Chinese stocks could rise by 20% as inflation expectations drive better earnings, according to UBS Securities Asia. The brokerage’s analysts suggest that more Chinese companies are preparing to increase prices this year due to higher input costs, with excess capacity showing signs of improvement.

Reflationary Environment and Valuation Re-Rating

According to a bottom-up survey of sector analysts, a reflationary environment is expected to lead to a valuation re-rating and stronger earnings-per-share growth. This could boost the MSCI China Index by 20%, as outlined in a note by UBS strategists led by James Wang on Thursday (Feb 26).

Wang noted that in the event of rising prices, the potential share price reaction is skewed towards the upside, given low expectations around reflation and low positioning in inflation-related stocks such as the consumer sector. This sentiment follows a tech-driven rally that has lost momentum this month.

Market Performance and Broader Outlook

The MSCI China gauge has fallen 5% in February, erasing year-to-date gains after a 40% surge from its April low. Chinese stocks have underperformed Asian and global peers this year. However, UBS’s bullish view on China is reinforced by recent improvements in the producer price index, which has turned less negative, and corporate profitability showing signs of improvement.

Wang also mentioned that bond yields have crept up, signaling some reflation expectations among investors. Despite these positive indicators, the analysts warned that if companies cannot raise prices due to sales pressure, earnings expectations could be lowered, potentially leading to a 7% to 10% downside for Chinese stocks.

Historical market experiences, such as Japan’s 2022 share market, suggest that sectors like materials, financials, and property typically outperform during reflationary periods. In China, the earlier beneficiaries could include certain consumer sectors due to light investor positioning, according to UBS.

Strategic Adjustments and Sector Outlook

The brokerage has adjusted its sector ratings, lifting property and consumer staples to neutral from underweight, while cutting the software sector to underweight. This move reflects lingering concerns around tech disruption and high valuations in the software sector.

Other major banks also have positive outlooks on local markets, driven by artificial intelligence and policy measures. In January, Goldman Sachs Group projected a 20% climb for the Chinese index, aligning with UBS’s expectations.

UBS’s previous forecast in November expected the MSCI China gauge to reach 100 by the end of 2026. With current market conditions showing signs of reflation and improving corporate fundamentals, the brokerage remains confident about the long-term prospects for Chinese equities.

Investors are closely watching upcoming economic data releases and policy announcements for further signals on inflation and growth. The performance of key sectors, particularly consumer and property, could provide further insights into the trajectory of the Chinese stock market in the coming months.