There are many reasons why some companies prosper and others don’t. They include high-quality management and workers, strong brands and high barriers to entry. A favourable regulatory environment is also a key factor. Yet many investors simply assume that robust economic growth will power stocks forward. The performance of Chinese equities over the past three decades highlights the folly of that approach.
Why investors should pay little heed to economic growth
Chinese stocks fail to mirror economic growth
Many investors assume there is a direct link between economic growth and stock-market performance. So, if an economy is growing strongly, that should be reflected in the earnings outlook for companies and hence their stock price.
However, there’s plenty of evidence to the contrary. In just three decades, for example, China registered ‘the greatest economic advance in world history’, according to the World Bank. It completely outpaced the world’s leading economy, the US. But that was not because the US performed poorly. The World Bank points out that the US economy grew faster than other leading markets, and that:
‘At no time in American history – not in colonial times, nor the railroad era, nor its post-war glory days – has the US economy ever advanced at anything resembling China’s recent rate. The relevant story is not America’s decline, but China’s spectacular rise.’1
Real gross domestic product (GDP) per capita in China and the US, 1992-2020
And yet, despite China’s huge economic outperformance, Chinese equities have significantly underperformed stock markets in the US and other advanced economies. The MSCI China index is still below its starting level in 1992 and even with dividends reinvested has only returned 1.9% per annum over 30 years.2 US stocks, meanwhile, have grown tenfold over the same period despite an economic background of much lower growth than that seen in China.3
Chinese equities have also underperformed all their counterparts in Australasia. Australian stocks have risen by 11% per annum over the past 30 years, slightly more than the US market. Meanwhile, the figures for India, Taiwan and Singapore are 9.1%, 8.1% and 6.6% respectively. Even Japan, which famously lagged markets for decades after the late 1980s boom has fared better than China, at 3.4% annual growth.4
The key drivers of equity performance
Schroders asks why the Chinese market has performed so poorly. The answer, it says, is that returns from a stock market reflect the returns of the stocks listed in that market, adding that ‘the quality of those companies (management, industry and countries in which they operate etc) will define returns’.5
It also says that ‘proper legal systems and the protection of property rights returns’ will affect returns, arguing that ‘this at least in part explains why stock markets based in countries with sound government and independent legal systems like Australia and Sweden have done well’.
The asset manager Charles Stanley adds that the Chinese stock index has failed to capture all the new areas of the economy on the scale the US index caught the digital revolution. It notes that the Chinese state has evolved ‘to a position where it is relatively hostile to private-sector enterprise in general and to successful entrepreneurs’. Furthermore, excessive property-based borrowings – which are now being reined in by the government – have driven much of China’s economic growth in recent decades. Many Chinese bought property rather than shares.6
Focus on the fundamentals
Targeting trends in GDP can lead to the wrong conclusions about the direction of financial markets and individual assets. It’s far more valuable for investors to focus on the quality of an asset in terms of its earnings, its management and its ability to generate earnings almost irrespective of the economic background.
1 https://www.morningstar.hk/hk/news/219916/china-stocks-the-road-to-nowhere.aspx
2 https://www.schroders.com/en-ch/ch/professional/insights/two-charts-that-show-why-you-should-ignore-chinas-index/
3 https://www.petiole.com/en/insights/articles/investment-opportunities-created-by-recessions
4 https://www.schroders.com/en-ch/ch/professional/insights/two-charts-that-show-why-you-should-ignore-chinas-index/
5 https://www.schroders.com/en-ch/ch/professional/insights/two-charts-that-show-why-you-should-ignore-chinas-index/
6 https://www.charles-stanley.co.uk/insights/commentary/why-chinese-shares-fail-to-reflect-its-economic-growth
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