By Peter Garnry, Head of Equity Strategy at Saxo
 Peter Garnry |
There are bad days in the equity market when everything is on sale with liquidity effects driving all stocks over the cliff, and then there are days when an isolated equity market plunges even when most other equity markets are on the rise. The latter happened in Monday’s trading session when the Hang Seng Index declined by 6% and the CSI 300 (mainland Chinese index) fell 3% as investors decided to sell first and ask questions later upon witnessing the shuffle in Chinese leadership presented over the weekend.
The weekend’s events in China are arguably the culmination of a long journey, in which China has been placing ever more emphasis on the importance of the public sector over the private sector, as encapsulated in the Chinese policy of “Common Prosperity”. The price action in Chinese equities speaks volumes when we see the tumbling Hang Seng Price Index trading at levels not seen since the global financial crisis in 2009, even if the total return index is less gloomy and only at a level last seen in 2013. More importantly, the spread in equity valuation between the Hang Seng Composite Index and S&P 500 has dropped to very low levels (60% below S&P 500) with the Hang Seng Composite Index now valued at a mere 6.8 times earnings.
The rising Chinese equity risk premium
The valuation differential reflects the growing political risk premium and lower confidence in those underlying Chinese earnings as Common Prosperity is likely a drag on private sector earnings growth longer term. At times in recent years, Chinese technology companies often traded at higher equity valuations than their Silicon Valley peers, but since Common Prosperity was adopted, the situation has changed dramatically with lower earnings and revenue growth among Chinese technology companies, leading to massive losses for investors. We maintain an underweight view on Chinese equities as a precautionary measure. Countries such as India, Vietnam, and Indonesia are the big winners of the current realignment of global supply chains and thus considering for Asian exposure.
A growing equity risk premium on Chinese equities naturally leads to the question of whether the US equity market could suddenly be jolted by a repricing of its China exposure. Is a dollar of free cash flow in China worth the same as a dollar of free cash flow from the US or Europe? Arguably not, and while this has been reflected in the revaluation of many semiconductor companies (also partly due to the US CHIPS Act) it has not been fully reflected in more consumer-oriented stocks like Apple and Tesla. With around 20% of its revenue coming from China, Apple ’s risk profile could be rising on the risk of a sudden repricing due of a Chinese equity risk premium. Tesla gets 25% of its revenue in China and thus also has significant China exposure that is currently not reflected in its equity valuation. Apple and Tesla shares are key for broader equity sentiment and any downside risk dynamics in these two stocks could quickly jeopardize the wider equity market.
Investor flows into Chinese equities and companies with high China exposure
While price action tells one story on China, investor flows in ETFs tracking MSCI China A shares are telling a slightly different story. The number of outstanding shares (essentially how much capital that is deployed in an underlying index) has been growing steadily over the years as China’s capital markets have opened up. The has led to more inclusion in EM- and global benchmark indices of equities and bonds. While we have seen significant outflows out of ETFs tracking CNY bonds, until very recently at least, we have observed the opposite in Chinese equities. Falling equity prices in China have prompted rising investor flows into a “China is cheap” narrative. But sometimes, things are cheap for a reason (the equity risk premium discussion above). Over the last couple of months, this trend has shifted: in August, the largest UCITS ETF, which tracks MSCI China A shares, has begun seeing declining outstanding shares. As of Friday the current drawdown was -12%. This could be an early sign that investor appetite is on the decline.
MSCI, the leading global equity index provider, has created an index called the MSCI World with China Exposure Index (USD). It covers 51 companies with the greatest revenue exposure to China. This index is a good starting point for any investor who would like to break down portfolio exposure to China. The 10 largest companies in the MSCI World with China Exposure Index (USD) are listed below.
- Qualcomm
-
BHP Group
-
Texas Instruments
-
Broadcom
-
Rio Tinto
-
Applied Materials
-
Woodside Energy
-
Lam Research
-
Fortescue Metals Group
-
Marvell Technology
-
As noted above, in addition to this list we would argue companies such as Apple and Tesla have considerable revenue exposure to China and thus have downside risks to their equity valuation.
