China's Stock Market: Is the Worst Over or Yet to Come?

Archive edition · Market data and company circumstances reflect 19 October 2024, when this newsletter was sent.

China Battling to Finish 2024 on a High

As we enter the final quarter of 2024, investors in China are closely watching the equity markets. The past few weeks have been a whirlwind for Chinese equities, with both soaring rallies and sharp declines.

The big question on everyone's mind is: Will Chinese equities end the year on a high, or will they continue to face adversity?

From Stimulus to Surge

In late September 2024, China's central bank announced a stimulus package that marked the most significant intervention since the pandemic.

The policy changes included cuts in borrowing costs, primarily aimed at reviving the struggling property market, and steps to enhance liquidity in the equity markets.

These measures sparked an impressive rally in domestic stocks.

The CSI 300 Index, a benchmark of China’s largest listed companies, and Hong Kong's Hang Seng Index both surged, capturing global attention.

Even China-exposed stocks, such as European luxury brands that rely heavily on Chinese consumer spending, saw a notable uptick.

This wave of enthusiasm was driven by investors’ optimism that China was finally taking the necessary steps to jump-start growth after a prolonged period of economic stagnation.

According to Jerry Wu, manager of the Polar Capital China Stars Fund, the rally was a result of a "sentiment shift" triggered by policymakers’ newfound focus on pro-growth and stimulus-driven measures.

However, the initial euphoria proved to be short-lived, as Chinese equities faced a massive setback on October 9, 2024.

The CSI 300 index dropped 7.1% on October 9, its largest one-day fall since 2020, leading to renewed concerns about the future.

The volatility in the Chinese stock market has left investors wondering whether the rally has legs or if more challenges lie ahead.

What is the Stimulus Package?

The stimulus package has exceeded market expectations, particularly in the areas of monetary, property, and equity markets. Here's a breakdown:

• The Chinese central bank announced significant interest rate cuts that were twice what the market had originally expected.
• The reserve requirement ratio (RRR) cut further bolstered the liquidity in the banking system.
• China cut mortgage rates by 50 basis points, and top-tier cities relaxed home purchase restrictions. This led to an immediate rebound in property transactions.
• Despite the cuts, challenges remain, as the mortgage yield is still lower than the rental yield in major cities like Beijing and Shanghai.
• For the first time, China announced direct lending facilities aimed at buying equities, in addition to setting up a potential stabilization fund.
• More long-term capital, including pension funds, is being funneled into the equity markets, creating momentum for stock prices.

Will This Stimulus Help China's Economy?

Despite the broad stimulus measures, the Chinese economy still faces significant challenges. Lu Sun, Senior Asia Macro Strategist at Goldman Sachs, states that while monetary easing makes funding cheaper, the real need is demand-side fiscal policies.

There have been reports of a potential two trillion yuan ($274 billion) fiscal stimulus package, with one trillion yuan earmarked for consumption support, and another trillion to help recapitalize major banks. These fiscal measures, if realized, could give the economy a further boost.

According to Goldman Sachs, the stimulus could add about 40 basis points to China’s GDP growth, which is a positive but modest outcome.

However, demand-side measures like targeted fiscal spending are seen as more critical to unlocking stronger growth in the coming quarters.

Market Reaction

The initial market reaction to the stimulus was strong, but Goldman Sachs explains that much of the surge was driven by short covering.

Investors, both onshore and offshore, had been extremely bearish on China, with hedge fund allocations to Chinese equities at multi-year lows. The broad market rally was a painful squeeze for those holding underweight positions.

Foreign hedge funds quickly participated in the rally, and we’ve already seen some profit-taking in the short term.

However, the "animal spirits" have returned to China's equity markets, as evidenced by the surge in new brokerage account openings during the country's Golden Week holiday. Local retail investors are showing a renewed interest in the markets, further bolstering momentum.

Have We Gone Too Far, Too Fast

Chinese stocks have seen their price-to-earnings (PE) ratio jump from 8x to 11x since early September 2024.

While this is near the highs seen during China’s reopening in January 2023, Goldman Sachs does not believe the market is overextended.

Historically, when China’s markets show strong momentum, they have rallied by 50% to 100%, as seen during previous cycles in 2014 and 2015.

Given the policy support for equities and the gathering momentum from onshore retail investors, Goldman Sachs believes the market still has room to run, even if the rapid pace of gains slows down.

The Chinese government is unlikely to intervene to cool off the rally just yet, as these measures are designed to uplift the equity markets.

Should Global Investors Reconsider China?

With local Chinese investors jumping back into the market, the question remains: Should international investors follow suit?

Long-term international investment in China remains relatively low, with geopolitical risks and political uncertainty acting as deterrents.

However, for those willing to take the plunge, a risk-parity strategy that involves holding both Chinese bonds and equities could be a smart move.

Since China lacks significant inflationary pressures, policymakers can remain focused on growth, and bond markets are likely to perform well in periods of policy easing.

Most importantly, China’s low correlation with global markets provides diversification benefits. As global economies face inflationary headwinds, China’s market dynamics remain distinct, making it an attractive option for portfolio diversification.

While the fastest phase of the rally might be behind us, China's market rebound appears to have some solid underpinnings. With the return of local investor enthusiasm and the possibility of further fiscal support, the rally could indeed have legs, albeit with a more measured pace going forward.

Keeping Track of the Global Economic Calendar

Understanding global economic events can provide crucial insights into market movements, enabling you to stay ahead of the curve.

That’s why we’re excited to dust off an old gem from our archives: How to Keep Track of the Global Economic Calendar to Gain Your Edge in the Stock Markets.

Don't miss out on this opportunity to enhance your trading skills and stay informed!

Archive note

This article preserves the analysis in our weekly newsletter sent 19 October 2024. Market prices, forecasts and company circumstances reflect the time of publication and may have changed.

This material is general information, not personal financial advice or a recommendation to trade. Investing and trading involve risk, including loss of capital.