CIO Insights: Has the tide turned for China’s economy?

China has lagged other major global equity markets over the past few years as a severe slump in the country’s property market weighed on its economy and markets. But the past few weeks have seen a rapid shift in sentiment, following a series of aggressive stimulus measures aimed at reversing the downturn. 

That’s contributed to a rally in Chinese equities – the MSCI China Index climbed as high as 40% from its recent mid-September low and is currently one of the best performing markets year-to-date. With investors asking if now’s the time to return to China, this month’s CIO Insights examines whether the tide has turned for its economy, and whether the latest rally has more room to run.

Key takeaways:

• China’s policy pivot has brightened its growth and market outlook. The economy is grappling with weak domestic demand, poor consumer confidence, and deflationary pressures owing to a severe downturn in its property sector. It will be difficult to resolve these challenges using the government’s usual playbook of monetary policy easing and capital expenditure, but these latest raft of measures are a solid starting point.

• More targeted fiscal support will be needed to sustain the revival in the economy and markets. Given the immense drag from the real estate downturn on the economy, large-scale fiscal stimulus will be necessary to revive consumer demand. We believe the government has the potential to deliver this over the course of the next 6–12 months.

• Chinese equity valuations have improved, but a structural improvement in earnings can drive a more sustainable rally. Most of the recent gains had been driven by the unwinding of short/underweight positions. That has brought valuations for Chinese equities back to their longer-term historical average – though still at a discount compared with other major global markets. For the rebound to continue, we’ll need to see China’s policymakers deliver on fiscal stimulus, a more sustained revival in the economy, and a continued improvement in corporate earnings.

• For global investors, China remains an important building block that cannot be ignored. China represents nearly 20% of the world economy, but comprises just 3% of major global equity indexes – that means there’s a lot of room for catch-up. As of our latest re-optimisation in April, our Economic Regime Asset Allocation (ERAA™) investment framework currently has a market-weight exposure to China, taking into account its attractive valuations and a more subdued earnings trajectory relative to other markets

A quick refresher on the situation in China 

The downturn in China's economy over the past few years has been tied to the bursting of its property market bubble – which came after years of over-leveraging by developers and excessive borrowing to fuel rapid growth.

The government's "Three Red Lines" policy in 2020, which aimed to control debt in the sector, triggered financial crises for these heavily indebted real estate firms. Slowing demand and an oversupply of housing, particularly in smaller cities, further compounded the problem, leading to liquidity issues and defaults among major developers.

As property prices began to fall, consumer confidence weakened, with many households holding much of their wealth in real estate. The resulting downturn in consumption and deflationary pressures further intensified the downturn, as falling prices and stagnant demand weighed on broader economic activity. This slowdown also hit industries connected to construction and property, amplifying China's overall economic challenges.

China’s policymakers’ more aggressive stimulus is a step in the right direction

Until recently, the government had taken a more modest approach to supporting the economy – preferring piecemeal policies over large-scale stimulus to avoid a resurgence in borrowing and financial instability. But in light of worsening economic conditions, policymakers finally responded with a more comprehensive and aggressive set of policies in late September. Those included:

• 20 basis points (bps) cut to its short-term policy rate, making it cheaper to borrow.

• 50 bps cut to banks’ reserve requirement ratio (RRR), making it easier for them to lend – and which would inject about 1 trillion yuan (US$140 billion) into the financial system.

• Reductions in mortgage rates, which could help 50 million households save about 150 billion yuan (US$21 billion) in annual interest payments – which could be directed toward consumption.

• An 800 billion yuan (US$112 billion) package to support the equity market via tools like share buyback programs and swap facilities.

The coordination and magnitude of these policies shows the determination of policymakers to arrest the downturn in the economy. For context, the Chinese central bank has cut its policy rate and RRR in the same month only a handful of times – one of those being during the Global Financial Crisis. 

Also highlighting the urgency of the situation: China’s Politburo, the country’s highest political body, laid out a series of pledges in its September gathering – including taking steps to halt the decline in the housing market and boost the equity market. The meeting’s focus on the economy and its more direct language were also departures from usual practice.

Monetary stimulus is good. Fiscal stimulus is better.

Monetary policy – which includes tools like interest rates and bank reserve requirements – is helpful for stimulating the economy because it influences borrowing costs, liquidity, and overall economic activity by encouraging or discouraging spending and investment. But these tools are also blunt and indirect, and studies show that the effectiveness of Chinese monetary policy is limited when not coordinated with the fiscal side.

This is why market participants have been focusing on fiscal policy as the missing piece in addressing China’s current downturn. This includes tools such as public spending, subsidies, tax incentives and transfer payments, which allows the government to directly stimulate demand, address weak consumer spending, and counter deflationary pressures.

The next big question is how much fiscal stimulus will be needed. While several announcements and press conferences since the initial package have been light on specifics, the market currently expects between 1–3 trillion yuan (US$140–421 billion) in government support. That’s equivalent to about 1–2% of GDP and appears broadly feasible, as it remains within China’s budget for the rest of 2024. In addition, the government can potentially boost the fiscal budget for 2025 to provide further support.

Moreover, local government spending – which is how the bulk of fiscal spending in China is carried out – is still well under the budgeted amount.

What about the time horizon? It appears that China is again taking a more measured approach rather than releasing all policy measures at once. While that has disappointed markets – which have pulled back somewhat since a recent peak toward the start of October – we believe the government’s strategy reflects a more deliberate timing.

That’s because China must carefully weigh its policy decisions, especially with the uncertainty surrounding the US presidential election in November – and the resulting policies from its winner. It’s highly plausible that China’s government is saving its ammunition as it waits for further clarity. In particular, we see potential for the unveiling of more substantial measures during its annual Central Economic Work Conference (CEWC) in December.

Chinese equities have rallied massively – but many investors are still on the sidelines

The reaction in Chinese equities over the past few weeks illustrates that market participants see the government’s shift as a positive. However, it's also important to note that much of this initial rebound has been driven by investors who had previously bet against Chinese stocks by borrowing and selling them, rushing to buy them back – a situation known as “short covering”. This buying pressure, combined with others adjusting their underweight market positioning, helped amplify the rally.

The dramatic rally also showed just how oversold China’s market was. As shown in the chart below, broad-based Chinese equity ETFs attracted weekly inflows of nearly US$5 billion following the announcement. To give you a sense of the scale of the underinvestment in Chinese markets, these few weeks of inflows exceeded the total net flows over the past 3.5 years!

After the recent rally, Chinese equity valuations are now back to their longer-term average, with a forward price-to-earnings (P/E) ratio of about 10–11x as of mid-October, up from a recent low of 8.5x in September. That highlights improving investor sentiment and a renewed confidence in China's growth prospects.

Even so, they remain at a significant discount to other major global markets. The S&P 500, for example, has a forward P/E ratio nearing 22x due to strong earnings expectations and resilient consumer demand. Fellow emerging market, India, meanwhile, is at 24x on investor enthusiasm on its growth prospects. (For more on that, see CIO Insights: Here’s why you should consider investing in India.)

A sustained rally in China’s equities will require a structural improvement in corporate earnings

Improved valuations are a good sign, as it signals improved investor confidence in China’s equity market. But as we wrote earlier this year, a sustainable bull run will require structural improvements in corporate earnings. (See that here: CIO Insights: China’s markets have been taking off – is it still time to hop on?) And ultimately, that hinges on China delivering on policies capable of reinvigorating the economy.

The good news: we’re already starting to see a cyclical recovery in Chinese earnings. As shown in the chart below, sell-side analysts are forecasting earnings growth of 7–8% over the next 12 months – back above the longer-term average of about 5%.

That said, as we shared back in June, this profile still isn’t as attractive as those of other major markets. Earnings for US companies, for example, are expected to grow 11–12% over the next year, while those in Japan and India are expected to grow about 15–16% and 17–18%, respectively.

China’s recovery is showing promise – ERAA™ remains market-weight

What does this mean for global investors? Given the size of China’s economy and the global reach of its companies, we believe its equity market is an important building block for multi-asset portfolios that cannot be ignored. Indeed, China represents 17% of nominal global GDP, but comprises just 3% of major global equity indexes. That means there’s a lot of room for catch-up.

For our ERAA™-managed portfolios, we’ve been maintaining a market-weight exposure to Chinese equities as of our latest re-optimisation in April – which has contributed to these portfolios’ positive returns in recent weeks as the market rallied.

Ultimately, China is too big of a market to ignore despite its economic challenges. The recent market moves underscore why having a well-diversified portfolio is crucial: it helps you to stay invested, ride through the market’s volatility and capture opportunities when they arise. Timing market rebounds is tricky, but a diversified portfolio ensures you're ready to take advantage of the upside when the cycle turns.