Bridgewater ®

Daily Observations
April 19, 2018 ©2018 Bridgewater Associates, LP

(203) 226-3030 Bob Prince

Erin Miles
Daniel Crowley
Oliver Simon

A Top-Down Look at the Chinese Equity Market

Within a decade or so there is a high likelihood that the Chinese equity market will be on par with the US and
European equity markets in terms of its size and importance to global investors. The size of the economy and the
related size of the cash flows that it throws off for companies will be of comparable size, listings on public
markets are growing rapidly, and the opening up to domestic and foreign institutional investors is happening
faster than most are ready for. With this in mind, a top-down view of the Chinese equity market in relation to the
US and Europe shows similarities in their fundamental drivers and important differences in how things are
playing out. To frame the discussion we will work our way top-down, from revenues to pricing, with
consideration given to important linkages.

Starting with revenues, the revenues of Chinese companies are quite representative of overall economic activity
in China. They are a more volatile version of China’s nominal GDP growth plus a small bump for economic
conditions in non-Chinese countries where they do business. Companies listed on the A-share market derive
86% of their revenues from inside China and only 14% from abroad. This is much more domestically focused
than the US (29% outside the US) and Europe (45% outside of Europe). Further, the sector composition of the
Chinese equity market is reasonably well balanced, thus representing a broad economic exposure. As shown
below, the revenues of China’s listed companies are more tightly related to China’s growth than those of the US
and Europe (all of the following charts are based on the full A-share market available to onshore investors).

CHN Corporate Sales Growth USA Corporate Sales Growth EUR Corporate Sales Growth
CHN GDP Growth USA GDP Growth EUR GDP Growth
25% 50% 15% 15%
40% 10% 6% 10%
20% 6%
30% 5% 5%
15% 3% 0% 3%
20% 0%
-5%
10% 10% 0% 0% -5%
-10%
0% -15% -10%
5% -3% -3%
-10% -20% -15%
0% -20% -6% -25% -6% -20%
05 08 11 14 17 20 05 08 11 14 17 20 05 08 11 14 17 20

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Bridgewater® Daily Observations 4/19/2018
But revenues are a function of not just domestic growth but also growth in other countries where companies do
business and the translation effect of exchange rate movements. Accounting for those, the revenues of all three
are similar to economic conditions in the respective mixes of countries.

CHN Corporate Sales Growth USA Corporate Sales Growth EUR Corporate Sales Growth

CHN Rev-Weighted
Rev-Wgtd NomNom Growth
Growth USA Rev-Weighted Nom Growth EUR Rev-Weighted Nom Growth
60% 15% 14% 20%
8%
22% 50% 10% 15%
6% 5%
40% 9% 10%
17% 30% 4% 0%
2% 5%
20% -5% 4%
12% 0% 0%
10% -10%
0% -2% -15% -1% -5%
7%
-10% -4% -20% -10%
2% -20% -6% -25% -6% -15%
05 08 11 14 17 20 05 08 11 14 17 20 05 08 11 14 17 20

Moving to earnings, the earnings of Chinese companies have grown much faster than those of US or European
companies over the past decade. As shown below, Chinese earnings-per-share growth has been double that in
the US and even more relative to Europe. Most of the difference came as the Chinese economy boomed through
2011; growth in more recent years has been more similar.

CHN Earnings per Share USA Earnings per Share EUR Earnings per Share
4.5 4.5 4.5
4.0 4.0 4.0
3.5 3.5 3.5
3.0 3.0 3.0
6% annualized
2.5 increase 2.5 2% annualized 2.5
12% annualized 2.0 2.0 increase 2.0
increase
1.5 1.5 1.5
1.0 1.0 1.0
0.5 0.5 0.5
05 08 11 14 17 20 05 08 11 14 17 20 05 08 11 14 17 20

Looking at the makeup of earnings shows it’s quite different across countries. As shown above, Chinese
companies have had the advantage of high nominal GDP growth, nearly four times as high as US companies
since 2005. US companies, on the other hand, have managed to expand their margins while the margins of
Chinese companies have narrowed. One of the forces behind this has been the difference between being an
“outsourcer” versus an “outsourcee.” US companies have been able to arbitrage the low cost of labor in China
and other countries without having to reduce their prices, widening margins. Over time this labor arbitrage was
closed. And the process of closing the labor arbitrage was a squeeze on Chinese companies, which had to pay
the associated ever-higher wage rates.

CHN Margins USA Margins EUR Margins

13% 13% 13%
Previously falling; now
starting to pick up off 11% 11% 11%
of lows
9% 9% 9%

7% 7% 7%

5% 5% 5%

3% 3% 3%
05 08 11 14 17 20 05 08 11 14 17 20 05 08 11 14 17 20

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Bridgewater® Daily Observations 4/19/2018
The charts below break down how this dynamic played out over time. Even though the productivity of Chinese
labor grew much faster than the productivity of American labor, Chinese companies had to pay for this
productivity. In the meantime, US companies were able to hold real wage costs down by shifting production to
China and other areas where the level of labor costs was lower relative to the level of productivity. European
labor was less productive and more than fully compensated for its productivity.

China United States Europe

Productivity Real Wages Productivity Real Wages Productivity Real Wages
350% 50% 50%
9% average 300% ~1% average
~1% average 40% 40%
productivity productivity
growth per year
250% productivity
growth per year 30% growth per year 30%
200%
150% 20% 20%
100%
50% 10% 10%
0% 0% 0%
00 03 06 09 12 15 18 00 03 06 09 12 15 18 00 03 06 09 12 15 18

In addition, US earnings-per-share growth has been amplified by financial engineering to a far greater degree
than China or Europe, as shown below, boosting EPS by 40% since 2005 versus only about 5% for Chinese
companies and 25% for Europeans.

Cumulative Financial Engineering Impact on EPS

USA EUR CHN
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
2005 2008 2011 2014 2017

With respect to pricing, all three of these equity markets have tracked their earnings over time. In China’s case,
prices moved much more wildly around earnings up until the bubble burst in 2015, driven by rapid buying and
then selling from levered retail investors. Since then, the pricing has moved more in line with earnings.

Prices in Relation to Earnings

CHN Price CHN Fwd EPS USA Price USA Fwd EPS EUR Price EUR Fwd EPS
200% 200% 250%

200%
150% 150%
150%
100% 100%
100%
50% 50%
50%

0% 0% 0%
05 08 11 14 17 20 05 08 11 14 17 20 05 08 11 14 17 20

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Bridgewater® Daily Observations 4/19/2018
Of course, the movement of prices relative to earnings is seen in P/Es, i.e., earnings yields. China’s P/E has
stabilized in the past couple of years, at a lower level than the US and more similar to Europe.

CHN P/E USA P/E EUR P/E

30 30 30

25 25 25

20 20 20

15 15 15

10 10 10
P/E today: 18 P/E today: 23 P/E today: 17
5 5 5
05 08 11 14 17 20 05 08 11 14 17 20 05 08 11 14 17 20

In part, this has reflected higher interest rates in China, which, all else equal, would be reflected in a lower price
for a given stream of earnings (lower P/Es).

China United States Europe

Real Yield Nominal Yield Real Yield Nominal Yield Real Yield Nominal Yield
5% 5% 5%
4% 4% 4%
3% 3% 3%
2% 2% 2%
1% 1% 1%
0% 0% 0%
-1% -1% -1%
-2% -2% -2%
05 08 11 14 17 20 05 08 11 14 17 20 05 08 11 14 17 20

Netting the earnings yield against the higher bond yield and applying the same equity risk premium across
countries, discounted earnings growth rates are now similar in China and the US and lower in Europe. Given that
China’s nominal growth rates are likely to be higher than the US’, similar discounted growth rates imply that the
US can continue to make up for that by improving their margins further or continuing financial engineering.
We’re not optimistic about that, contributing to our assessments of relative valuation favoring China. An
alternative way of looking at this is that risk premiums are now higher in China due to the past few years of
tightenings in their financial system (seen most clearly in the relative return of a balanced portfolio). This would
imply a higher rate of discounted earnings growth than the US, but a higher equity risk premium (either way,
more attractive expected returns). Below, we show one simple way to look at how much earnings growth is
implied by today’s equity and bond pricing, assuming constant discount rates and risk premiums.

China United States Europe

Implied Earnings Growth Implied Earnings Growth Implied Earnings Growth
6% 6% 6%

3% 3% 3%

0% 0% 0%

-3% -3% -3%

05 08 11 14 17 20 05 08 11 14 17 20 05 08 11 14 17 20

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Bridgewater® Daily Observations 4/19/2018
More on the Underlying Structures of These Markets

As shown above, the Chinese equity market reflects the underlying fundamentals of the country, just as the US
and European markets reflect theirs. A big difference is that it is still more vulnerable to overshoots relative to
fundamentals due to the lack of diversification of its investor base. As shown below, the Chinese market is
dominated by retail investors. Any one type of investor group has biases, and if a particular group dominates the
trading in a market these biases will manifest themselves in price action. In the case of retail investors around
the world, as a very general rule they are more inclined to follow trends, thus contributing to a tendency for
trends to be overdone if they are a dominant group. As the Chinese markets continue to open up, bringing others
who have their own alternative biases (e.g., value managers have a bias to buy dips, the opposite of retail
investors) will diversify the behavior patterns and stabilize market conditions.

Equity Market Ownership (% Free Float Market Cap)

China
United States Europe
(A-Shares)
Institutional 57% 87% 33%
Mutual Funds 26% 44% 21%
Foreign 20% 25% 1%
Pension 9% 4% 2%
Insurance 0% 2% 8%
Broker/Dealers + Others 1% 12% 1%
Households 43% 13% 67%

It is worth noting that, after getting burned in the bubble, retail investors have been much more conservative in
their willingness to lever up at the same time as regulators cracked down on some of the more egregious uses.
Margin balances fell after a long period of rise, and have stabilized at levels similar to the US (not to imply that
the US is immune to high volatility and leveraging up).

Margin Balance (% Mkt Cap)

United States China
5%

4%

Similar
3%

2%

1%

0%
2011 2012 2013 2014 2015 2016 2017 2018

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Bridgewater® Daily Observations 4/19/2018
The pace of opening up to both foreign and domestic institutional investors has been rapid of late, but the rate of
adoption has been slower than the rate of opening up for both groups. We expect this to evolve, an important
outcome to achieve. Below we outline some of the most notable changes made in recent years up through last
week:

• Launched Hong Kong-Shanghai and Hong Kong-Shenzhen Stock Connect programs to allow foreigners
easier access to the A-share markets and to push for their inclusion in MSCI and other major indices.

• Just this month, announced plans to increase daily quotas for cross-border Stock Connect trading.
Although a small deal in isolation as the existing limits were rarely hit, this change will enable larger
cross-border flows as China’s weight in global indices increases over time.

• Announced plans to launch a China Depositary Receipt program and loosen IPO requirements to encourage
more offshore-listed and private companies to list onshore (particularly tech giants like Tencent and Alibaba).

• Later this year, planning on opening a London-Shanghai Stock Connect program to complement existing
Hong Kong-based programs.

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Bridgewater® Daily Observations 4/19/2018