China steps on the accelerator

Extensive monetary and fiscal policy stimulus

The price rise was triggered by the Chinese government's announcement in September that it intended to loosen both fiscal and monetary policy, and to do so on a massive scale. Monetary policy measures announced included an interest rate cut and a reduction in the minimum reserve requirements for banks. Measures to support the property sector were also announced, including a reduction in interest rates for property loans and capital requirements for property financing.

Although the planned fiscal policy measures were somewhat specified three weeks later on 12 October, the amount of money to be spent remained largely open. Nevertheless, the planned packages appear far-reaching. Beijing wants to support over-indebted local governments, support the lower income groups, recapitalise state banks and stabilise the real estate sector. How large the sum will ultimately depend on how much new debt Beijing approves at the next meeting. Judging by the tone of the latest announcement, however, it could be a significant package.

And this is also necessary. After all, the economy has been sending out warning signals for some time now. Consumer confidence is at rock bottom and the property sector is simply not getting back on its feet. The result is subdued consumption and deflationary pressure, which has recently been reflected in falling producer prices in particular. For capital markets, however, this economic data has been pushed into the background for the time being in view of the planned measures. Nonetheless, the Chinese government will have to provide details very soon and should not disappoint.

The economic turning point?

In macroeconomic terms, the measures could certainly make a difference, provided they are large enough in total. This is because a major problem in the Chinese economy is the insecurity of consumers, who simply do not want to consume despite extremely high savings,preferring to continue saving instead. The consumption rate in China is well below the global average. One of the main reasons for this insecurity is likely to do with the weak property sector, which plays a decisive role in the capital formation and the sense of financial security of Chinese households. Tackling the problems in consumption and the property sector with the announced measures could therefore prove to be the right strategy.

Nevertheless, there should be no illusions. Because one thing is clear to everyone: Chinese economic growth will weaken in the longer term despite these measures. A return to the high growth rates of the past remains illusory and the government is not seriously aiming for this. The structural problems are too great. However, a comprehensive package could at least have a stabilising effect on the Chinese economy and pull the stock market out of its slump.

Can the stock market defy the slowdown in economic growth?

Many investors remain sceptical. After all, the development of the Chinese stock market over the past 15 years has been very disappointing despite high economic growth. Companies have not managed to translate the high growth into rising profits. In addition, they have hardly allowed shareholders to participate in the company's success. Often inadequate corporate governance has also contributed to the loss of confidence. Why should this change now, when economic growth is slowing down?

We believe that the Chinese equity market has the potential to defy the slowdown in economic growth. This is because slower economic growth does not necessarily have to go hand in hand with lower earnings growth and lower equity returns. In our view, the key to success lies in profitability and shareholder alignment. Companies in China are increasingly focusing on profitability and return on capital. In addition, dividend payout ratios and share buybacks are rising. In our opinion, Chinese companies are sending a clear signal to shareholders: "We want you to participate in the company's success." This trend towards a more profitability-orientated and shareholder-friendly approach is ultimately one of the key reasons for our optimism.

Valuations are simply too favourable to ignore

Curiously, the second main reason for our optimism lies in the widespread pessimism of many market participants. This pessimism is reflected in the absurdly low valuations of many companies in China. Although the recent rise in share prices has led to a certain recovery in valuations, the expected P/E ratio* of the MSCI China Index is still around 20% below the twenty-year average. This makes the Chinese equity market one of the cheapest among the larger regional markets. 

Don’t neglect political risks

Political risks are undoubtedly a major source of uncertainty. These include, above all, possible tightening of trade relations between China and the western industrialised nations. There is also the chronic risk of a military conflict between China and Taiwan. In our view, however, a massive escalation of these two risk factors is unlikely. This is because the economic dependencies are simply too great, the supply chains are closely interlinked worldwide and the public finances of the major players are already so strained that it cannot be in anyone's interest to put additional pressure on the economy, let alone trigger another costly geopolitical conflict. Even if the political risks should not be neglected, we believe that they are largely priced into the valuations.

Favourable starting position for the Chinese stock market

In summary, the combination of cheap valuations and a more profitability- and shareholder-oriented strategy of companies represents a favourable starting point in our view. Added to this are the planned support measures, which could act as a catalyst for a sustained stock market rally in China if they fulfil expectations. If the government succeeds in at least stabilising the property sector and boosting consumption at the same time, the recent rally could be the starting point for a major move.

* The expected P/E ratio corresponds to the price/earnings ratio based on the average earnings expectations for the next 12 months.