China’s large-cap rally: Five years of flat returns
The below graph reflects the long-term outperformance of Chinese and Korean equities over U.S. equity markets, while Japan, the red line, has made a strong comeback post-2012. As global economies engineered monetary and fiscal stimulus to mitigate the impact of the 2008 financial crisis, equity markets recovered handsomely. China and Korea returned to high levels, though Chinese equities have remained mostly flat since 2009. The U.S. equity market continually grinds higher while Japan experiences fits of growth on monetary policy activism.
This article considers China’s prospects to see its equity market rally once again after a few years of soft landing–induced tightening. It might appear that China has avoided the hard landing so far and that the caution baked into Chinese equity valuations could subside as 2014 progresses. The outlook for Chinese equities based on low valuations is looking more positive, though China’s capacity utilization and producer price levels need to see some improvement before the bull market returns in Chinese equities in general. Baidu, Apple, and Google China have remained somewhat removed from manufacturing declines and credit contagion, though with a fairly high price-to-earnings multiple, even these technology companies could become vulnerable to near-term selling if panic spreads through the overall Chinese equity market. Hopefully, strong wage growth and low unemployment will continue to support Baidu and other Chinese equities in 2014 while excess capacity declines and PPI improves. However, if excess capacity and PPI deteriorate as 2014 progresses, investors may have to temper growth expectations for even technology-related companies.
Equity outlook: Will multiple expansion spread to China in 2014?
Asian markets have remained flat since 2013, and China is no exception. More recently, tensions in Ukraine had led to a nearly 20% sudden drop in the Russian stock market, though it has recovered half of its losses since. China’s Shanghai Composite Index is also down 15% from its 12-month peak. The VIX volatility index in the USA had risen to 17.0% during the height of the Ukraine situation, though it’s back to a very low 14.0% (April 28). This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in global markets is being driven, to some degree, by the tensions in Ukraine and evidence of some deterioration and oversupply in China. Given this cloudy international outlook, it might appear that investors are finding comfort in the U.S. dollar and US equities, while international markets, such as Japan, China, and Korea, are receiving less attention. With the U.S. at record highs, it might take an interest rate spike and equity market drop to refocus attention on China’s lower price-to-book equities. Plus, as consumer sentiment and consumption are starting to pick up in China, it’s possible that the apparent manufacturing overhang will look less menacing as the year progresses.
China credit issues: A few bumps, or getting worse?
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting trust product investors take the losses on this $500 million coal company loan, it might appear that the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk. This should keep the speculative investment climate a bit cooler in China, and Asian markets in general will likely not see significant real money asset allocations increase any time soon. The engineering of potential slowdown in China has investors a bit skittish, though as clouds clear, China’s relatively low equity valuations should become attractive as the year progresses. However, as we mentioned earlier, both excess manufacturing capacity and producer price indices will need to show signs of recovery if strong growth expectations are to be realized.
China, Japan, and Korea
Though post-2008 issues have cooled interest in Asian equities in general while the U.S. market has been on a bull run, readers should remember that Japan is in a very different situation than China and Korea. The effects of Japan’s massive monetary and fiscal stimulus that applied over the course of 2013—and that’s still reinforced with equal vigor in 2014—has probably not been fully felt in the broad economy in Japan. Japan’s trade deficit with China could shrink. While China has various growth-related issues to mitigate as the year progresses, at least China has managed a soft landing so far. If the U.S. and EU can get back to trend growth of 2.5% or so in the next year or two, that should be enough to support China’s excess capacity and producer price weakness near-term. Meanwhile, the Chinese consumer appears to be picking up some of the demand slack in the West. This scenario would support Chinese equity valuations and the earnings for Baidu, Apple, and Google China.
To see how Chinese ETFs are performing in comparison to Japanese and Korean ETFs, please see the next article in this series.
To see an overview of the U.S. macroeconomic recovery that could support China’s export economy, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Asian equity outlook
The weakening yen and relatively flat wage growth in Japan have supported Japanese markets, as reflected in the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ) ETFs. Aggressive monetary policy in the USA has supported the S&P 500, as reflected in the State Street Global Advisors S&P 500 SDPR (SPY), the State Street Global Advisors Dow Jones SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV), which have been up nearly 18% over the past year. However, tapering is now in play, and higher rates in the five-year Treasury could cool U.S. valuations going forward. Given China’s current financial challenges in the banking system, both the U.S. equity markets and the Abenomics-driven Japanese equity markets may continue to outpace China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). However, if U.S. valuations continue to increase over the year, China’s valuations should become increasingly compelling. With FXI’s key holding, the banking flagship Bank of China, trading at a 0.84 price-to-book ratio and a 4.95 price-to-earnings ratio, you have to wonder how much lower Chinese banks and financials could go.