Sometimes you can’t help but be attracted to potential. Like going for the giant stuffed animal at a fair or taking the 50-1 odds on a horse bet. The what-if scenario for a big payoff can be attractive, despite low odds.

Investing in the Chinese stock market has been that for me. You can see in the chart below, how nicely upward sloping it was for years. Yet around 2017 (where the dashed line starts), it started wobbling, with several head fakes that might have looked like potential.

This most recent move higher, driven by substantial government stimulus, came as a surprise (as previously it seemed like they weren’t very concerned about not meeting their growth goals). Since expectations are nearly everything in investing, the announcement pushed Chinese stocks much higher—20% to 50%—depending on what you’re looking at, while related areas like casino stocks (the Macau connection) and oil prices (general expectation of rising demand from rising growth) also rallied on this news.

Why did China act? Economic struggles

Simply put, China’s property sector began imploding, which set off a chain reaction, leaving the country grappling with greater deflationary pressures that were already in existence from the Covid period. The real estate sector holds 70% of Chinese household wealth, so its collapse severely damaged consumer’s confidence and their willingness to spend.

The more traditional places the Chinese economy found support (foreign markets absorbing its manufacturing surplus and investing directly in the country) weren’t there. Rising geopolitical tensions, particularly with the US and Europe, led to increasing resistance against Chinese exports and foreign investment. These factors contributed to subpar economic growth, falling nearly 1% below the government's annual target of close to 5%.

The stimmies

In response to these challenges, China unveiled a 7.5 trillion yuan ($1.07 trillion) package to inject liquidity into the economy and stimulate growth. The package impacts interest rates to the stock market: 

• Lowered short-term policy rate from 1.7% to 1.5% via the 7-day reverse repo, a loan the central bank uses to increase liquidity and influence banking rates

• Cuts to rates on existing mortgages

• Reduced bank reserve requirements

• Lowered down-payment ratio on second-home purchases from 25% to 15%

• Relending programs to support local governments in buying unsold homes and converting them into subsidized housing

• A 500 billion yuan ($70.9 billion) structural monetary policy facility to provide liquidity for security houses, fund-management firms, and insurance companies when purchasing stocks via a swap line

• A 300 billion yuan ($42.4 billion) relending facility with a 1.75% interest rate to guide banks in supporting listed companies’ stock buybacks and purchases

While this stimulus is substantial, it remains to be seen whether it will be enough to spark a sustained economic recovery, or lead to just another head fake from the market.

Impact and investor sentiment

The initial market rally in response to the stimulus does make sense for a couple of reasons:

• The sheer size of the stimulus, estimated to be equivalent to about 3% of the free float of the China A-shares stock market.

• Valuations have been depressed. As the chart below shows, the relative valuations of the Shanghai Composite Index compared to the S&P 500 have been near their 2014 lows really since the pandemic. In 2014, Beijing implemented similar stimulus measures—cutting interest rates and injecting liquidity to stimulate the economy. This current package is larger and more comprehensive, leading markets to reprice Chinese stocks accordingly.

But, despite the initial market bounce in 2014, valuations eventually fell back toward their lows. 

This history has made investors, like me, cautious this time. My concern is that while the stimulus may initially boost the Chinese equity market, it might not as effectively revitalize the broader economy. And there is the question of whether the stock market flew too high, too fast. In fact, we have seen some China stock market-related indices fall 8-11% in the last few days. It might be an entry point to nibble and watch—I lean that way—but it could just as well never come to fruition.

As China aims to transition from a manufacturing-driven economy to one more focused on consumer services, consumer spending will be key. Stabilizing property prices and more government support for consumers will be crucial for restoring consumer, and investor, confidence.