The gradual recovery of Chinese equities strongly accelerated since the end of June. Both onshore and offshore Chinese equity indices are up around +15% in July. While the rally was broad across sectors, the momentum was particularly strong for the tech and consumer discretionary sectors, while defensive and energy stocks lagged. The rally is unfolding in extreme trading volumes, supported by strong domestic and foreign inflows.
The improving macro environment set the stage for this rally. China is leading the way in restarting its economy after dismantling its lockdown. The recovery in industrial activity and economic releases have surprised to the upside since March, with manageable infection cases resurgence so far. Equity markets are also benefitting from strong macro liquidity, a large part of which resulted from Chinese authorities’ targeted but continued stimulus. Improving liquidity has become palpable in surging monetary aggregates and social financing, as well as in liquidities released from banks and in foreign demand for Chinese assets. However, these positive factors do not convincingly explain the recent surge. On balance, economic surprises in June were actually milder with signs of a more laborious recovery in household and external demand. Besides, liquidity indicators have not particularly spiked in June.
Instead, three factors may have been more direct catalysts for the rally. First, the lag in Chinese equity valuation and prices relative to EM and developed markets had not reflected China’s relative success in managing the virus impact. Second, corporate profits announced late June were better than feared and back in positive territories (+3% y/y in May). Earnings revisions also started to stabilize, with 2020 FY EPS estimates marginally improving. Finally, domestic investors’ flows amplified the surge in prices, while emphasizing improving domestic confidence. In particular, retail flows, trading leverage and the opening in domestic new trading accounts all accelerated in July.
As a result, early signs of euphoria are appearing. Chinese stock valuations are not anymore cheap, measured in absolute, through P/E multiples, or relative to economic and market differentials with other regions. Also, Chinese stock prices are now overshooting foreign-stocks that have high exposure to Chinese revenues, usually a sign of overheat. Meanwhile, key tactical Chinese equity indicators (technical, breadth, valuation in particular) are flashing red. Finally, with Chinese indices reaching their 2017 pre-trade-war resistance levels, risks following the passage of HK’s new law from a new round of U.S. tariff escalation or renewed pressures on Chinese tech, both look shrugged off.
Yet, the rally may have further room to expand, supported by prospects of extra monetary/fiscal stimulus and by the inertia of momentum forces, in our view. The current rally is also much more moderate compared to those in 2015 and 2008. While Chinese markets may be getting more vulnerable to corrections, we maintain our O/W stance for the time being.
Chinese equity managers appear to have successfully captured the rally. According to Lyxor’s peer group of Chinese Equity Ucits funds, they have increased their net exposure over the recent months to record levels. They only marginally took profits over the recent days. They also benefitted from their tilt towards growth, quality, tech, and tertiary/services stocks, as well as those likely to benefit from infrastructure spending. We estimate that the strategy is still generating alpha and has fully recovered losses early this year.
Correlation across managers’ returns has remained historically high, suggesting a lack of diversifying themes. However, surging dispersion in managers’ return point to diverging views as to the next phase of the rally. This is also calling for a closer monitoring.