LONDON — Any veteran investor will tell you that
financial markets overshoot when trouble hits, but what if that market is the
world's second-largest economy and the government has decided the rules of the
game have changed?
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China's months-long regulatory
crackdown has included big names in e-commerce, the gig economy, exam
cramming, and most recently online insurance.
Close to $1 trillion in market
value has been wiped off China Inc. since February.
For big firms that also list on markets like Wall Street
because it brings in international investment, 2021 is already the worst year
since the global financial crisis.
It could spring back of course, but there's the rub.
Many
analysts are convinced things will settle, but only the Beijing ruling elite
know if and when that might be.
"
Investors have been jolted," said Paul O'Connor,
head of multi-asset at Janus Henderson.
"This will weigh heavily on the outlook for profits,
valuations and investor sentiment in China."
But by how much?
Morgan Stanley estimates MSCI China, which has seen one of its
biggest lags on record versus world stocks this year, now trades at 13.9 times
12-month forward price-to-earnings, a 5 percent premium over MSCI's broader
emerging market benchmark.
That compares to about 17 times at the start of the year. It
could get down to 13 times, says Morgan Stanley.
Analysts bullish on Chinese stocks heading into the tumult
are now assessing the damage.
In March, before the latest crackdown, the average consensus
12 month share price target for stocks in the MSCI China Index, was about 40
percent higher than a year earlier.
The majority of analysts rate giants Alibaba Group Holdings
and Tencent Holdings at least a "buy", according to Refinitiv data,
while most recommend a "hold" or "buy" for New Oriental
Education & Technology Group, whose stock has tumbled close to 90 percent
this year.
"The process of earnings downgrades and ratings
downgrades has barely started," said Janus Henderson's O'Connor.
Evergrande Property Services, part of China's most indebted
property developer, has already lost more than half of its market capitalization
from the peak.
The share price is currently trading around 13 times forward
price-to-earnings multiples, significantly lower than peers.
Problems vs possibilities
Having pumped in more than $800 billion over the past five
years, investors are not about to fold their bets that China will offer the
biggest boost to global financial markets in the decades to come.
And while they acknowledge the changes are part of a broader
plan to make economic growth more inclusive in the long run, they are mindful
that future returns will depend much more on careful assessment of risk.
"It's important to distinguish between what is really
volatility or noise and what is here to stay," said Michael Bolliger,
chief investment officer, emerging markets, at UBS Global Wealth Management.
While some damaged sectors are likely to bounce back over
time, others, like tutoring, which the government now wants to be nonprofit
making, almost certainly won't.
"They changed almost the DNA of these companies,"
said Bolliger.
The hit has been painful. EPFR data shows around $2 billion
was pulled out of equity funds with significant China exposure in the first
week of this month alone. Morningstar figures point to China-focused funds nursing
at least 7 percent negative returns. For context, they made around 13 percent
on average for the past five years.
Bust or boon?
It has not only been stocks that have suffered.
China's giant bond markets have been roiled by debt crises
besetting firms such as Huarong and Evergrande, with the latter's problems
coming as the government seeks to slash leverage in the property sector.
Here the moves point to rising distress.
Chinese credit's
Z-score, a measure of market volatility, reached 0.7 standard deviations above
its 15-year mean last month, from 1.8 in January.
Typically, a score below 1.8 suggests looming bankruptcy.
"Will the government allow these property developers to
default and have a big debt crisis? I find it very unlikely," said Gustavo
Medeiros, Ashmore Group's deputy head of research.
Widening spread differentials have historically offered an
attractive entry point, said Michele Barlow, SSGA's Asia-Pacific head of investment
strategy and research. But there's still caution.
"Investors will have to change their style of investing
from being focused on yields to one based on fundamental analysis," said
Shamaila Khan, Alliance Bernstein's head of EM debt on the Global Markets Forum.
And it may also put Chinese assets on a more sustainable
footing, supporting earnings in the long-run.
Having been on the receiving end of China's tumble this
year, Hans Peterson, global head of asset allocation at SEB Investment
Management, is staying in and may add if Beijing and the central bank signal
fresh stimulus.
"It is good to keep an eye on the possibilities in
China, rather than the problems," he said.
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