Chinese stocks are cheap for a reason

China shows that rapid economic growth isn't necessarily matched by high stockmarket returns. The MSCI China index has only doubled since 2003, while the economy has grown more than fourfold. Although the last few years have been relatively disappointing for investors in China, the near future could well be worse, according to a recent research note from Deutsche Bank's John Paul Smith and Mehmet Beceren.

One issue facing the market is that overcapacity resulting from the lending spree of the past few years is set to crimp profitability. Part of the problem has been the central government's limited control of the regions: "the Chinese variant of Communism has always been much less centralised than itsSoviet counterpart". This has meant that reducing local loans or subsidies and enforcing industrial consolidation plans have proved difficult.

Investors should also keep in mind that around 70% of the profits in the MSCI China universe stem from ten state-controlled companies. "The primary purpose of these sectors is to serve the needs of the Chinese authorities rather than to provide returns for investors." Now the economy is set to slow as Beijing is trying to reduce its dependence on investment, while the external environment is weak.

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So "to cushion the impact" of this transition on the Chinese population, the government seems all the more likely to interfere in sectors such as utilities, telecoms and banks. What's more, all this assumes China merely faces a difficult transition rather than "a major financial crash", or hard landing. The MSCI China index may look enticing in price/earnings ratio (p/e) terms, but it's "cheap for a reason". As the note warns, the S&P 500's p/e looked low in 2007 too, and look what happened next.