is bearish for the U.S. dollar. Gave describes the dollar as "clearly overvalued." There is another reason Gave thinks the dollar is due to weaken. China is sitting on a $100 billion monthly trade surplus, the largest in history, as Beijing has identified exports as a key source of growth to offset weakness at home.
"Given the sheer size of this surplus, something should rerate -- either the Chinese currency or Chinese asset prices. But for a host of reasons, including the view that China is uninvestible, they have not. Any change in this dynamic could have rapid investment implications," Gave writes.
Christine Phillpotts, a manager on Ariel's emerging markets strategies, is gravitating toward China. But she has a relatively sober view of the near-term economic picture and thinks it could take a while after the still- struggling real estate market stabilizes for consumers to feel better about spending.
Phillpotts also expects the geopolitical risk to stick with China but she says valuations already bake in a lot of that uncertainty, with Chinese stocks trading at an equity risk premium of about 9.5%, compared with the average over the last 20 years of 6% while other markets, like the U.S., don't factor in the possible fallout.
That said, Phillpotts is gravitating toward companies more insulated to U.S.-China tensions and are tied more to market share gains at home, as well as margin improvement. That includes Great Wall Motor, which is benefiting from Beijing's supportive policies and isn't as vulnerable to trade tensions hitting others in the auto industry because only about a third of its cars are exported -- and primarily to other emerging markets.
The widening dispersion of returns and financial performance among companies in China is a major draw, with Phillpotts looking for companies with several levers at their disposal. That includes firms increasing dividends and buybacks -- an area where she sees more potential given the net cash companies are sitting on.
"There's also margin expansion opportunities with new products and new services, as well as a greater level of efficiency that has come alongside a tougher economic environment where companies -- across e-commerce, autos and online travel, have had to pull themselves up by their bootstraps," Phillpotts says. Among her top holdings: e-commerce giants Alibaba Group and JD.com, travel firm Tongcheng Travel Holdings, and electric bike maker Yadea Group Holdings.
In a note to clients, HSBC consumer analyst Lina Yan also identified a handful of stocks well-positioned for the downturn she still sees ahead in consumer company earnings. On the list: Yum China, whose strong dividend yield is underpinned by a good visibility to earnings and Giant Biogene, which makes recombinant collagen that is popular lately in the beauty industry.
Also highlighted: sportswear giant Anta, which Yan describes as a steady compounder with prudent shareholder return policies like buybacks, and Haier Smart Home, which gets the extra boost of policy support such as subsidies for consumers to swap out old appliances for new ones. While a changing global economic backdrop could spur investors to dip their toes into Chinese stocks again, investors may want to stay nimble as gains in the last couple of years have not proven to be sustainable -- and Chinese structural challenges persist.
Write to Reshma Kapadia at reshma.kapadia@barrons.com
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August 27, 2024 02:30 ET (06:30 GMT)
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