The Case For Chinese Stocks

Includes: ECNS, FXI, MCHI
by: Russ Koesterich, CFA

China recently modestly lowered its annual growth target to 7.5% from 8.0%. This change has made many investors nervous that China may be in for a period of sluggish growth. While investors are reasonably concerned about a hard landing, I believe such a scenario can be avoided in 2012. As a result, I continue to advocate overweighting Chinese equities for three reasons.

1) Relatively Strong Growth Expectations: The lowered growth target isn't necessarily a precursor to a hard landing. Why? The government's 2012 growth target is a reasonable estimate for Chinese potential going forward.

The new target reflects the government's endorsement of a beneficial, long-term rebalancing of the Chinese economy. China can't, and probably shouldn't, try to maintain the pace of growth achieved during the past decade as much of that growth came from fixed investments. In order to create a more sustainable long-term model, China needs to raise consumption and moderate investment, a rebalancing that will likely help support Chinese equities. Currently, China is unusual, even for an emerging market, in that only about one-third of its economic activity comes from personal consumption.

In addition, even if China grows at 7.5%, it still would be one of the world's fastest growing economies and the government's growth goal is typically a floor. In fact, actual Chinese growth is expected to be in the 8.0% to 8.5% range this year.

2) Attractive Valuations: Assuming China can grow as expected in 2012 and engineer a soft landing, Chinese equities look attractive from a valuation perspective. While Chinese stocks are up significantly this year, the Chinese market is still down nearly 8% over the past 12 months. It's now trading for less than 1.7x book value, a significant discount to where it has traded over the past five years and well below the emerging market average.

3) The Inflation Outlook: Rising prices were a major problem in China last year, with consumer prices up 5.5% in 2011. But inflation in China is now decelerating. Currently, prices in China are up only 3.2% from a year earlier, and inflation is expected to stay low for the remainder of the year. Lower inflation will provide more latitude for the Chinese central bank to loosen monetary policy, which should further support the local economy and local stock prices.

To be sure, the Chinese market is not without risks, particularly surrounding local property prices. Still, as I expect China will most likely engineer a soft landing, the market's decelerating inflation, cheap valuations and strong relative, and rebalancing, growth make it one investors may want to consider. For those looking to gain exposure to Chinese equities, my preferred methods of access are the iShares MSCI China Index Fund (NASDAQ:MCHI), the iShares FTSE China 25 Index Fund (NYSEARCA:FXI) and the iShares MSCI China Small Cap Index Fund (NYSEARCA:ECNS).

Source: Bloomberg

Disclosure: The author is long FXI.

Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and investments in smaller companies may be subject to higher volatility.

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