beyondbrics

The Shanghai Composite is the region’s worst performing stock market this year. It’s lost almost 20 per cent in 2010, and currently sits a full 57 per cent off its 2007 peak. The local nuances of the Chinese investor base can’t be the only reason – Hong Kong’s ‘H’ shares index has fallen pretty hard too – down 46 per cent from its 2007 peak.

So with growth in China back in the double digits – and many analysts revising their expectations towards softer monetary policy – are Chinese stocks undervalued?

Morgan Stanley sees some buy signals. A note today from Jonathan Garner, head of MS’s emerging markets strategy, explains why they’ve decided to increase their weighting in emerging markets stocks and out of cash and bonds. In relation to China, MS sees a market trough and has China and Korea as the top overweight picks.

In the last week Chinese equities have begun to outperform MXEF and MXAPJ, reversing this year’s under performance. In the past, particularly in 1998, this has tended to occur around the time of a market trough. Within the Shanghai A-share market, the property sector, having underperformed the market year-to-date, appears to have made a performance relative trough in recent trading (again tending to lead the overall market in the past).

But how easy is it to predict moves in the Chinese market? UBS’ Jonathan Anderson and his team released a note on Tuesday, explaining why the performance of the Shanghai market just doesn’t add up.

Looking for an asset class that can truly generate independent, non-correlated returns in a world where everything seems to be driven by the same Great Risk Trade? We suggest that you focus on Chinese equities.

The point is summed up very simply in this chart:

If you can make it out – the pink circle is where China sits, when you chart stock market returns against cumulative GDP growth. And it’s not to do with company earnings, which UBS says have closely followed GDP – China is simply an anomaly. And with the performance of Hong Kong H shares increasingly becoming “a near one-to-one proxy for the A-share market” – you can’t put it down to the heavily domestic investor base in Shanghai.

So in some respects there is agreement – there are indications that Chinese equities look undervalued compared to regional peers.

But if the Chinese market is totally uncorrelated – the fact that Chinese equities look cheap isn’t necessarily a good indicator of where they are heading next.