How Financial Markets will value the china’s market?

State Street Global Advisors

Why It’s Time to Reconsider Your China Exposure

The macro rationale for China investment remains intact. While the country’s growth trend is decelerating, its growth rate will remain far above that of developed markets and slightly above that of other emerging markets. Even if annual GDP growth were to slow to a persistent level of 4% to 5%, this would provide a lot of room for companies to grow their earnings at an attractive rate. Moreover, China’s size means that its companies can take advantage of a larger home market – China’s domestic economy is larger than the economies of all other emerging-market countries combined.

While some of our macro arguments are debatable, our core investment thesis is not. China’s equities market appears structurally undervalued. China’s equities-market capitalization is stuck at 82% of GDP, far below that of any developed market. Figure 1 uses the Buffett Ratio to show the comparison. This relatively low ratio provides leverage for China, as we estimate that market-cap-to-GDP should reach 100% by 2025, driven by new stock issuance and the growth of the current market. In addition, cyclical markers also indicate excessive discounting, with China’s current price-to-earnings ratio falling well below 20-year averages and global/ developed-market benchmarks.

Second, despite the size of the China market, global investors currently have relatively little exposure. The economy represents roughly one-sixth of the global economy, but Chinese equities represent only 4% of the MSCI ACWI (on a free float basis). All other EM countries make up about 8% of the MSCI ACWI. The bond side looks much the same, with foreign investors owning only 3.2% of the Chinese bond market. By comparison, bond markets in India, Brazil, and Russia have foreign investor participation rates in the double digits, and they represent the most closed markets among the G-20. All of these China figures reflect several years of net capital inflows, as well as inclusion in major indices.

Third, Chinese assets retain very low correlation to other markets and maintain excellent diversification features. The pandemic illustrated how much China follows its own economic cycle and its own policy priorities. Limited integration with global financial markets also helps to reduce correlation with other markets. And while China’s equity correlation with other emerging markets has picked up in recent years (see Figure 2), it still remains below that of any other comparable correlation pair (its correlation with developed markets has remained low).

Mckinsey & Company

China’s consumer market has considerable growth momentum

In 2017, Chinese consumers accounted for more than 40 percent of sales of EVs, 30 percent of global car sales, 45 percent of fish and seafood, 37 percent of fresh meat, 24 percent of wine, and 22 percent of womenswear. Across 24 consumption categories we studied accounting for $10 trillion of global consumption, China had an average 18 percent share of the global market (Exhibit 30).

China’s contribution to growth in various consumption categories is even more startling. In auto sales, between 2010 and 2017, China accounted for 50 percent of global growth. Chinese consumers have accounted for more than 90 percent of growth in the global box office since 2007; in 2017, they bought 27 percent of all box office receipts in the world. In economies where consumption has been under pressure, the arrival of Chinese tourists has helped to boost spending; in Thailand, for instance, spending by Chinese tourists is equivalent to 9 percent of the economy’s private consumption. These trends have largely been driven by the fact that incomes in China have been growing at 11 percent a year since 2010.

Chinese consumers are becoming richer

China’s consumption has been fueled by rising household incomes and an accumulation of wealth. The share of households in the mass affluent category and above (defined as a household with disposable household income of 18,000 renminbi or more per month) quadrupled from 3 to 12 percent from 2010 to 2018. By 2030, 58 percent of Chinese households are likely to be in the mass affluent category or above, surpassing today’s South Korean share of 55 percent.

Interestingly, the spending profile of urban Chinese consumers is converging with that of their counterparts in cities around the world. Residents of China’s cities are devoting a greater share of their income to discretionary spending. Spending on food declined from 50 percent of total household consumption in 2000 to 25 percent in 2017. This is similar to the pattern of urban consumers in developed countries – Japan at 26 percent, South Korea at 29 percent, and the United States at 17 percent. Comparing urban China’s spending profile with that of other developed Asian countries, Chinese consumers devote a larger share of spending to apparel (7 percent) and household products (6 percent), and less to personal products (3 percent).

Asian Monetary Imbalances

With its state-owned banking system balance sheet 304% greater than GDP, we believe China is facing one of the most extreme monetary and credit imbalances of any major country in history. China’s extraordinary economic expansion of the last several decades has been fueled by and influx of Western capital compounded by ever-expanding domestic bank credit. The extreme growth of bank assets relative to GDP points to the likelihood of an enormous hidden non-performing loan problem. Overwhelming levels of debt, declining and encumbered international reserves, a current account in secular decline, declining foreign capital inflows, rising M2-to-international reserves, these issues often foreshadow a full-blown currency and credit crisis. China is facing all of them.

The relative performance of Chinese versus US equities has been dismal. The FXI ETF was recently down over 50% since February of 2021, reaching its lowest levels in 13 years. Predominantly, as shown in the chart below from 2013 to 2020, the China-to-US equities ratio has an incredibly strong correlation with the changes in the yuan relative to USD. Logically, this relationship makes sense. As one economy struggles relative to the other, their respective currency will likely be pressured to the downside. This leads us to believe that the recent strength in the Chinese currency is unsustainable and fundamentally unwarranted. China’s current economy is in a downturn and the PBOC will likely be forced to significantly ease monetary conditions into an already inflationary environment. We believe a major yuan devaluation is ahead of us.

We are likely facing the early innings of a deglobalization super-cycle that should further escalate protectionist policies and curtail capital inflows into China. Foreign direct investment is imperative to maintaining the value of China’s currency. Rising geopolitical problems and the ongoing trade war will negatively impact China’s position as the manufacturing plant of the global economy. These important macro shifts are pressuring the Chinese yuan to devalue significantly against the US dollar, but also relative to hard assets like gold. Similar pressures exist on the Hong Kong dollar under its pegged exchange rate regime.

My conclusions and considerations

As we have seen the consumption growth in China is really astonishing over the years and understanding how this growth could influence the Chinese’s economy and the consumers is extremely important in my view.

I also think that the China’s market is still not a priority in the financial markets, but we cannot not see how is growing the attention on the China’s economy.

We have even see how is gone the growth on consumptions over the past decade on China and we can imagine how it could go over the next decades.

• China’s equities-market capitalization is stuck at 82% of GDP, far below that of any developed market.
• Chinese assets retain very low correlation to other markets and maintain excellent diversification features.
• The China-to-US equities ratio has an incredibly strong correlation with the changes in the yuan relative to USD.
• Foreign direct investment is imperative to maintaining the value of China’s currency.

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics and in doing so he shares with you the most interesting charts and comments.

Disclosure

This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.