China looks undervalued based on its fundamentals. When you view Chinese stocks from the value perspective, they look cheap relative to other emerging markets and the broader market. For instance, the MSCI China index is currently trading at below 9x forward earnings, versus 10.6x for the MSCI EM index and nearly 15x for MSCI World index.
At these valuations, Chinese equities look like a good long-term value considering that it’s still growing faster than developed countries and other EM countries, including the rest of the BRIC countries. In addition, even if China’s growth slows to below the government’s current annual target of 7.5%, say to about 6%, this would still be a multiple of growth anywhere in the developed world.
And while the Chinese economy is slowing, this is intentional on the part of the Chinese authorities, who want to transition the economy to one driven more by consumption than by investment. This transition is good news for the market as it should help make China’s growth more sustainable and help stabilize the local financial sector over the long term.
To be sure, concerns about the stability of China’s financial system are also playing into the market’s poor performance lately. However, based on my team’s research, much of China’s underperformance can be attributed to most investors being stuck in a “growth-play” mentality. They’re focused on seeing signs of faster Chinese growth (such as more accommodative monetary policy or more aggressive fiscal stimulus) at a time when the country’s government is more tolerant of slower growth in exchange for structural reform. Thus, investors continue to be disappointed, and Chinese stocks suffer.
One caveat for investors — slowing rates of economic growth, even if they are still higher than in other parts of the world, can be associated with future earnings downgrades. That could put China at risk of becoming a value trap until its economic growth stabilizes.
While a downward earnings revision remains a near-term risk, at today’s valuation there is long-term opportunity in Chinese equities. For this reason, I continue to advocate an overweight to Chinese stocks, which can be accessed through the iShares China Large-Cap ETF (FXI) and the iShares MSCI China ETF (MCHI).
Russ Koesterich, CFA, is the iShares Global Chief Investment Strategist.