SIMON FILLMORE: You may already be invested in the next bull market

We have slowly started to see positive signs emerge from China and, with some of the cheapest valuations we have seen in our investment careers, it has stirred our animal spirits. 

What have we seen changing in China? Against the backdrop of a stock market that is down 40% in three years, a slowing economy and a property bust, most Western investors have been anticipating a big bang stimulus announcement to rouse the economy. So far, they have been disappointed. 

However, we have noted more subtle news flow emanating from Chinese officials. Specifically, announcements concerning the stock market, where:

• The Chinese sovereign wealth fund has started buying domestic exchange traded funds (ETFs).
• The Chinese Securities Regulatory Commission (CSRC) has encouraged institutional investors to participate in the stock market with greater effort.
• The finance ministry has halved stamp duty costs on stock purchases.
• The CSRC has reduced margin requirements for stock investments.
• The cabinet has issued guidelines for a high-quality stock exchange and called for a higher proportion of stock-focused funds in the mutual fund industry.
• Regulators have changed the risk weighting of stocks when assessing insurers’ capital adequacy.

Why is this important? Chinese investors are significantly underinvested in stocks, and households have 70% of their wealth invested in residential real estate, with much of the balance in cash. Household cash balances have increased 65% since 2020 and now sit at $7.4-trillion, more than Germany’s or Japan’s GDP. Chinese households became fearful after Covid-19 and have hoarded cash ever since.

Investing habits

Given the extremely low base, a change in the investing habits of Chinese institutions and households towards stocks will have a meaningful effect on stock prices. This would set off a virtuous cycle and create a positive feedback loop. A rising market makes investors feel wealthy and imbues them with a sense of confidence, which encourages spending. When this is done at scale, it raises employment and productivity and drives GDP growth.

We sense the market may be missing the potential structural change from the above-mentioned regulatory changes. Chinese stocks are trading at historically low levels compared with peers. They are 70% cheaper than Japanese stocks, 67% cheaper than Indian ones and 64% cheaper than US stocks. The combination of a low base and highly undervalued stocks could result in well above-average returns. 

To illustrate the valuation dynamics of some of the large Chinese technology stocks:

• Tencent’s forward price-earnings (PE) ratio of 15 times is the lowest it has been in 20 years.
• Alibaba’s net near cash represents a third of its market capitalisation, and the imputed PE ratio of the core business is a low single digit.
• JD.com’s net near cash represents 80% of its market capitalisation, and the imputed PE ratio of the core business is a low single digit.

From a macroeconomic perspective the slowdown in the Chinese economy can be viewed positively. Much of the growth over the past two decades was caused by debt-fuelled infrastructure and housing spending. The current duress will help purge past excesses and ensure capital is deployed optimally in future and that debt levels are reduced to acceptable levels. These are traits of a sustainably growing economy.   

There has been big investment in its future as China evolves to advanced manufacturing and offers cutting-edge technological solutions and products. We also don’t buy the Chinese demographic time bomb argument, as most countries globally face a similar issue and China is likely to augment its lead in manufacturing automation due to it. The nature of employment will change from dull, repetitive industrial tasks to compassion-based care as the Chinese population ages.

Highly sensitive

There is also a misconception that the Chinese economy is struggling tremendously. It is true that growth has slowed down from the go-go years, and certain sectors such as housing are under severe strain. However, Chinese economic data is mainly relatively good, even compared with the US. GDP growth for 2024 will be higher than that of the US and inflation is also lower in China. China has a current account surplus, its fiscal deficit is lower than that of the US, and its general gross government debt to GDP ratio is lower.

Through serendipity, most SA investors already have high exposure to China due to their exposure to Tencent through Prosus and Naspers. Of course, JSE-listed commodity businesses are also highly sensitive to the vagaries of the Chinese economy. There are also Chinese-focused ETFs listed on the JSE. Therefore, SA investors may already be invested in the next bull market.

Global financial markets are in no-man’s-land. Interest rates remain high, yet central banks are nervous about reducing them as US inflation has proven stubborn at the 3% handle. There is also heightened geopolitical risk with the upcoming US elections, the Ukraine war and the tension in the Middle East. 

Against this narrative, Chinese equities could surprise and quietly outperform. Any outperformance would be a welcome gift for battle-scarred SA investors who have endured a long, frustrating period of underperforming global stock markets.

• Fillmore is chief investment officer at Independent Securities.