Are Chinese shares ahead of the curve?

16/07/2020

Emerging market share prices took a beating in the first half of 2020, as the coronavirus pandemic spread around the world. From the start of the year to its low on 23 March, the MSCI Emerging Markets Index of the largest emerging market-listed company shares fell by more than a quarter.

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This time around, emerging markets – countries in the process of catching up with developed economies, usually with rapid growth and increasing industrialisation – have been slower to recover from the global downturn than their developed market counterparts.

This relative underperformance is partly due to the remarkable performance of the US stockmarket, which had recovered its 2020 losses by early June and is therefore flattering developed markets by comparison.

It also stems from the nature of emerging market economies, which are often big exporters. The major disruptions to trade from the coronavirus lockdown has therefore severely hit economic growth.

However, emerging markets are extremely varied. Economies such as Chile, Peru and Russia are heavily commodity-related while others, mainly in Asia, boast innovative technology companies. This latter group includes China, the largest emerging market by far and the world’s second-largest economy.

Resilience of the Chinese stockmarket

China’s stockmarket has fared well through the coronavirus crisis. After dealing with its initial outbreak, China started to reopen its economy when the rest of the world was in lockdown.

The CSI 300 Index of the largest stocks listed on the Shanghai and Shenzhen stock exchanges fell by 14% from the start of the year to its low on 23 March (compared to 27% of the MSCI Emerging Markets Index). By the end of June, the CSI 300 had recovered its losses and, more or less, was back to where it started 2020.

The relatively domestic nature of the Chinese economy – the share of exports in China’s gross domestic product (GDP) dropped to around 17% in 2019, from more than a quarter in 2010 – together with supportive government policy, are both factors behind this resilience.

The rise of global Chinese companies

Investors’ hopes for Chinese companies are arguably justified by its tech titans, Alibaba and Tencent. These companies were very resilient during the lockdown as their businesses (being e-commerce, and digital services and video games respectively) were suited to people staying at home.

While both Alibaba and Tencent have demonstrated how Chinese companies can expand on their domestic success to emerge as world players, there are also lesser-known Chinese companies that offer this long-term potential. One of those is Hollysys Automation Technologies, a provider of automation and control systems to the rail and power industries.

Many companies like Hollysys have benefitted from the Chinese government’s continued investment in infrastructure – one of the structural tailwinds for domestic companies to grow quickly and then leverage that success overseas. The wealthier, ageing Chinese society could also present long-term opportunities for companies to emerge.

Reasons to be cautious

But China is not immune to the challenges facing other markets around the world. In the first three months of 2020, China’s economy shrank 6.8% from the year before – the first such decline since quarterly GDP records began in 1992.

Corporate governance is also mixed in China. While there are well-run firms that are focused on delivering returns for all shareholders, there are others that ignore their minority investors.

Take Luckin Coffee, for instance, which was considered China's answer to the world's biggest coffee chain, Starbucks. An accounting scandal came to light earlier this year revealing £250m of fake transactions, resulting in its shares being suspended from trading. The failure of Luckin Coffee highlights the need to be selective as investors. Focusing on governance is important to help avoid future blowouts.

There are also geopolitical risks to consider when investing in Chinese companies. US-China trade concerns had eased when the pandemic struck, but any resumption of tariffs could have an impact on the exports of Chinese companies. Furthermore, geopolitical disputes could affect companies’ access to certain markets, as we have seen with the US government’s sanctions against technology firm Huawei.

Is there better value in other emerging markets?

Chinese company shares look expensive by most measures. The forward price-to-earnings (P/E) ratio – which compares a company’s share price with its forecast annual profits per share – of the MSCI China Index of large Chinese-listed shares is 40% higher than it was a decade ago after the Global Financial Crisis.

Although China dominates any discussion about emerging markets, other such markets might offer investors attractively valued opportunities. There are global leaders in technology from Taiwan and South Korea, for instance.

Typically, but to varying degrees, other emerging markets benefit from long-term structural trends like favourable demographics, with a relatively high working-age population, as well as high levels of infrastructure investment and urbanisation. Local companies stand to benefit, either directly or indirectly, from these trends.

As active investors, we can look out for promising ideas among companies that might not be fashionable, but are well managed and have healthy balance sheets. Such companies may sometimes be overlooked by others, especially in less-researched emerging markets.

Please bear in mind that M&G is unable to give financial advice. The views expressed here should not be taken as a recommendation, advice or forecast.

Of course, all investments carry the risk of loss. When you're deciding how to invest, it's important to remember that the value of investments will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.

It is also important to remember that past performance is not a guide to future performance.