Market Sentiment Shifts: Intl. Investors' Perspectives
The Chinese stock market has experienced a remarkable surge in recent weeks, igniting interest and concern among global investors. By the end of the Golden Week holiday, the MSCI China Index and the CSI 300 Index had rebounded significantly, showcasing gains of 36% and 27% respectively from September lows. Such robust recoveries are notable, particularly as they represent some of the strongest and most concentrated movements since these indices were introduced in 1993 and 2005, according to Goldman Sachs. The escalation, marked by an impressive eight standard deviation increase, translated into nearly $3 trillion added to the market's valuation, which is strikingly equivalent to 20% of China’s nominal GDP for 2023.
However, the joyous refrain of rising stocks quickly dulled post-holiday, as market sentiment shifted dramatically. The A-share market opened with a bang on October 8, only to succumb to volatile fluctuations shortly thereafter. The Shanghai Composite Index fell from a high of 3,674 points to 3,301 points by October 10. This turmoil prompts further examination of the underlying factors at play in the market's recent rollercoaster ride. Morgan Stanley's chief equity strategist for China, Wang Ying, pointed out that before this correction, the valuation of the MSCI China Index had soared from an already high nine times earnings to twelve times, almost returning to the previous five-year average. However, despite the resurgence in valuations, corporate profits had not experienced a corresponding recovery. Thus, a sustained upward trend in the market will likely necessitate additional fiscal support, particularly aimed at ameliorating the current economic fundamentals and deflationary pressures.
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Interestingly, the latest market shift reflects contrasting behaviors from different types of investors. Around the middle of September, significant monetary policy easing measures unleashed a wave of capital influx from international funds, notably hedge funds, which plunged into the market following the announcements of interest rate cuts and other financial easing measures. Reports indicated that between September 25 and October 2, approximately $6 billion in passive capital flowed into Chinese stocks. Yet, active funds, especially public equity funds, showed a more cautious approach, adding only about $300 million—an indication that many active investors had not fully engaged in these developments.
Notably, before the Golden Week, hedge funds were holding the lowest levels of exposure to the Chinese stock market in five years, at just 6.8%. Coupled with the expectation for an increase in allocations, this suggested significant potential for growth in investments. However, hints of profit-taking were evident during the holiday period itself. According to a report from Goldman Sachs, hedge funds executed a record sell-off of Chinese equities on October 8, spurred by a lack of stronger stimulus policies post-holiday. The actions signaled not only a retreat from long positions but an increase in short positions, leading to a heightened level of volatility in the markets as traders returned from their break.
The frenetic trading activity during the holiday translated into impressive performances from index funds, with the Hang Seng Index climbing substantially and volume reaching unprecedented levels. The tech-heavy Hang Seng Tech Index experienced gains as high as 10%, while brokerages—pivotal players in the market—saw their stocks surge by margins ranging from 50% to potentially 100% in some cases.
Despite these fluctuations, the recent pullback was not entirely unexpected. Prior to the holiday, many analysts projected the MSCI China Index and A-shares could see technical rebounds of approximately 10% to 15%. However, those targets were hit in mere days, illustrating the market's volatility. Wang Ying mentioned that the forward price-to-earnings ratio of both A-shares and the MSCI China Index had returned to the mean levels witnessed over the last five years, indicating that market valuations shifted back to historical norms. But such a return to average doesn't guarantee ongoing higher trajectories; it raises questions about sustainable growth moving forward.
Market analysts predict a potential stabilization or oscillation in values as this period of retraction unfolds. Morgan Stanley suggests that while large-cap stocks rebounded, growth stocks lagged behind in recovery. The Hang Seng Tech Index, for instance, remains priced at a 27% to 37% discount compared to its five-year average, unveiling significant room for valuations to adjust upward in tandem with market growth.
Investment managers have voiced cautious optimism about the near term as they navigate a landscape where fiscal policies remain expansive. The comments from BlacRock's Kai Bi suggest that this wave of support might mitigate steep declines in the short term. The backdrop for this market encouragement lies in the broad expectations surrounding future economic improvements. Analysts anticipate that over the next two to three months, the market will shift its focus to observable patterns in economic health. Concrete signs of recovery might provide indices the impetus for further upward movements. But should those improvements not materialize, it could prompt the need for enhanced policy interventions to maintain market stability.
Leading investment firms are now harboring cautious outlooks towards corporate profitability amidst the forthcoming quarters. The consensus is that earnings will remain pressured through the end of the year unless substantial fiscal stimuli exceed prevailing expectations. Wang Ying's analysis indicates that of the five bull markets in the past, only the 2016-2018 phase was driven by earnings growth; the others leaned heavily on valuation corrections. Notable factors like supply-side reforms, consumer expansion, and internet development were crucial in fostering that earlier profitability surge. The historical average for stock market performances, lasting approximately 231 days with gains of about 66%, highlights how valuation corrections account for a significant portion of those increases.
For the ongoing market rally, the initial stage was propelled by cheap capital and stock repurchases—now fading. What lingers is a second phase, where confidence and belief in China’s capacity to rebound from deflation have begun to reshape valuations, narrowing the discount that once extended to 30% down to a mere 13%. However, this latter stage relies heavily on market sentiment devoid of real earnings growth; substantial macroeconomic stabilization will be necessary to support further increases, especially as future indicators related to real estate inventories, sales conditions, and consumer and credit demands come into focus.
Looking ahead, the financial markets remain poised for potential disappointment in the third and fourth quarters. With rising hopes for recovery in corporate earnings by mid-2025, the trajectory of the bull market hinges critically on solidifying support from profitability. Absence of genuine earnings backing could risk transforming this rally into another fleeting spike reminiscent of prior valuation-driven ups swings.
As we approach mid-October, attention will turn towards upcoming announcements from the Ministry of Finance regarding the potential scale of fiscal stimulus—an event expected to shed light on government actions that could profoundly influence market dynamics. UBS's chief economist Wang Tao forecasts that reasonable expectations may lead to modest fiscal measures in the short term, envisaging initial stimuli in the range of 1.5 trillion to 2 trillion RMB, with broader expansions contemplated for 2025. Critical policy discussions are anticipated post the Golden Week and in conjunction with the Q3 data release, indicating that market participants are bracing for vital information that could dictate the direction of China's economic recovery.