Chart Room: Earnings, not valuations, will carry China's rebounding markets forward

After a fast and furious re-opening rally in China since last October, equities have traded sideways in recent weeks. We think it’s a temporary pause, and improving corporate earnings are likely to take over from cheap valuations as the main driver in the next stage of the rebound.

The rapid reopening rebound in Chinese equities since late last year has left the depressed valuations of the country’s Zero Covid Policy era behind in the dust. The flipside is that shares don’t look so cheap anymore, and caution is starting to sink in as the fast money takes profits. The MSCI Golden Dragon Index - which includes companies from across Greater China that are readily accessible to offshore investors - is currently heading to its first monthly fall since October. Is China’s stock rally running out of steam?

On the contrary, this week’s Chart Room looks at several factors that suggest the market could just be warming up for the next round. Cyclical stock market rallies like this one tend to begin with investors scooping up shares on the cheap, followed by an improvement in corporate earnings that adds fuel to a longer-term recovery. Here, we define a rally with the common understanding of a bull market - when a market moves 20 per cent higher.

The first act has already played out in China. 12-months forward Price-to-earnings (P/E) ratios have raced nearly 40 per cent higher since the market bottomed in late October, approaching the levels at which recent historical rallies have peaked in terms of average rise in P/E (48 per cent). Up next, however, could be a gear switch to earnings as the main driver for future gains. Earnings per share (EPS) - up 6 per cent since the rally began - still has a long way to go to catch up with the 25 per cent historical average peak increase. Of course, past performance is not a reliable indicator of future results. But we think earnings growth will determine the market’s trajectory from here on.

Chinese corporates enjoy some favourable tailwinds at the moment. Monetary and fiscal policies are both accommodative. Money supply is up, while mortgage rates are at record lows and inflation remains benign, possibly to the envy of policymakers elsewhere. 

Companies are confident, too. Fidelity International’s Analyst Survey shows China may have the strongest labour market growth among major economies and the fastest corporate revenue growth this year. Crucially, factories are humming again, according to our leading indicators monitor which tracks new orders and finished goods inventory. That is constructive for earnings. 

Of constituents in the MSCI Golden Dragon Index that had an earnings revision from analysts in the past month or so, over 40 per cent enjoyed an upward revision in their 12-months forward EPS, above a 30 per cent “pessimistic” average typically seen near previous market bottoms. Our technical analysis shows that Chinese equities tend to rally until optimism starts to dominate - usually when the upward earnings revision ratio hits 60 per cent, a point we are nowhere near.

Risks remain, including geopolitics. Any flare-up in tensions involving China is likely to influence sentiment, but we expect these for the most part to be short lived, and generally unlikely to knock China’s domestic economic recovery off course. Pent-up demand from consumers will continue to be a dominant growth driver. Earnings, backed by a brighter economic outlook, will be much more important to watch for interested investors.