Investing.com -- Societe Generale (OTC:SCGLY) has maintained a positive outlook on China equities, citing the potential for continued outperformance relative to government bonds and other emerging market (EM) stocks.
Despite the diverse performance of emerging equity markets since February 2024, China has demonstrated significant growth. The sentiment towards China's equity market has improved from being extremely bearish a year ago.
According to Societe Generale, China's equity risk premium (ERP) has remained relatively stable due to a sharp decline in bond yields. This stability has contributed to a re-rating of China equity, making it more attractive both on an absolute basis and relative to bonds.
“A sharp drop in bond yields has cushioned the fall in the ERP,” the bank noted.
Despite the mean reversion observed in China equities, their performance on a three-year rolling basis is still below the historical average. “This indicates that the mean reversion we are observing in China equity may be far from complete,” it added.
In contrast, the risk-reward profile of China government bonds is currently viewed as unattractive by the bank.
The yield gap between China bond yields and US Treasury yields is narrow, and within the emerging market context, China's government bonds offer a low yield. This, combined with a low coupon and high duration, means that these bonds may underperform compared to other major emerging market government bonds, especially if bond yields rise or fall by 50 basis points.
Societe Generale’s analysis also indicates that China equities do not necessarily need to rise to outperform China government bonds (CGBs).
With the equity risk premium below the historical average, equities could potentially offer lower excess returns than the historical average. However, the cost of equity in China is significantly higher than the 10-year government bond yield, implying that equities “should materially outperform bonds” unless there is a deflationary spiral.
Furthermore, the current gap between dividend yield and CGB yield is near a historical high, and dividends have not kept pace with earnings growth. This suggests that there could be a rise in China equity dividends.
Historically, when dividend yields are higher than bond yields, equities have delivered strong returns over the following 12 months, a trend that has been consistent in both the US and China equity markets.
In summary, China equity “remains attractive relative to government bonds and other emerging market equity,” Societe Generale emphasized.
“With dividend yield exceeding bond yield and cost of equity four times higher than bond yield, China equity should continue to outperform.”