After a sharp sell-off starting in February 2021 that spanned nearly 18 months, Chinese stock markets have staged a spectacular rebound. Investors are excited.

Signs that the Chinese government was easing up its regulatory crackdown on tech and providing support to the ailing economy and property sector offered fodder for the strong rally since last October.

The surprise government decision to re-open the economy last December was also a tailwind for Chinese equities, which are outperforming global peers by a big margin.

Chinese ADRs have also benefited after the Public Company Accounting Oversight Board in the US sounded positive about auditing issues which have been a major overhang for more than two years.

However, after a rally of 50% to 80% by the major Chinese stock market indices in a short span of time, investors must be careful not to think that Chinese equities will continue to rise in a straight line and continue posting outsized gains in the short term.

No doubt, there are good reasons to be positive on Chinese equities in the medium term. However, investors need to be prepared for volatility as the economy grapples with the surge in Covid-19 cases after China dropped its zero-Covid policy and opened its international borders in January.

China’s factories will need time to resume full production after workers return from an extended leave following the Lunar New Year holidays. It is possible that some workers may decide to leave the workforce to spend time with their families given the long lockdown over the past three years. This could disrupt production in China temporarily.

The Chinese property market is also not out of the woods and will take time to get back on its feet, even though the worst appears to be over.

On the policy front, we cannot assume Chinese regulators will not reverse some of its measures if excesses re-emerge or if markets get too euphoric. The pressure may have eased on tech firms for now, but they will have to tread carefully under the watchful eyes of the regulators.

Even as China reopens, its export sector may face challenges given the weaker US dollar and the stronger Renminbi, coupled with the slowdown in developed economies.

Chinese households are sitting on a large amount of excess savings accumulated over the past few years due to the long lockdown. Nevertheless, consumers may be cautious initially about letting their guard down to go on a spending spree given the economic uncertainties and the ingrained fear of Covid-19 resurging.

There are also questions around how China’s re-opening would impact global inflation as China’s recovery could fuel greater commodity demand and push up commodity prices. If global inflation proves to be sticky, investors will worry the major central banks could continue raising interest rates and maintaining tight monetary policy, possibly hurting global markets and Chinese equities.

China could also face greater geopolitical challenges in the next two years. Despite China’s international charm offensive since the Chinese Communist Party’s 20th party congress in late October - with President Xi Jinping traveling overseas to meet several world leaders - US-China tension could escalate once again in the run-up to the US Presidential elections next year. American politicians have raised issues like the economic and military threat posed by China, and China’s perceived support for Russia in the Ukraine war and its pursuit of territorial claims. The recent ‘spy balloon’ incident doesn’t help, either.

These raise fears of further economic sanctions against China and its impact on the economy.

Still, we remain overweight on Chinese equities as well as equities in Asia ex-Japan which will benefit from China’s renaissance. Despite the recent strong rally, the MSCI China index is still about 40% below its February 2021 peak. Valuations of Chinese equities are less compelling now, but still reasonable considering the potential strong economic recovery ahead.

China’s economy could do well once the dust settles with the Covid situation, consumer confidence improves and supply disruptions ease. China is poised to be the only major economy in 2023 to post improved economic growth. The economy grew by 3% in 2022 and we expect growth to pick up sharply to 5.2% this year.

The forward blended 12-month price-to-earnings (PE) ratio for the MSCI China index based on Bloomberg estimates is now just above its 10-year average, versus being at a deep discount last October when the PE ratio was at 1.5 standard deviations below the historical average.

So, investors should not expect the phenomenal returns of the past three months to continue unabated. They should not get carried away and over-invest just because things are looking more upbeat. It is important to manage exposure to Chinese equities within a diversified portfolio comprising multiple assets classes.

Investors should take heed from the lessons of history where excessive exuberance has sometimes given way to sharp pullbacks and misery when sentiment or news flow turns negative.

Those looking to invest in Chinese equities must have a strong risk appetite and must take a strategic medium-term view. There is more upside for Chinese equities, but the road ahead may be bumpier and the returns less spectacular.

Perhaps a more balanced way to invest in Chinese equities is through funds that offer a diversified exposure to Chinese stocks, instead of individual counters. Spreading fresh investments gradually over time instead of timing the market is also a prudent strategy.

For those looking to buy directly into China-related companies, the reopening of the economy could benefit consumption-related companies and industries. The relaxation of international travel should also bode well for travel-and-leisure-related companies. Other longer term investment themes aligned with policy priorities including renewables, electric vehicles, and industrial automation.

Whatever route investors chose to participate in China’s stock markets, it is important to keep a cool head, invest carefully, and not get carried away just because Chinese stock markets are on a tear.

Contributed by Vasu Menon, Executive Director of Investment Strategy, OCBC Bank

This article was first published in The Business Times on 11 February 2023.