China will overcome Covid-19. But will the markets recover?

When and if Beijing will finally relax its strict control measures against Covid-19 and the real estate sector are basically the only questions on the minds of investors in Chinese equities lately. There are some signs that real change may finally be on the horizon.

But the more structural conundrum remains: How profitable are investments in the Chinese market likely to be over the next decade, even assuming the best real estate and Covid-19?

Chinese stocks rebounded this month after a terrible couple of years. MSCI China rose 21% in November as Beijing refined its tough pandemic restrictions and increased support for the struggling real estate sector. Even after the rally, the index has still lost more than half of its value since early 2021, essentially erasing all of the gains of the past decade.

A quick turnaround in China’s Covid-19 policy or in the real estate market is unlikely. The recent surge in Covid-19 cases and resulting lockdowns across the country are a stark reality check for the wide-eyed optimism evident in some press and brokerage reports earlier this month. But the feeling that the worst is over is likely to continue to drive the market for months to come – especially given how battered Chinese stocks really are. The Hang Seng China Enterprises Index is trading at nine times expected earnings, according to FactSet, and is hovering just above its lowest level in decades.

Trading multiples for Chinese stocks have fallen, but that doesn’t answer the question of how much investors should pay. Earnings per share for stocks in the MSCI China Index have fallen 31% from their peak last October, according to Citi, with real estate, technology and consumer stocks leading the decline. An eventual reopening of the economy will help boost profits, but that will likely take months.

More importantly, long-term earnings growth in China has long lagged other countries — and there’s now new reason to believe that trend will continue. MSCI China earnings per share have been flat since 2010 despite strong economic growth, notes Citi. During the same period, the MSCI USA Index’s earnings per share have grown by 9% annually.

That’s partly because, while earnings growth of old-fashioned Chinese market favorites like state-owned energy and telecom companies have slowed, they still make up a large portion of China’s stock index. But the earnings growth engine that should replace these sluggish stocks — China’s previously vibrant internet sector — is now facing structural headwinds after regulators’ concerted action over the past two years.

Also, it’s unclear what might take their place. China faces an uphill battle in the extraordinarily capital-intensive chip sector. And while there are strong competitors in the electric vehicle and battery space, these industries are still in their infancy and could face further technological disruption from abroad.

In other words, even if China’s economy recovers significantly with the easing of Covid-19 and controls on the property sector, it is far from clear what will translate into robust earnings growth for investors over the medium term. A China that focuses on massive — and potentially lavish — capital expenditures to pursue self-reliance in key industries may not be a China that offers outsize rewards to public equity investors.

Write to Jacky Wong at [email protected]

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