FOR years, investors have been wary of the persistent drag of deflation on Chinese equities. However, a structural regime shift is finally happening within China’s equity market, especially within the offshore space, leading to sustainable return on equity (ROE) and valuation recovery.
In Morgan Stanley’s recent China equity strategy report, we upgraded the MSCI China and Hang Seng indices to equal weight and raised our targets. Despite the top-down challenge of deflation, we are increasingly confident that the ROE trough is behind us.
This is supported by three main drivers: Namely, diligent corporate self-help and active shareholder enhancement activities compounded by the structural shift in the listed company universe towards higher-quality companies or sectors. These effectively create a positive feedback loop.
First, corporate self-help and active shareholder enhancement activities – such as cost control, buybacks and leveraging-up for key companies that were previously under-leveraged – have led Chinese equities, particularly in the offshore market, to embark on an increasingly clear journey of enhancing shareholder returns.
As a result, dividend yields for the MSCI China and Hang Seng indices have been rising steadily since 2020, with an acceleration of share buyback activities since 2021.
Second, the offshore Chinese equity universe is becoming less influenced by macroeconomic and deflation factors. Since 2022, as macro slowdown and deflation concerns persisted, the index weight of sectors heavily impacted by broad gross domestic product growth and deflation has been diminishing.
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Sectors such as consumer staples, property, materials and industrials, as well as healthcare have seen their share of the aggregate index drop by nearly nine percentage points to 15 per cent.
Finally, the latest technology breakthroughs from Chinese companies such as DeepSeek have put China back to the centre of the tech debate – potentially enhancing margins and ROE growth.
As seen in Japan in the 1990s, technology firms can thrive in deflationary environments. China’s tech-focused sectors have reminded the market that they can still stay at the forefront of innovation by leveraging the country’s deep pipeline of engineers, data availability, well-established ecosystem in the social network and e-commerce space, as well as potential top-down regulatory support.
As a result of these developments, MSCI China’s ROE has improved from 9 per cent in mid-2023 to 11 per cent. With further room for enhancement on the way, we see the index’s ROE potentially exceeding 12 per cent by end-2026, compared to that of the MSCI Emerging Markets Index, which is currently at 11.9 per cent.
Re-rating justified
Overall, we believe the structural valuation regime shift justifies an MSCI China re-rating, reducing China’s equity risk premium and improving investability. The latest private entrepreneurship symposium signalled that Chinese regulators are ready to move from rectification to revitalisation, with a more favourable approach towards the private sector and entrepreneurship.
Furthermore, on the technology front, DeepSeek’s rise shows early signs of success for China’s diverging path on artificial intelligence. This is a game changer for global investors and a wake-up call that the country will be able to stay in, or even lead, the global tech competition – and therefore deserves a valuation reflective of that.
We think MSCI China’s 12-month forward price-to-earnings trading range will likely sustain a range of 10 to 12 times, from 8 to 10 times since 2022. We have increased our 2025 year-end China offshore index targets and moved MSCI China to equal weight from underweight within our Emerging Markets/Asia ex-Japan framework.
Our new targets are 24,000, 8,600, and 77 for the Hang Seng Index, Hang Seng China Enterprises Index, and MSCI China, respectively. Our year-end target for the CSI 300 index remains unchanged at 4,200.
There should be ample room for global investors to engage as there have been very low foreign inflows recorded, given that the improvement in equity risk premium only just happened, and major institutional investors have sizeable underweight positions.
We expect stronger momentum for offshore versus A-shares in the near term, but on-par returns over the course of the year. This is as the A-share market’s composition suggests a larger drag in the near term from current deflation, with more deflation-affected sectors representing 42 per cent of the CSI 300’s total index weight versus 15.5 per cent for MSCI China.
However, the CSI 300 will likely catch up eventually, given its wider offering of tech stocks, record-low foreign ownership, and the diminishing A-H shares premium.
To get more bullish beyond the current level of valuation upside, we believe there would need to be a major uplift in the macro environment and fundamentals.
This includes an earlier-than-expected reversal of the current deflationary trend, which is still forecast to persist through the entirety of 2025 and even part of 2026. Also needed is further alleviation of geopolitical concerns, such as the removal of some of the existing tariffs and/or technology restrictions.
There remain key risks around the re-escalation of US-China confrontation, however, particularly regarding tariffs and technology restrictions. The “America First” trade policy review in April is a key event to watch. In addition, any sudden tightening of fiscal and monetary policy could further entrench deflation.
The writer is chief China equity strategist at Morgan Stanley