Quick question: Do you know which market segment has more than tripled the performance of the S&P 500 over the past three months?
If you answered Chinese stocks, then give yourself a red star.
Since early May, the iShares China Large-Cap ETF (FXI) — an exchange-traded fund pegged to the FTSE China 25 Index — is up an impressive 16%. We’ve also seen strong gains from China’s broader “A shares” market, which are Chinese stocks based in the mainland and that trade on Chinese exchanges. Over the past three months, the Deutsche X-trackers Harvest CSI 300 China A-Shares Fund (ASHR) is up 16%.
These performance numbers dwarf the relatively paltry gain of just 5.1% in the benchmark measure of large-cap domestic equities, the S&P 500 Index. And with outperformance like this, it’s easy to see why the alpha-hungry investors are ordering Chinese.
Yet given the recent outperformance in Chinese stocks, as well as the big run higher in the sector of late, many investors are asking themselves if that U.S.-beating run can continue through the remainder of 2014.
I suspect the answer is “yes,” and that Chinese equity prices will continue to be bid up well-beyond their domestic brethren, for the following key reasons.
#1: Shanghai-to-Hong Kong Convergence Trade
If you haven’t heard of the Shanghai-to-Hong Kong convergence trade, don’t worry — you’re not alone. After all, the internal machinations between China’s Shanghai Exchange and the Hong Kong Exchange aren’t the subject of mainstream financial news.
Yet in about two months, the linking of the Shanghai and Hong Kong exchanges will allow approximately 23.5 billion yuan ($3.8 billion) of daily trading between the two, which essentially will open up the mainland China equity markets to more foreign investors. It also will allow Chinese investors easier access to the Hong Kong stock market.
According to Bloomberg News, the Shanghai-to-Hong Kong convergence trade is generating record inflows into ETFs that invest in mainland China. From the report:
“The two biggest ETFs tracking China’s A shares lured about $2.5 billion from the end of May through yesterday [Aug. 13], the most for any similar period since they both started trading. By contrast, the largest ETFs that buy Hong Kong-traded Chinese companies, known as H shares, posted just $67 million of inflows.”
But why the migration to A shares before the convergence takes effect?
The short answer is valuation.
#2: Chinese Stocks Are Undervalued
The inflows into China’s A shares is, in effect, a valuation play, as investors basically are getting a home-grown discount by buying shares on Chinese exchanges rather than in Hong Kong. Currently, there’s a valuation gap in the ETFs pegged to the H shares vs. those in the A shares. For example, the current trailing 12-month P/E ratio on the stocks in the H shares ETF, the iShares MSCI Hong Kong (EWH), is 10.9. The P/E ratio on stocks in FXI is just 7.9.
Moreover, there’s a wider valuation issue here that makes both variety of Chinese stocks far more attractive on a valuation basis than U.S. stocks. The P/E ratio on the SPDR S&P 500 ETF (SPY) — the ETF pegged to the benchmark index — is 18.7. That valuation is far higher than either the A shares or the H shares market, and that means investors are likely to continue seeking relative value in China.
#3: Stimulus Winds
Another reason why Chinese stocks are likely to continue their outperformance for the remainder of the year is due to confidence in Chinese policymakers. Specifically, there is a faith in the country’s ruling elite that they are prepared to take whatever measures necessary to prevent the economy from slipping below their annual targeted growth rate of 7.5%.
The latest GDP print showed the Chinese economy growing at that 7.5% pace in the second quarter. Yet more recent data such as the industrial production, retail sales and credit growth showed clear signs of softness. Meanwhile, China’s manufacturing sector has continued to show strength, with the official PMI reading coming in at 51.7 in July, the country’s best reading in more than two years.
If, however, we see the manufacturing data begin to trend lower, or if we continue to see softness in retail sales or credit growth, look for the Chinese government to make more stimulus efforts — stimulus that likely would be added fuel feeding the latest buying frenzy in Chinese equities.
As of this writing, Jim Woods did not hold a position in any of the aforementioned securities.