How Much Room is There for Valuation Recovery in China-Linked Stocks?

After significant declines and valuation pressures over the past two years, Chinese assets have started to show impressive gains, buoyed by a series of macroeconomic stimulus policies. According to a report from Goldman Sachs, market participants have responded positively, with Chinese stocks recording their largest single-day net inflow since March 2021 on Tuesday. Additionally, open interest for call options on the iShares China Large-Cap ETF (FXI) surged to its highest level in a decade, indicating growing investor confidence in China-linked stocks.

Despite this recent rally, Goldman Sachs reports that hedge funds’ overall and net allocations to Chinese stocks remain at their lowest levels in five years, suggesting the rebound in Chinese equities could have further room to grow.

Background: Extreme Low Valuations in Chinese Stocks

Over the past few years, geopolitical tensions and macroeconomic downturns have pushed many global investors to dramatically reduce their exposure to Chinese assets, with some even taking short positions. This has driven Chinese stocks to extremely low valuations.

Charts illustrating the low allocation of Chinese assets over the past five years and the high volume of short positions indicate that the market is extremely oversold. For instance, the MSCI China Index has dropped to around 10 times earnings just before the recent Q3 2024 rebound, following two years of valuation contraction after a period of expansion in 2020 and 2021.

When comparing the price-to-earnings ratios (P/E) of the MSCI China Index and the S&P 500, it becomes clear that while U.S. stock valuations have continued to expand, the ratio between the two indices has significantly decreased, reaching approximately 0.42 before the latest rebound.

Marginal Improvements in Earnings: Is It a "Davis Double Play"?

Despite stagnant earnings growth for Chinese stocks in recent years, there are signs of optimism. The Bloomberg expected EPS for the MSCI China Index has remained relatively flat, while the S&P 500 has seen steady earnings growth. However, recent Chinese monetary policy actions—including lower reserve requirement ratios (RRR), interest rate cuts, and reduced mortgage rates—are improving macroeconomic fundamentals in China. These measures are expected to boost earnings expectations, potentially breaking the current low valuation trend for China-linked stocks.

For example, consumer goods and internet sectors, which are highly sensitive to consumer spending, are likely to see earnings improvement due to reduced household mortgage burdens. This could stimulate greater consumer spending, thereby driving sectoral rebounds. These sectors have already seen noticeable growth, which further supports the argument that the recovery in Chinese stocks could have significant room to run.

What’s Next for China? Fiscal Policies and Fed Rate Cuts

Many institutions believe the recent policy measures are just the beginning, with expectations of more fiscal stimulus and structural reforms to follow. While the current market rebound has been positive, sustaining momentum will require further fiscal expansion and more aggressive structural policies.

According to Bank of America, the long-term performance of Chinese equities will depend on fiscal stimulus and structural reforms to resolve issues such as overcapacity and deflationary pressures. A true economic recovery in China will also require improvement in corporate earnings and macroeconomic fundamentals, especially within the real estate sector and financing for small and medium-sized enterprises.

From a monetary policy perspective, with most global central banks moving toward rate cuts, China still has potential for additional easing. HSBC forecasts another 10 basis point cut in interest rates and a 50 basis point reduction in reserve requirements for the remainder of this year. However, the potential for inflation in commodities, driven by stimulus measures in China, poses a risk. This could slow the pace of inflation decline in the U.S. and influence the Federal Reserve's rate-cutting plans, which investors should closely monitor.

The Outlook for China-Linked Stocks: Opportunities and Risks

The recent rebound in China-linked stocks has raised the question: Is there still room for valuation recovery? With Chinese asset valuations at extreme lows, combined with improving earnings expectations and supportive monetary policies, many investors believe the market still offers substantial upside. However, risks remain, especially related to global inflation concerns and the sustainability of fiscal measures.

Singaporean and Malaysian investors should closely monitor China's fiscal policies and the global economic landscape, as these factors will play a pivotal role in determining the future performance of China-linked stocks in the region.

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