Why Chinese Stocks May Still Make Sense Over the Long Run

Though 2014 is the year of the horse, I’ll be the first to admit that Chinese stocks haven’t galloped ahead as I predicted they would late last year.

Rather, Chinese equities have tumbled 8% year to date, as measured in dollars, underperforming a broader emerging market (EM) benchmark by 5%.

Investors in 2014 have been concerned about the Chinese market, given a spate of disappointing economic data pointing toward slowing growth, news about corporate loan defaults, and a depreciating local currency.

It’s no wonder, then, that many investors are asking me whether they should abandon Chinese stocks. My answer: “no”. While the Chinese market is certainly not without real near-term risks (more on that below), Chinese stocks still look cheap compared to their developed market, and even emerging market, peers.

The MSCI China, for instance, is trading at a price-to-book ratio of 1.4, representing a 25% discount to the 5-year historical average and a 47% discount to U.S. equities, while broader EM markets are trading 16% below their historical average.

Based on such measurements, Chinese equities look attractively priced and like a good long-term value play, especially relative to the market’s fundamentals, and when you consider the three points below.

China is making progress on much needed financial system reforms. Concerns about currency depreciation and corporate defaults have been overshadowing evidence that China is moving toward achieving necessary structural reforms and that there’s likely to be a quicker timetable for key reforms than many market watchers currently expect. In March, for instance, China announced a widening of its currency band, the range within which the local currency can float. Meanwhile, the country’s central bank recently suggested that it will relax control on a number of bank deposit and fixed-income product interest rates within the next one to two years.

The Chinese government is unlikely to abandon their growth objectives. The government’s recent pledge of more stabilizing measures almost immediately following news of disappointing growth data indicates that China will prioritize achieving stable economic growth while gradually pushing ahead with much-needed reform. Meanwhile, the slowing of the Chinese economy is at least partly intentional on the part of the Chinese authorities, who want to transition the economy to one driven more by consumption than by investment, a transition that should be good news for the market. It’s also important to view China’s growth in context: China is still growing faster than other developed and emerging economies.

The Chinese market is potentially less vulnerable to tighter U.S. monetary policy. The Chinese currency and market are better positioned to withstand a rising-rate environment than many other emerging markets, given China’s current account surplus, ample foreign exchange reserve and low external debt.

To be sure, many of investors’ concerns are justified, and there are significant short-term risks for investors in Chinese stocks. These risks include the country’s unregulated shadow banking system and the risks associated with the inevitable slowing of credit growth. While an accurate estimate of the system’s size is difficult, even conservative estimates imply that it has more than doubled in size since 2008. In addition, one consequence of the China’s excess credit accumulation since 2008 is capital misallocation, or a diminishing economic impact from easy credit.

Meanwhile, headline defaults – although small and not systemic – from wealth management products and corporate bonds are signs that China needs to rein in credit growth before a possible bubble bursts. Finally, some of the reforms I mention above may be disruptive to markets in the near term, and like any value-driven investment call, my overweight to China may take a while to work.

But despite these short-term risks, I believe that Chinese stocks are worth sticking with over the longer term. You can read more about my country views in my latest Investment Directions monthly market outlook.

Source: Bloomberg, BlackRock Research

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.


Read more commentaries by iShares Blog