MARKET VIEWS

Staying the course in China A shares amid global uncertainty – Part 3: Comparing valuations

staying-the-course-in-china-a-shares-amid-global-uncertainty-part-3-comparing-valuations

A five-part series on what four Invesco experts think about how the current pandemic is affecting Chinese onshore equities and the economy through macroeconomic, fundamental-based and factor-based analyses.

As the Covid-19 outbreak escalates in many parts of the world, China looks set to emerge as the first major economy to recover from the crisis. Against this backdrop, what has been driving the recent performance of Chinese onshore equities? How has the outlook for China A shares and China’s economy changed amid the turmoil in global markets?

Invesco’s Chin Ping Chia, Managing Director, Head of China A Investments, recently chaired a panel discussion with fellow experts exploring these issues through macroeconomic, fundamental-based and factor-based analyses. Titled “Staying the course: Outlook for China A Shares amid global uncertainty”, the wide-ranging discussion was broadcast online in mid April. We present a summarized, edited version of the discussion, split into five parts. You can read part 1 here.

In this section, Senior Portfolio Manager for China A Quant Andrew Tong discusses with Chin Ping Chia, Head of China A Investments, on how the uncertainty has impacted valuations. 

Chin Ping: I’d like to switch gears to the valuation aspect. Andrew, in the context of the various Chinese equities segments comparing A shares with other classes, what is your view on the current valuation for Chinese equities?

Andrew: If you look at the valuation gap between onshore and offshore Chinese equities, one of the best gauges is the Hang Seng Stock Connect China AH Premium Index, with about 130 pairs of shares that are listed in mainland China and in Hong Kong (see figure below). 

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This index has gone through some changes over time, for example from 2006 to 2008, the premium rose to a high of 200 from the base level of 100 but then declined after a couple of years back to just over 100. Sometime in 2014, 2015 – more or less coinciding with the opening of the Stock Connect program in Hong Kong and Shanghai – the premium went up to 130, 140 and stayed at that level for that next couple of years.

This year as the China A-share market outperformed the rest of the world, including H shares, we started to see the premium rise again. But that premium has shrunk back to where it was at the beginning of the year after offshore share rebounded with the global markets. There is a premium between A shares and H shares, but it’s not very much different from where it stood before the pandemic started gripping the market.

From another point of view, if you look at historical valuations of A shares on its own, and then compare that to Chinese companies listed overseas – comparing MSCI China A valuations to MSCI China valuations – you will find that the MSCI China A valuations, in terms of forward PE, is around 12x to 13x, which is below still below its 10-year historical PE average of about 15x. Whereas for MSCI China, its current valuation is around 13x to 14x, and its historical average is also around the same level. From a historical point of view, the current A-share valuation is at a greater level of discount than their H-share counterparts.

Chin Ping: Is it conceivable to see China A shares trading at a premium versus other emerging market equities?

Andrew: To answer that, we have to think about the appeal of China A shares currently versus the rest of the world (see figure below). 

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Here’s a chart of the current level of market risk represented by the light blue line based on the MSCI China A index. You can see that the historical peak of A shares risk has been around 60% p.a. which was set around the 2008 Great Financial Crisis peak and the stock market crash of 2015. 

The past couple months have brought A-share risk to a short-term high but not near the level that we saw in 2015. Compared to what we see in the US, where risks is now double that of A shares, it has been a complete reversal of the higher market risk that A shares command versus the rest of the world. Again, that’s a sense of the decoupling we tend to see between A shares and global markets whenever we see significant global volatility spike or drop.

Another thing I like to look at is idiosyncratic risk, because that shows how well factors are behaving – or not – within the market. Apart from looking at the overall regime changes (that has the implication for investors to review their models and assumptions), we also need to look at the changing correlation between factors. Typically, during a bear market or during a high-risk regime, we can see high correlation between factors. As a result, stocks tend to move together and that really deflates the level of specific risk contribution in the market. That’s when you hear stock pickers saying that it’s very hard to find good opportunities. 

However, we saw a very healthy level of specific risk contribution this year, and that came from a drop off in specific risk in 2018 when the A-share market was taking a beating (see figure below). From this point of view, factor correlation is healthy, and the level of specific risk continues to be quite abundant for active management, and that speaks to the appeal of the China A-share market.

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Next: "Part 4: Trade war, second war"

Chin Ping Chia is Managing Director, Head of China A Investments and Andrew Tong is Senior Portfolio Manager for China A Quant at Invesco.