China looks cheap—but it has burned investors before

Sitting on cash was more profitable in 2023 than investing in Chinese shares, buying bonds sold by Chinese companies or betting on the performance of the yuan, the country’s currency. In many cases, even throwing away 5% or 10% of your cash would have been less costly.

China’s CSI 300 stock index is down about 14% this year, putting it on track for its third consecutive year of declines. Hong Kong’s Hang Seng Index, which includes the shares of many Chinese companies, is on course for four years of losses.

The prolonged slump in Chinese assets is raising serious questions about the benefits of investing in the world’s second-largest economy. The risks are relatively clear, most obviously the great-power rivalry with the U.S. and the chance of conflict in the Taiwan Strait. But what about the rewards?

Some Wall Street analysts say the rewards are coming, predicting that cheap stock prices, improving earnings and government support in areas such as renewable energy will help drive China’s stock market higher next year. But even the bulls don’t think a stock market rally in 2024 will make up for the heavy losses of the past few years.

At the start of 2023, investors were even more optimistic. Portfolio managers bet that the end of China’s draconian Covid-19 policies would lead to a rapid economic recovery. The hope was that consumers finally freed from lockdown would celebrate with a spending boom. They did, briefly—but since then the country has fallen into deflation and economic malaise.

“The biggest problem is that at the beginning of the year the China trade looked like a guaranteed winner. But anything that you tried to buy has been disappointing,” said Ben Bennett, a senior investment strategist at Legal & General Investment Management.

“It wasn’t just that China was the wrong theme. Everything in China fell. You were lucky to have not got sucked in and just been watching it.”

China’s weak performance this year looks even worse given bull markets elsewhere. U.S. stocks have been on a tear, with the tech-heavy Nasdaq Composite up 43% so far this year. Stock markets in India, Japan, Korea and Taiwan have all jumped. The Nasdaq Golden Dragon China Index, which tracks Chinese companies listed on U.S. exchanges, has fallen 8%.

Chinese bonds with an investment-grade rating have performed about as well as U.S. bonds this year, but neither market has looked all that compelling to investors who have been able to pick up 5% returns from U.S. money-market funds.

Junk bonds from China are doing a lot worse, losing around a fifth of their value since the start of the year. Dozens of Chinese real-estate companies have defaulted on dollar bonds over the past two years, and bondholders hoping to reach deals with these companies in 2023 were largely disappointed.

There is no guarantee that an economic power will have booming stock and bond markets. Japan’s stock market collapsed in the early 1990s—when the country was still considered the greatest threat to U.S. supremacy—and it spent decades in the doldrums. Its corporate and government bond markets have offered paltry returns for years.

Indeed, some analysts warn that China risks becoming the next Japan, pointing to its aging population and the chance of a balance-sheet recession, where heavily indebted companies and households focus on paying back debt rather than investing. Chinese companies, not including financial institutions, have debt worth around 28% of gross domestic product—the highest level in the world, according to the International Monetary Fund. Some economists think the comparisons to Japan are overblown, but they show how dramatically the tone around China has soured this year.

What does this all mean for 2024?

More optimistic investors argue that after the yearslong decline of Chinese stock prices there are bargains to be picked up. Shares in the Hang Seng Index are trading at an average price of about eight times their projected earnings, close to their lowest level in at least two decades, according to FactSet.

Chinese tech companies are usually touted as the obvious picks for bargain hunters. E-commerce giant Alibaba’s U.S.-listed shares are also trading at a price around eight times projected earnings. Shares of Tencent, a huge social media and videogame company, are trading at about 13 times earnings. The Magnificent Seven tech stocks that have powered the U.S. stock market rally this year are trading at an average price-to-earnings ratio of more than 30.

There is also a chance that China bears run out of steam. Shorting Chinese stocks is the second most crowded trade among global fund managers, according to a recent survey by Bank of America. (The most crowded: buying the Magnificent Seven stocks.)

But a lot will depend on politics.

Many Wall Street economists think China needs a big fiscal stimulus package to really kick-start its economy. China’s economic growth is still impressive by global standards, but it is weaker than many had expected and it looks set to get weaker still. Goldman Sachs expects China to grow 4.8% in 2024, down from a predicted 5.3% this year. The bank predicts that by 2030 growth will settle at around 3%.

Beijing has so far proved reluctant to unleash a fiscal bazooka, instead pushing through a series of piecemeal changes to ease pressure on property developers and stretched local governments.

At the recent Central Economic Work Conference, a high-level government meeting, the country’s politicians vowed to boost consumption and raise income levels. But they didn’t make clear the extent to which they will help the country’s embattled property developers complete tens of millions of apartments that remain unfinished, a major drag on confidence.

China’s economy isn’t the only thing keeping investors awake at night. Beijing’s policy shifts can lead to huge market consequences. A continuing real-estate slump started when the government attempted to reduce debt in the sector. A clampdown on internet companies that began around three years ago fueled a huge stock-market selloff.

Investors got a reminder of the power of policy last week, when a proposed rule change that would limit how much people can spend while playing videogames wiped off more than $60 billion of value from the Hong Kong-listed shares of Tencent and NetEase, its smaller rival.

Meanwhile, U.S. politicians are pressuring index funds and private-equity shops to cut China out of their portfolios, leaning on Wall Street to sever ties, and directly trying to cripple some of the country’s most promising companies with sanctions.

Wall Street analysts disagree on what comes next. On Nov. 12, Goldman Sachs and Morgan Stanley released outlooks that included predictions of how Chinese shares will perform in 2024. Goldman Sachs predicted the CSI 300 index will rise 16% in 2024. Morgan Stanley analysts expect returns of less than half that.

The more optimistic of those two projections won’t wipe out the losses from this year, let alone the past three years. Even the bargain hunters will need a strong stomach.

Write to Matthew Thomas at [email protected]