Is the China equity recovery durable?

China’s equity rally faces a wall of scepticism after years of false dawns. However, this time could be different: Beijing’s crackdown on irrational competition in key industries and sustained stimulus, compounded by moderating US trade rhetoric ahead of a potential Trump-Xi meeting, are setting the stage for a sustainable equity market rebound most are missing.

Light positioning reflects a lack of conviction

The Hang Seng index and MSCI China index have soared over 25% year to date (YTD). However, China equities still registered a net fund outflow this year. This illustrates that global investors have yet to gain high conviction on China equities. Such sentiment could be mainly attributable to policy uncertainty and lacklustre equity performance in recent years, among other reasons.

Reasons for optimism

We see reasons for optimism for a durable recovery in China equities. Early signs of economic improvement are emerging, including stronger-than-expected 6.4% year on year (yoy) retail sales in May. Sceptics may view this as bad news, since this, when combined with the improving market performance, may signal no urgency for further policy stimulus to revitalise domestic demand. We argue otherwise.

There are two trends on which authorities are placing increased emphasis: (1) rising savings rates and (2) persistent deflationary pressures. The Chinese are known for saving up for the ‘rainy day’. However, the acceleration in the household savings rate from 44% in 2023 to 55% in 2024 has been startling, masking concerns about economic uncertainty. This uneasiness is understandable given the challenging global environment. While US-China tensions have eased of late, tariffs on Chinese imports have gone up. Meanwhile, excess manufacturing capacity, after front-loading of exports to beat US tariffs fades, could sustain deflation. For instance, producer price deflation worsened more than expected to -3.6% yoy in June.

Downside risk fuels expectation of more stimulus

There is a risk China’s retail sales growth could decelerate without incremental stimulus. Subsidised trade-in consumption programmes launched last year, which contributed to strong retail sales in the first half, will likely lose steam in the coming months. Given consumption is a key engine of China’s growth, we see increased likelihood of additional policy measures to drive retail growth tactically and structurally. Policies will likely include ways to widen the scope of consumption subsidies and ease restrictions on household registration (“hukou”). Hukou relaxation could be strategically bundled with housing stimulus and social safety net reforms.

On one end of the demographic spectrum, retirees could be incentivised to shift to lower-tiered cities or rural areas with lower costs of living and better living conditions. The lower-tiered cities suffering the largest housing supply gluts could turn the unoccupied housing projects into social housing developments for the seniors. Affordable housing projects could also be developed in the outskirts of top-tiered cities, with the aim to attract younger, educated migrants, who, encouraged by better career prospects, could establish families sooner.

Structurally, China is seeking to spur childbirth by recently announcing the first nationwide cash handout programme for every child under the age of three. Furthermore, the nation will likely accelerate the upgrade of elderly care goods and healthcare services to stimulate consumption of the “silver hair” segment, including the development of humanoid robots for elderly care.

Policy to tackle irrational competition to lift risk sentiment

Recent official meetings since July have further reinforced our optimism about China’s policy outlook. On 1 July, the Central Commission for Finance and Economic Affairs called for the need to curb irrational price competition, accelerate eradication of obsolete capacity, and promote local government standards to support businesses. Following the meeting, the State Council pledged on 16 July to regulate the irrational price competition in the EV industry. The State Administration for Market Regulation also met with major online food delivery platforms to stem unfair competition. We believe these measures align with China’s shift in growth focus from quantity to quality. These measures will help mitigate deflation, boding well for China equities. There is no coincidence that the policy-sensitive onshore A shares index, which has underperformed Hong Kong’s Hang Seng index YTD, has been catching up with the latter in July.

China’s equity fundamentals reaching a turning point

Backed by improving fundamentals, China’s equities are at the cusp of a turnaround, with earnings expectations bottoming and valuations ticking up. China equity valuations, partly constrained by low investor positioning, still trail their historical and peer averages, with price-to-earnings multiple of 12-13x notably below the US level of above 22x. China’s earnings prospects are also brightening as pricing and profit margin trends stabilise with policymakers focussing on rationalising competition and capacity.

Add to China equities within a diversified allocation to generate alpha

Rising prospect of a Trump-Xi meeting this year, the dollar’s ongoing weakness and a peak in trade tensions are broadly supportive of our positive view on global equities. Within our globally diversified allocation, we are overweight Asia ex-Japan equities. Within Asia ex-Japan, we believe China equities will generate excess returns (alpha) thanks to Beijing’s concerted and targeted policy measures to sustain growth, reduce capacity and overcome deflation. That said, we reiterate the importance of diversifying across asset classes, including quality bonds, gold and alternative investments, to produce optimal returns and protect your wealth against market volatility.

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