Falling Chinese prices do not derail the case for emerging markets

Pessimists have been quick to use China’s October inflation data as evidence that its growth recovery remains tepid.

The country’s headline consumer price inflation gauge posted a 0.2% year-over-year fall last month, below expectations for a 0.1% decline and compared to a flat reading in September. Reading beyond the headlines, the main driver appears to be food-prices of livestock and meat fell 17.9% compared to a year ago, while pork prices fell around 30% over the same period. Producer price inflation data-often used as a proxy for corporate pricing power-slid 2.6% year-over-year, but slightly beat consensus forecasts.

But we do not think that China’s price data indicates a truly deflationary environment, nor do they derail the case for Chinese and emerging market stocks over a six- to 12-month investment horizon:

• A holistic look at Chinese economic data paints a more encouraging picture. Myopic focus on inflation risks overlooking more encouraging signs of stabilization. Non-food prices rose 0.7% year-over-year in October, masked by the outsized food price swings—an industry prone to boom-and-bust production. While trade data earlier in the week showed disappointing exports to developed markets, China’s October import growth of 3% year-over-year (the first monthly climb in eight and well ahead of market expectations for an 8% decline) suggests domestic demand is recovering.
• Prior policy actions look set to boost confidence and activity. China has used a variety of fiscal tools-more recently the announcement of an exceptional CNY 1tr central government bond quota for infrastructure spending-to stabilize growth this year. Selective monetary easing measures, such as cuts to reserve requirement ratios and key lending rates, may help boost credit growth and bolster consumer spending without exacerbating excessive risk-taking in the overindebted property sector. On balance, we expect China’s economy to expand around 5% this year, ahead of the 4.5% consensus forecast.
• Chinese and emerging market stock valuations are priced for gloom. We expect a peak in US interest rates, increase in the industrial cycle (especially for emerging Asia), and scope for selective emerging market policy easing to support emerging market (EM) and Chinese stocks into 2024. Our bottom-up earnings per share forecasts for next year look brightest for Asia ex-Japan (18%), EM (16% in USD), and China (9%, the same as the US). Valuations, especially relative to US equities, do not reflect this more encouraging outlook, in our view. For example, MSCI China trades on less than 10x forward earnings, a 16% discount to its 10-year average, while the MSCI Emerging Markets Index trades at a substantial discount to the S&P 500 Index on book value.

So, we think investors would do well to consider China’s economic and market outlook beyond a single “deflation” headline. Emerging market equities remain most preferred within our global strategy.

We suggest seizing opportunities and managing policy risks by adopting a barbell strategy within Chinese stocks. This involves holding growth beneficiaries such as Chinese internet, consumer, and select industrial names, alongside higher-yielding stocks in less cyclical sectors such as insurance, utilities, and banks.

And for investors looking beyond China, we see most opportunity in India, a likely beneficiary of robust domestic demand growth, a growing role in global supply chains, and anticipated double-digit earnings growth that is underappreciated in current valuations.