Enter the dragon – will China's stock markets turnaround?

According to the lunar calendar, Chinese New Year began on 10th February.  In China itself, Lunar New Year is accompanied by the world’s biggest human migration, as millions of workers travel home from cities to rural villages to spend time with their families over the Spring Festival season. 

The Chinese zodiac dictates that the new lunar year is the Year of the Dragon. Those born during the years of the Dragon – the last of which was in 2012 – are believed to possess the characteristics of being ambitious, confident, and reluctant to accept defeat.  

These attributes associated with the Year of the Dragon will certainly be welcome if they are reflected in the performance of China’s stock markets over the coming year, as Chinese equities have endured a truly torrid run over the last three years. 

What's wrong with the Chinese stock market?

Since peaking in February 2021, the MSCI China Index has plunged -57% in total return terms (in USD). Caution towards China has been fuelled by:

• Weaknesses in China’s economic model, which historically has been too reliant on debt-fuelled internal investment and exports 
• State crackdowns on technology companies and the education sector have also spooked investors 
• The deterioration in China’s relationship with the West accelerated with the COVID crisis and concerns have brewed about the authoritarian direction under President Xi and China’s sabre rattling over Taiwan  

China's impact on wider emerging markets and Asian indices

Cast your mind back, and it wasn’t so long ago that the rise of China as a future economic superpower seemed unstoppable. Some plaudits predicted this would be a ‘Chinese Century,’ one that would see China eclipse the US as the world’s largest economy.   

As recently as early 2020, when the spread of the COVID virus caused a major global healthcare and economic crisis, some commentators boldly predicted that the pandemic would even accelerate China’s path to become the world’s largest economy – arguing its swift and highly draconian response would provide it with an advantage over western democracies squeamish about curtailing personal liberties.  

As we now know, this proved woefully wrong, with China only finally ditching its extreme lockdown restrictions in December 2020 in the face of mounting social unrest and having inflicted severe damage to its economy.  

China's economy opened – why did western companies go elsewhere?

Hopes in early 2021 that the reopening of the Chinese economy would result in a sharp economic recovery, soon faded when: 

• Cautious Chinese consumers focused on rebuilding their savings rather than upping their spending 
• Problems continued to surface in China’s vast property sector 
• While inflation has been a major post-pandemic problem across much of the globe, China is grappling with the opposite challenge: falling prices amid weak growth 
• Recent official data has showed consumer prices falling at their fastest rate in 15 years, underlining the dilemma facing the nation’s policymakers as they try to revive the economy, and global investors’ confidence in it 

Burned by the experience of supply-chain blockages during the pandemic when Chinese factories shut their doors, western companies have also sought to diversify their manufacturing supply chains away from China, to both lower-cost economies like India and Vietnam, as well as closer to home. This is a trend that may continue to play out over years.  

International investors have been pulling cash out of Chinese equities over the last year at breakneck speed. Data from the Investment Association reveals that funds in the China/Greater China sector have seen a pattern of outflows in every month since February 2023.  

The week prior to Chinese New Year, the Chinese equity market rout had continued into 2024, with the MSCI China Index. But in days leading up to the start of the Year of the Dragon, Chinese shares staged a dramatic fight-back as authorities stepped in to try and arrest the market slump.  

Measures taken to clamp down on short-selling of Chinese shares – trades that bet on declines – and China’s sovereign wealth fund was ordered to plough money into Chinese Exchange Traded Funds. The news that President Xi had replaced the head of the Chinese financial market regulator has further stoked expectations that more measures to support the Chinese stock market could be on their way.  

Chinese investments – dead cat bounce?

For investors, a key question is whether this might be a turning point, even a buying opportunity or a temporary spike – a so-called ‘dead cat bounce’ – before the downward trend reasserts itself. It is too early to say. Chinese shares are undeniably trading on historically very low valuations, and it’s possible that Chinese shares could prove a bit of a wildcard performer in 2024. However, sceptics may conclude that moves to shore up the equity market through intervention smack of desperation.

It is certainly a reminder that despite the veneer of market capitalism, political authorities have a huge influence over markets in this one-party Communist state.  

State intervention in the markets won’t fix the fundamental fragilities that have been exposed in China’s economic model in recent years. Nor will it solve a more long-term headwind: China’s deteriorating demographic profile, fuelled in large part by its disastrous – and now abandoned – former ‘one child’ per family policy.  

China's ageing population and shrinking workforce

From here on, China’s population is set to age, while the workforce shrinks dramatically. This has eerie parallels to the situation that Japan has found itself in since 2010, with one big difference: Japan had long before reached the status of a major developed economy.

China is at real risk of being consumed by the challenge of a rapidly diminishing workforce before reaching its economic potential and left languishing in a middle-income trap.  

While there could be a near-term trading opportunity in Chinese equities if authorities follow through with further measures to kickstart ailing stock markets, such as strong-arming state-owned entities to buy stocks, there are still risks on the near horizon to consider too: 

• China’s relationship with the US – its biggest export market - remains under strain and a potential victory by Donald Trump in the Presidential elections in November would see trade wars firmly back on the agenda  
• A ditching by the US of Joe Biden’s green agenda could also have implications; China has a dominant position in the manufacturing of solar panels and has a huge market share in wind turbines 

China and India – emerging market rivals

For longer-term investors, China’s main rival for the emerging market crown – India – has a more convincing case for inclusion in a portfolio. Its demographic profile is compelling. It has a fast-growing population, which overtook China’s last year and made India the world’s most populous nation – the average age is 28.  

Under Prime Minister Narendra Modi, who looks set to be re-elected for another term this year, India is basking in its longest period of political stability since gaining independence and has seen a combination of meaningful reforms and massive infrastructure investment that will modernise the economy.  

India is also well positioned to benefit from foreign companies seeking to reduce over-reliance on China as a supply chain hub. For example, Apple plans to shift a quarter of its iPhone production to India by 2025. The Indian economy has been growing at breakneck speed and it has a rapidly expanding middle class, driving consumption. According to estimates by BMI, India is on track to become the world’s third largest consumer market by 2027, potentially making it too big an opportunity to ignore. 

So, while there are undoubtedly selective opportunities in China, investors might consider broader Asian and Emerging Market funds and investment trusts with a meaningful exposure towards India rather than funds focused exclusively on Chinese shares.