Is China an undervalued market?

“China’s real-estate collapse may be morphing into something much larger: a deflationary economic bust,” writes investment strategist Ed Yardeni. “Buying a home was one of the primary ways that Chinese citizens used to invest and build wealth but new home prices have fallen by 5% year on year, marking the 13th month of consecutive declines. So the housing bust has taken a toll on Chinese consumers’ confidence, now at near-record low.”

According to the People’s Bank of China, 96% of residents own a home and 20% own more than one, yet the population is ageing rapidly, reducing demand and hence construction activity. Average house prices soared from £321 per square metre in 2005 to £737 in 2020, leading to a housing price-to-income ratio of 29. As a result, household consumption accounts for just 37% of GDP, compared with 68% in the US, according to economist Diana Choyleva. “More spending is crucial to revive China’s flagging performance.”

While households respond to falling property prices by increasing savings, the response of the government is to stimulate industrial production, rather than consumption, says Yardeni. So output rose 5.1% year on year in July, while retail sales growth of just 2.2% was far below the 10% achieved historically. With money supply now contracting for the first time this century, “Chinese nominal GDP growth could turn negative over the next six months”, says Yardeni.

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Is China being overlooked by investors?

Against this economic background, it’s not surprising that ten-year government bond yields have plunged to 2.2% and that stock prices, especially for property shares, are on a downtrend, having fallen over 40% in four years. Most Asian fund managers are cautious; Schroder Asian Total Return trust is “significantly underweight” with an allocation of 15% to China (including Hong Kong) compared with 33% in its benchmark index.

Invesco Asia Trust takes a contrarian view. Managers Fiona Yang and Ian Hargreaves are overweight China. “Green shoots in China are being overlooked [with] abundant household savings, solid balance sheets and supportive policy announcements recently,” they say. “Should attitudes towards China start to improve, they will be doing so from a low starting point, with deeply discounted equity valuations likely to be very sensitive to signs that corporate fundamentals are starting to improve.”

Invesco Asia has £240 million of net assets while its shares trade at an 11% discount to net asset value (NAV) and yield 4.3%. Performance in the last year has been flat, thanks to its caution about booming India and prematurely favouring China, but the shares have returned a respectable 36% over five years. 

“IAT’s contrarian approach means investors are likely to get a differentiated portfolio to what is available elsewhere while the contrarian approach has been successful over the longer term,” says Kepler, a broker.

Ongoing geopolitical tensions

“Geopolitical tensions linger,” admit Yang and Hargreaves, but China appears to prefer bullying and threatening Taiwan to the risk of an actual invasion. Whoever wins the US election, tension between America and China is likely to continue. 

“At its core, the US-China rivalry is a clash of ideologies,” says Choyleva, “with America seeking to create a united front against China’s expanding reach and to confront its economic practices,” such as its predatory industrial policy and intellectual property theft. 

Perhaps China is just following the doctrine first espoused by UK prime minister Lord Palmerston nearly 200 years ago: “We have no eternal allies and we have no permanent enemies. Our interests are eternal and permanent, and those interests it is our duty to defend.” If economic adversity is mellowing China’s confrontational approach, Invesco’s strategy could pay off handsomely.

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