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The US-China conundrum

As US equity markets continue to hit new highs, it is no coincidence that the country is also attracting record flows of capital. Analysis this month from the International Monetary Fund showed that America has taken almost a third of global cross-border investment since COVID, up from less than a fifth before the pandemic. Money has flowed towards higher US interest rates, while huge financial incentives to boost domestic semiconductor and renewable energy production as part of Joe Biden’s re-shoring program have also acted as a magnet for overseas cash.

Emerging markets – where capital is needed most to accelerate economic development and the energy transition – have had the raw end of the trade deal, seeing net outflows for only the second time this century according to the IMF data. Among the biggest losers, unsurprisingly, is China whose share of global finance has fallen from around 7% in the decade pre-COVID to 3% in the four years’ since – a period that has coincided with the Chinese stock market underperforming the US by almost 100 percentage points.

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The result is that China, despite still being a growth market on many metrics, has a stock market priced at multiples of earnings and book value more akin to value equities. Consider GDP growth, expected to be 70% higher in China than the US this year, or company earnings that are expected to grow 50% faster[1]. Yet, Chinese equities (forward P/E 10x) can be bought at a record 50% discount to US stocks (forward P/E 20x).

Technology glitch

The anomaly is perhaps starkest for technology companies. The 10 largest members of the tech-heavy US Nasdaq Index are priced at 37-40x next years’ earnings, compared to 10x for Hon Hai and 18x for Taiwan Semiconductor Manufacturing Company, two the world’s most sophisticated and fastest growing businesses.

Geopolitical risk is clearly a factor, particularly with the US presidential race too close to call and Donald Trump promising to resume Chinese trade wars if he's returned to the White House, but the valuations of US tech companies heavily reliant on Chinese and Taiwanese manufacturing capabilities, suggest this is only part of the puzzle. Apple (33x P/E), for example, sources more than 95% of iPhones, AirPods, Macs and iPads from China where it uses a complicated network of over 50 companies, whereas Nvidia (73x P/E) uses TSMC for around 40% of its semiconductors.  

The Magnificent Seven also rely on China and Taiwan for around a fifth of revenues, on average, according to Reuters, so trade barriers that impact US access to these markets would cause a level of damage that doesn’t appear to be reflected in their current share prices.

Turning tide?

It is hard not to conclude that the valuation gap between China and the US, which can’t be explained by economic fundamentals, earnings outlook or geopolitical risks, is unsustainable. Economic theory dictates that financing flows will change direction in favour of countries where the returns on limited capital are highest and asset prices will rise.

The question is not if, but when?

Flows into Chinese equities from overseas have been steadily rising for several months according to Bloomberg, with investors encouraged by government initiatives to support the stock market and flagging economy, including recent measures to breathe life into its struggling real estate sector. These have helped lift China’s stock market by over 20% since its January lows, outperforming US equities by almost 10 percentage points during this period[2].

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While one swallow doesn’t make a summer, this could be an important turning point. With cracks also starting to appear in the Magnificent Seven in recent weeks, it wouldn’t be a surprise if we soon see a meaningful shift in the direction of capital that has heavily influenced stock market performance in recent years.

[1] Source: IMF Global Economic Outlook for GDP growth (4.6% China vs. 2.7% US), April 2024; JP Morgan Guide to the Markets for EPS growth (15% China vs. 10% US), May 2024.
[2] MSCI China vs. MSCI USA indices, 22/01/2024-24/06/2024.

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