investment insights
China’s equity rally is at odds with fundamentals
Key takeaways
- Chinese and Hong Kong stock markets have rallied. That either reflects expectations for a rebounding Chinese economy, or concerns about a currency devaluation
- Corporate revenues will be key to sustain
- ing the rally. However, the Chinese economy continues to suffer from deflation, prompting expectations for looser monetary policy
- A more sustainable equity rally looks unlikely without a looser yuan policy. China’s central bank cannot devalue the yuan while fighting deflation as this would increase capital outflows and weaken domestic demand
- We anticipate further weakness for the yuan and maintain our preference for the US dollar.
Hong Kong’s Hang Seng Index (HSI) has gained 17% over the last month. Does this mean that the worst is over for Chinese equities? We examine the factors driving this stock market rebound, the measures being taken to support it, and whether investors should expect a devaluation of the Chinese yuan to boost a struggling domestic economy.
Until recently, the HSI was one of the world’s worst-performing stock markets. But year to date it now outperforms the US’s S&P 500. Investor optimism can partly be explained by the dominance of Chinese mainland technology shares in the Hang Seng China Enterprise Index (HSCEI), a subset of the HSI comprising mainland Chinese companies listed on the Hong Kong exchange. This market has surged 34% since a 22 January low, or more than 16% so far this year. Is it possible that the caution and negative sentiment that recently characterised China-related risk has faded on an improving economic and financial market outlook?
The equity rally may be driven by a combination of fear-of-missing-out, hopes of a Chinese economic recovery, Beijing’s pro-growth policy stance, foreign investor rotation from US and Japan stocks, as well as attractive valuations, particularly in technology-related names. Furthermore, the stability and consistency of the Hong Kong’s dollar peg to the US dollar also offers foreign investors some confidence. Meanwhile, Chinese authorities would like to sustain the rally with policy proposals. The latest plan would exempt individual mainland investors from a 20% tax on Hong Kong-listed dividends.
The rally therefore seems to be expectation-based and liquidity driven. Whether it can continue largely depends on China’s corporate revenue outlook. First quarter earnings for China’s big tech names will provide a sense of whether positive price momentum can be sustained.
A more pessimistic explanation for the rally would be that China’s economy is weakening to the point that onshore investors see a yuan devaluation as inevitable and are therefore trying to convert their local currency to Hong Kong dollars and/or gold. China’s gross domestic product growth in the first three months of 2024 surpassed estimates, but economic data published since March has underwhelmed, including falling retail sales growth and output.
Can the PBoC devalue the yuan?
Importantly, China’s property sector shows few signs of life, and is still posting declines in price and sales volumes across major cities. Credit has also stalled. April’s new aggregate total financing fell to CNY 12.7 trillion (USD 1.7 trillion), missing expectations, its first drop since 2005. Commercial banks have tried to extend loans to the market, but credit demand from firms and households seems lacklustre amid broad-based deleveraging. Looser monetary policy would be more consistent with China’s disinflationary struggle as consumer prices have remained stubbornly below 1% since March 2023. The outlook for producer prices also remains bleak.
Why is the People’s Bank of China (PBoC) reluctant to cut interest rates? Since the easing cycle started in December 2021, the benchmark 5-year lending reference rate (the loan prime rate) has fallen 70 basis points (bps), while the Consumer Price Index has fallen 120 bps. A decision to ease rates looks straightforward but the problem is the yuan, or rather the need to protect the currency’s value, and so counter devaluation expectations. Onshore retail investors are so convinced that the yuan will devalue that speculative demand for physical gold, denominated in US dollars, is pushing the metal’s price to record highs. The average daily trading volume of gold products rose 79% over March and April compared with the same period a year earlier.
Does devaluation makes sense? Most major currencies are weak compared with the US dollar, and until the Federal Reserve (Fed) starts cutting interest rates, that will not change. In the meantime, China’s exports are recovering. The country exported more than USD 1 trillion by value through April 2024. Further currency weakening would exacerbate trade tensions with global partners. A currency devaluation would raise import costs, weighing on domestic consumption.
The yuan nevertheless remains under pressure with outflows from equity markets, re-shoring by investors, Chinese foreign travel, and capital flight. Since the second quarter of 2023, foreign financial inflows fell to zero, the worst result since the yuan devaluation episode in 2015.
If monetary policy loosens, pressure on the currency could intensify. While we expect a stable exchange rate of around 7.3 yuan to the US dollar, the Japanese yen’s recent experience illustrates the possibly disruptive and unintended consequences of a weakening yuan.
The yen and the yuan
Since its 2021 peak, the Japanese yen has fallen 34% against the US dollar. This is because of both a strong dollar and Japan’s unorthodox monetary policy, but the yen’s weakness is upsetting the trade, competitiveness and pricing balance between Japan and China. Since 2021, Singapore’s dollar, China’s yuan, and Korea’s won have all appreciated against the yen with implications for their countries’ competitiveness and economic growth.
Both Japan and China are intervening to support their currencies. But interest rate differentials with the US mean their currencies will remain under pressure until the Fed starts cutting rates. We expect Japan’s central bank to raise rates and reduce bond purchases to provide an additional anchor for the yen.
We expect China to maintain its currency stability in coming months, pending major monetary policy decisions elsewhere – notably further rate hikes by the Bank of Japan and a first rate cut by the Fed. We do not rule out a Chinese devaluation after November’s US presidential election as Donald Trump’s potential return could result in the imposition of blanket 60% tariffs on Chinese exports to the US. We remain neutral on Chinese stocks, and expect the premium offered by mainland-China listed shares over Hong Kong-listed stocks to narrow as domestic capital outflows continue. A more sustainable Chinese equity rally therefore looks unlikely without a looser yuan policy. We maintain our portfolio preference for the US dollar and US stocks and see further volatility for the Japanese yen.
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