The rising Chinese equity risk premium
The valuation differential reflects the growing political risk premium and lower confidence in those underlying Chinese earnings as Common Prosperity is likely a drag on private sector earnings growth longer term. At times in recent years, Chinese technology companies often traded at higher equity valuations than their Silicon Valley peers, but since Common Prosperity was adopted, the situation has changed dramatically with lower earnings and revenue growth among Chinese technology companies, leading to massive losses for investors. We maintain an underweight view on Chinese equities as a precautionary measure. As we have noted in previous equity notes countries such as India, Vietnam, and Indonesia are the big winners of the current realignment of global supply chains and thus considering for Asian exposure.
A growing equity risk premium on Chinese equities naturally leads to the question of whether the US equity market could suddenly be jolted by a repricing of its China exposure. Is a dollar of free cash flow in China worth the same as a dollar of free cash flow from the US or Europe? Arguably not, and while this has been reflected in the revaluation of many semiconductor companies (also partly due to the US CHIPS Act) it has not been fully reflected in more consumer-oriented stocks like Apple and Tesla. With around 20% of its revenue coming from China, Apple’s risk profile could be rising on the risk of a sudden repricing due of a Chinese equity risk premium. Tesla gets 25% of its revenue in China and thus also has significant China exposure that is currently not reflected in its equity valuation. As we have stated in our previous equity notes, Apple and Tesla shares are key for broader equity sentiment and any downside risk dynamics in these two stocks could quickly jeopardize the wider equity market.
Investor flows into Chinese equities and companies with high China exposure
While price action tells one story on China, investor flows in ETFs tracking MSCI China A shares are telling a slightly different story. The number of outstanding shares (essentially how much capital that is deployed in an underlying index) has been growing steadily over the years as China’s capital markets have opened up. The has led to more inclusion in EM- and global benchmark indices of equities and bonds. While we have seen significant outflows out of ETFs tracking CNY bonds, until very recently at least, we have observed the opposite in Chinese equities. Falling equity prices in China have prompted rising investor flows into a “China is cheap” narrative. But sometimes, things are cheap for a reason (the equity risk premium discussion above). Over the last couple of months, this trend has shifted: in August, the largest UCITS ETF, which tracks MSCI China A shares, has begun seeing declining outstanding shares. As of Friday the current drawdown was -12%. This could be an early sign that investor appetite is on the decline.