Chinese Stocks Rally, Then Plunge—What Happens Next?

The Year of the Dragon is supposed to bring good fortune, but investors in Chinese equities may wonder whether this year will also bring adversity and market volatility.

Late in September, China’s central bank announced its most dramatic stimulus measures since the covid-19 pandemic, reducing borrowing costs to boost the ailing property market. Meanwhile, moves to enhance equity market liquidity lifted domestic stocks, with the CSI 300 and Hang Seng experiencing blistering rallies. This spread to China-exposed stocks, like European luxury names.

But the exuberance did not last, as questions grew about what Beijing plans to do next. Chinese equities suffered huge losses on Oct. 9, with the CSI 300 declining 7.1%—its biggest one-day fall since 2020. All eyes are now on Saturday, when the finance ministry will give a press conference to disclose what additional support is in store to boost consumer and business confidence.

Expect More China Equity Volatility

Nicolò Bragazza, associate portfolio manager at Morningstar Investment Management, thinks a pullback after such strong market performance is to be expected. “The rally was driven by a significant change in market sentiment—which was at very depressed levels—following the announcements of new supportive measures,” he says. “One example of how depressed the sentiment was around China is the performance of Chinese equities during the equity selloff at the beginning of August. Chinese equities barely moved because of the already-depressed valuations.”

As the market awaits more clarity around the impact of future policies, Bragazza does not rule out significant volatility again driving sharp fluctuations in sentiment. “The role of fiscal policy is particularly important, not only because investors pay a lot of attention to it, but also because balance sheet recessions need this kind of support, as monetary policy may prove less effective without coordination with fiscal policy,” he explains.

He continues: “If the government disappoints, we may see some further pullback in Chinese equities, but we believe that the long-term rationale for such a position remains intact, as it is mainly driven by the sharp disconnect we see between company fundamentals and their valuations.”

What Drove the Rally?

The bull run that led the Chinese equity market to soar after years of stagnation was driven by authorities announcing several policies, including a mortgage rate cut for existing homeowners and extra liquidity for stock purchases to securities firms and asset managers

“What has developed in the last two or three weeks is a change in the narrative. It is more a sentiment shift rally because policymakers finally capitulated and changed the policy narrative to become more pro-growth and stimulus-driven,” says Jerry Wu, manager at Polar Capital China Stars Fund, which has a Morningstar Medalist Rating of Silver. “But a lot of that narrative shift has started to be digested. A lot of that re-rating has happened very quickly in a short period. Now we are at the juncture where policy needs to deliver,” he adds.

Wu feels Chinese authorities still need to provide tangible fiscal stimulus to deal with deflation and fragile consumer sentiment: “We have reasonable confidence that the sort of narrative pivot of a few weeks ago means they are pretty much committed to getting out of this downward and deflationary spiral.”

In this policy-driven market, Wu is hopeful that Saturday’s announcement will lead to another rebound for Chinese companies. However, he places significant importance on China’s policy around consumers and property owners to guarantee a sustainable boost for the economy and stock market.

“The reason consumer confidence is very low is that their balance sheets are going down. 60% of China’s population has assets in housing. But over the last two to three years, China’s property prices have gone down between 30% and 40% across the board,” Wu says. “So when you have 60% of your balance sheet going down and you are not seeing the end of the pricing downward revision, you are not going to spend, even if you have quite a lot of savings.”

What do China Investors Want to See?

Sharukh Malik, portfolio manager at the Bronze-rated Guinness China A Share Fund, welcomes these initiatives but believes consumer support should be prioritized, as it has been neglected in the past.

“When the government has tried to help the economy, they have tried to help business first rather than the consumer directly. There was a trade program announced a few months ago. If you have an old washing machine or TV, you can trade that in and get a subsidy to buy a new one,” he says.

Though he supports this trade-in program, Malik notes that compared with retail sales last year, it’s worth only 0.3%. He feels this package needs to be significantly expanded. “There are other ways they are trying to support consumers, so consumption vouchers are fairly new,” he says. “The government gives cash handouts and you can spend them on restaurants, hotels, cinemas. We saw in the past few weeks Shangai giving out $71 million to their residents. It sounds like a big number, but when compared with retail sales, it’s tiny.”

Malik believes the government will expand support by issuing sovereign bonds, which will allow them to raise capital for a larger trading program, and “cash for clunker” schemes, which could let the public trade in used cars for lump sums to encourage the purchase of electric vehicles.

“What they have done so far makes sense, but it needs to be scaled up. And of course, no one really knows [what they will do]. Is it going to be announced tomorrow or next week? But I can see the path to growth because the government is making it clear in their statements,” Malik explains.

Is China the Next Japan?

For Sandy Pei, portfolio manager at the Bronze-rated Federated Hermes China Equity Fund, any fiscal stimulus decisions must address deflation to prevent China from following in Japan’s footsteps. “The stock market is about confidence, and we talk about how cheap China is,” she says. “So why are people still not buying? Because they have no confidence. If you get confidence back, the economy can work on its own. But if you let things continue on its own, we are going to become like Japan, because the market will digest slowly, and once that perception has set in, things will get cheaper every day.”

Pei points to the Japanese property market, where yields of 20% are still not encouraging new buyers, who are worried about price weakness in housing. “In Japan, because they have seen that for so long, they do not believe property prices can ever go up. And that is very dangerous.” In Pei’s view, Chinese authorities must act as soon as possible to ensure consumption is a bigger driver of economic growth.

What Are the Chinese Stocks to Watch?

One stock that lifted Pei’s portfolio during the rally was digital broker and wealth management firm Futu Holdings FUTU. In the year to date, the stock’s share price has jumped 115.42%. “Their business by nature is leveraged, so their earnings will accelerate exponentially because trading volumes have jumped so much. You have seen so many new accounts opening. So far, the two-week rally has been driven by retail investors and passive buying,” she says. Pei also saw her investments in beer and dairy companies boosted during the rally, as the market priced in a possible consumer recovery.

Malik also saw many of the more obscure names in his portfolio lifted. Manufacturer Jing Chang Mechanical, consumer chip company Syna Wealth, and industrial automation equipment manufacturer Shenzhen Innovision Technology jumped during the bull run.

The top 10 holdings in the Morningstar China Index also saw a boost in their total return rates, with the charge led by JD.com JD (56.58%), PDD Holdings PDD (55.26%), and Meituan MPNGY (51.56%).