China Equities Outperform India for 2023
Bottom Line: We now feel that China equities can outperform the U.S. (CSI 300 v S&P500) by 10-15% this year, rather than 5-10% we identified in the December outlook. The reopening is going quickly and with less major disruption than we thought, which can start to benefit real sector data in Q1 and produce upside cyclical economic and earnings risks. Meanwhile, Indian equities have underperformed, both on RBI tightening feeding through and as global investors switch from underweight China/overweight India. India equities can outperform the U.S. in 2023, but lag Chinese equities. On 5yr view we still see this as being India’s decade and China will still have the structural headwinds of the labor force peaking and slowing productivity growth.
China equity market has started the year with a healthy performance, as the shift away from zero COVID is producing hopes of an economic rebound.This has helped EM Asia equities, though Indian equities have lagged behind.
Figure 1: China Equities Starting to Rebound (Jan 1 2018 = 100)
Source: Datastream/Continuum Economics
China Equities Helped by Recovery Hopes
Chinese equities have had a good start to the year, as the quick shift away from zero COVID policies has prompted optimism that growth and earnings will rebound in 2023. China’s authorities appear committed to the shift away from zero COVID, with additional relaxations announced on December 26. Fear among public appears to have peaked with footfall and public transport data suggesting that China population are adjusting to COVID being more widespread. It will be interesting to see how movement around China during the New Year celebrations contrast with 2019, but it certainly appears that a boost to consumption could come through in Q1 rather than Q2/Q3 as we had previously anticipated. The December retail sales figure has attracted skepticism (here) and while the actual consumption trajectory is unclear, a rebound could kick in and produce upside risks to 2023 China growth forecasts.
Monetary/fiscal and regulatory policy are also helping the market rerating. The PBOC continues to encourage sufficient total social financing growth to ensure a rebound in nominal and real GDP, though the odds of one final cut in loan prime rates is now fading. Fiscal policy remaining supportive with central and local government seeking to bring forward expenditure to support the economy. However, it is regulatory policy that is attracting the greatest interest, with additional measures to help residential property developers manage the deleveraging and restructuring process and the attitude towards technology companies become less aggressive. The equity market has taken note of Tencent getting games approved and Jack Ma signaling that he would relinquish control of Ant. How far can Chinese equities outperform the U.S. in 2023?
At the time of the December Outlook (here) we saw a 5-10% outperformance of China versus U.S. equities. Over the last 1 month Chinese equities (CSI 300) have marginally improved versus U.S. equities (S&P500).We still forecast a rollercoaster for the S&P500 down to 3500 as a mild U.S. recession is discounted before a rebound to 4200 on hopes of a 2024 recovery.
Figure 2: China and India Earnings to Bond Yield Relative (%)
Source: Datastream/Continuum Economics.Cape earnings yield minus 10yr real bond yield.
Chinese equities will likely outperform U.S. equities in any decline in the S&P500 and sustain this outperformance in the remainder of 2023. We can see scope for the outperformance to be greater than 5-10% versus the U.S., as China equities still remain cheap. Though the bounce since October has reduced the extreme undervaluation (Figure 2), China equities remain below the 10yr average for the 12mth forward P/E ratio and absolute levels of earnings yield remains well above the 10yr government bond yield. Looking at the MSCI China forward P/E ratio the rebound in the market saw the ratio rise to over 15 in 2009, 2016-17 and 2020 versus the current 10.6. We do see 10yr bond yields rising to 3.15% by end 2023, but any PBOC policy normalization will likely only amount to around 40bps hike by end 2024 and this will not really hurt the Chinese equity market.
Even so, foreign investors see the tactical opportunity, but are unsure of the strategic outlook. The last two years have caused concerns of a shift to state capitalism under president Xi, which is seen to be less business friendly than the last 20-30 years and risks hurting long-term profit growth. Though we feel the risk of an invasion of Taiwan is a low probability in the next five years (here), the risk is restraining investor long-term view on Chinese equities. Domestic investors could fuel further gains, but normally a shift to overvaluation requires a money and credit boom and this is not happening. Indeed, China’s authorities want a goldilocks credit growth of not being too cold to stall growth, but not too hot to cause renewed long-term debt problems. The three red lines policy for property developers remains in place, while the clean-up of the shadow banking system and weak rural banks remains under way.
On balance, we do feel that the valuation argument is still strong enough to revise up outperformance versus the U.S. to 10-15% in 2023, given that the Chinese authorities are committed to reopening and the economic benefits will likely start coming through in Q1 and produce cyclical upside risks for growth and earnings in 2023.
This can spillover to benefit EM Asia equities, especially as Fed Funds peak and Asian growth is likely to be the best in 2023 in a mixed global economic picture. India equities have lagged over the last month however, as the previous pessimism over China had seen EM equity players being overweight India/underweight China. Global players are now adjusting to a less overweight position for India and less underweight China. At the same time the cumulative tightening from the RBI is starting to become a headwind for the Indian economy and also curtailing financing for the equity market. Additionally, this is prompting a refocus on the overvaluation of the Indian equity market, with the MSCI India 12mth forward P/E ratio at 21.4. Compared to real bond yields (Figure 2), India is just a bit above average levels but not cheap like early 2016 or late 2020.This overvaluation can probably do with some derating and India could lag in H1 2023. Even so, 2023 earnings expectations remain strong (circa 21% for MSCI India) and enough earnings growth exists for the Indian equity market to outperform the U.S. by 5% in 2023 as a whole.
Additionally, we forecast that the 2020’s will be India decade rather than China’s. India still has a huge demographic dividend alongside the normal uplift in productivity in the shift towards a middle income country. Our long-term forecast published in November (here) see the prospective growth slowdown in India being only temporary and for growth to accelerate through until 2027. India story is also helped by the prospect of the reform mind PM Modi being reelected in 2024. In contrast, the cyclically recovery in 2023 and 2024 for China with the post COVID reopening (here) is likely to fade. China total non-financial sector debt is now so high, that the authorities remain reluctant to return to credit fueled growth. Meanwhile, the labor force is peaking and China is unlikely to see large scale inward migration or an increase in the already high female participation rate. A restart of rural to urban migration can help, but will not be enough to stop the trend growth slowdown in China to 3-4% (here). Finally, state socialism is being softened for now, but President Xi does not want a return to capitalist forces that were evident in the last 20-30 years and this impacts long-term profit growth and return on equity. Figure 3 shows this contrast of long-term growth prospect and on a 5 year view we look for Indian equities to clearly outperform Chinese equities.
Figure 3: Continuum Economics 2023-27 GDP Growth Forecasts (%)
Source: Datastream/Continuum Economics