#57 Weekly Charts — Chinese Consumers & Unprofitable Companies
Topics of the day:
- Chinese Consumers
- Unprofitable Companies
JP Morgan AM
The rise of Chinese Assets in global portfolios
The next decade should see significant structural change in the Chinese economy and continuing capital market reforms, with profound implications for Chinese assets and their role in global portfolios. Despite the recent volatility in Chinese equities amid changing regulations, we still believe it is an opportune time to talk about allocating to Chinese assets. Our 2022 forecasts suggest onshore Chinese equities and government bonds will continue to offer long-term investors a substantial return premium over developed markets, with low correlations. Despite Chinese assets’ higher volatility, the diversification opportunities, currency appreciation and alpha opportunities will likely attract more investors — and prompt more individuals and institutions to consider investing in China as a stand-alone allocation.
Over the past 15 years, China’s onshore stock and bond markets have become the second largest in the world, helped by international investment flows spurred by China’s inclusion in benchmark global stock and bond indices.
Too big to ignore — yet largely overlooked
The average international institutional investor’s total China exposure is 4.6% of its total assets. A large part of this is likely to be in offshore Chinese equities, because institutions invest in China mostly through an emerging market (EM) equity strategy, such as allocating to the MSCI EM index. While China accounts for around 34% of the MSCI EM index, the weight of onshore Chinese equities (China A shares) is only about 5%. Given such large onshore equity and bond markets, and ongoing capital market reforms and opening, Chinese assets’ weight in global portfolios will likely rise over time.
EQUITIES Local retail investors once dominated the A-shares domestic stock market, but their footprint has gradually diminished: Retail investor holdings fell to 42% of all equity holdings in 2020, from 60% in 2010, a decline that could continue in the years ahead, though at present retail remains a higher fraction in China than in other major emerging and developed equity markets (EXHIBIT 2A). Retail investors still dominate trading volume, accounting for 70% in 2020. In their place in the future, we anticipate more institutional investors, attracted by equity market legislation, such as 2020’s new Securities Law, which strengthened investor protections.
McKinsey & Company
Fast forward China: How Covid-19 is accelerating 5 key trends shaping the Chinese Economy
Over the last few months, COVID-19 has spread across the world, uniting humanity in a shared experience that has highlighted the vulnerability of our societies. As the first country to grapple with the crisis, China has been on the frontlines both of post-COVID-19 economic recovery, and of the societal changes the pandemic has precipitated. Efforts to stabilize the domestic economy are already well underway, and though China’s first quarter gross domestic product declined 6.8 percent over the previous year, according to government statistics, our simulations suggest that economic activity may have bottomed out in the first quarter.
Declining Global Exposure
Over the last decade, the engine of the Chinese economy has become more domestically driven by the rapid expansion of its consumer market, deep localization of supply chains, and strong emphasis on local innovation. As a result, China’s relative exposure to the rest of the world in terms of people, capital, and technology has declined. Meanwhile, the rest of the world’s exposure to China, which has increased at a steady pace over the past decade, in part as a result of the globalization of supply chains, as well as the expansion of the Chinese middle class, is now in question. The forces that were already driving a restructuring of the relationship between China and the global economy may with COVID-19 be accelerating this trend on a global scale.
Classic signs of speculation
Every bubble is unique. The economic environment is unique, the players are unique, the industries and companies caught up in the frenzy may be unique. All true. But classic common threads also run through bubbles because they are born of human nature: the fear of missing out, watching with envy as others get rich around you, career risk and (far investment professionals) keeping up with peer groups and benchmarks, the willing suspension of healthy disbelief, and the dissolution of discipline.
Making money on companies that make no money
Bidding up the prices of money-losing enterprises is a classic bubble sign. lt has shown its face in the SPAC phenomenon, certainly. But in the chart, we see the same phenomenon in established companies. Today, 60% of the Growth stocks in the Russell 3000 lndex make no money, and this was true even before the COVID-induced recession. Yet these very companies have been generating huge returns in price movement over the past few years, dramatically outperforming their Value counterparts. The Russell 3000 Growth lndex was up 84% cumulatively over the last two years through August (more than double the return of its Value counterpart). So investors are making money on companies that make no money — never a good sign when it is done this pervasively and at these valuations. And while not common, it is also not unique. We all witnessed the same speculative behavior in the late 1990s and in the 2008 speculative bubble.
STATE STREET GLOBAL ADVISORS SPDR
Forecasts for 2021 global economic growth are projected to peak at 5.9%, with expectations for 2022 and 2023 to fall to 4.9% and 3.6%, respectively. While those rates are lower than the figures for 2021, they are still above the average growth rate for the past fifteen years.
From a relative growth perspective, US stocks trailed the rest of the world in 2021 (44% versus 59%). But in 2022, US stocks are projected to grow their bottom line by 8.04% (above their 15-year average) compared to just 5.80% for non-US equities (below their 15-year average).
The global figures are being dragged down by weak sentiment in emerging markets (EM) where low vaccination rates present reopening challenges in some nations. As a result, EM stocks have witnessed nearly the same amount of upside revisions to downside for their 2022 estimates. EM stocks also have the worst recent one-month change to their forecasts — declining by 24 basis points in October, following September’s nearly 2% decline.
Focus on quality, not quantity
During the first part of the pandemic rally, profitability was less of a concern. From May 2020 to May 2021, US stocks with negative earnings over the prior 12 months outperformed firms with positive earnings by 34%.
Since May 2021, that performance trend has flipped. Unprofitable firms have trailed profitable ones by 7%. Unfortunately, that trend has not forced more firms to become profitable, as there are now over 1,100 firms with negative trailing 12-month EPS compared to 843 before the pandemic. As growth slows, this is unlikely to drastically change — at least not in the near term.
Profitability, however, is different than growth. A firm can have a 40% year-over-year growth rate but still be unprofitable, as its EPS could have improved only from -$0.75 to -$0.45 per share. The ability to generate a profit is just one consideration of the quality factor, however. The other is centered on the reliability of growth. Or rather, the volatility of earnings. And pure high-quality stocks have started to noticeably outperform low quality stocks, as shown in the following chart. Yet, the relative performance ratio has yet to re-test pre-pandemic levels and just recently broke through its 50-moving day average — indicating there still may be more room to run even though high quality has outperformed low quality by 6.5% over the past three months.
…the global growth outlook faces many risks that prevailed before the pandemic, including populism and elevated debt.
Relative valuations of defensive sectors, such as health care, consumer staples, and utilities, are much lower versus their 10-year history than sectors such as information technology and consumer discretionary. Within expensive sectors, investors can also find select high-quality companies that trade at attractive valuations.
We own quality compounders — quality stocks that can consistently compound shareholder value — with consistent growth drivers, rather than hypergrowth themes with stretched valuations. Among stocks with undervalued stability characteristics, we like attractively priced companies with solid business models. We prefer companies that earn higher return on invested capital over rebounding companies with no earnings to show. Select supermarkets and utilities, for example, are attractively valued in historical terms and versus other stocks, with much higher free-cashflow yields compared to bonds too. Finally, we look for companies that have been mispriced by the markets despite improving future prospects.
My conclusions and considerations
- The world is changing and even the economies as well. Faster than we think.
- One of this is the China’s economy and their consumers. Really interesting.
- Despite Chinese assets’ higher volatility, the diversification opportunities, currency appreciation and alpha opportunities will likely attract more investors — and prompt more individuals and institutions to consider investing in China as a stand-alone allocation.
- China’s relative exposure to the rest of the world in terms of people, capital, and technology has declined.
Here you can find other articles about it:
- Today, 60% of the Growth stocks in the Russell 3000 lndex make no money, and this was true even before the COVID-induced recession.
- Profitability, however, is different than growth. A firm can have a 40% year-over-year growth rate but still be unprofitable, as its EPS could have improved only from -$0.75 to -$0.45 per share.
Here you can find other articles about it:
Join the conversation with your own take on these topics in the comments below.
About the Author
Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics and in doing so he shares with you the most interesting charts and comments.
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.