Is the Recent China/EM Rally for Real?
Excitement in Chinese stocks has ratcheted up this year, with share prices rising rapidly in China and in emerging markets (EM) equities in general. Ironically, this is occurring at the same time that EM-listed corporate profits have been contracting. So it appears that it is not profits that are driving Chinese and EM stocks higher.
Importantly, Chinese stocks were not cheap before this rally commenced. According to BCA Research, excluding financials and energy, Chinese investable stocks (predominantly H shares and B shares) were trading at a P/E ratio of 20; they are now trading at a P/E of 25. As for mainland-listed domestic stocks, the Shanghai A-share Stock Price Index's P/E ratio stands at 22, and for domestic small caps it is a hefty 55.While we continue to monitor markets like Brazil and China, we have felt for some time that the low-multiple segments of the EM stock markets are "cheap" for good reason; it is difficult to discern what is on bank balance sheets, falling commodity prices will dampen earnings, and state-owned enterprises are often poorly managed.
Multiple expansion typically occurs when profit growth is positive or expected to recover. With the exception of India perhaps, this is not the case with EM and Chinese stocks at the moment; their per-share earnings are shrinking, and the contraction will deepen further in the next nine months or so. It is difficult to sustain a rally when equity multiples have expanded at a time when profits were set to contract. Other than specific cases, we cannot find conviction in this latest China/EM rally. Meanwhile, it may be no coincidence that the number of new retail brokerage accounts has increased 15-fold in China since last June, while gaming revenue from mainland visitors to Macau has fallen by nearly half. With this in mind, Chinese equity markets could certainly rally for a while longer before the reality of fundamentals takes over.One final note: Many EM countries finance themselves in U.S. dollars, which creates several issues in terms of potentially higher financing costs. First, the dollar, we think, is likely to continue to appreciate from here for reasons that are beyond the scope of update. This means that the debt and interest payments for EM countries are appreciating at a time when their revenues are depreciating in foreign currency exchange terms. Second, U.S. interest rates are set to rise, meaning that any variable interest payments will rise immediately at that time, and future refinancing will take place at higher rates. EM markets will have a duel squeeze on financing costs over the coming years, leading us to question the sustainability of the recent rally.