China’s telecom stocks, a proxy for the value of industrial automation, turned in the best performance in China’s CSI 300 Index of mainland large-cap stocks during February. The telecom subindex of the CSI 300 rose by nearly 20% as of Feb. 20 from its January 17 low.
Although the telecom index has gained about 20% since January 2019, the recovery looks like a dead cat bounce on the chart. Closer analysis, though, indicates that the telecom rally just before and after the Lunar New Year holiday is significant.
Telecom companies in the West are a consumer business. In China, they provide key infrastructure for industrial automation, in the form of dedicated broadband networks for industry, mining and logistics. 5G networks offer high data capacity as well as low latency (very rapid response to signals), and support a wide range of artificial intelligence applications.
High-speed cameras upload thousands of photos per minute of industrial machines or components on a conveyor belt, automating preventive maintenance, quality control and other functions. Machine learning algorithms analyze the uploaded data and identify defective parts, machines in need of maintenance, foreign objects in mining output and other functions.
Wireless communication among industrial robots, moreover, speeds the optimization of automated production and supports quality control.
A statistical technique called principal components decomposition drills down in to the factors that move markets. The first factor is the overall movement of the market. This explains 64% of the daily variation of the sectoral indices of the large-cap A-shares market.
The second most important factor is the relative movement of telecom stocks against the rest of the market. This could be thought of as an investment-vs-consumption factor (it is positive for telecoms and negative for consumer staples and consumer discretionary stocks.) A strong showing in this factor suggests that investors believe that high-tech investment will earn disproportionate profits.
During the past several days, the “telecom factor,” or the second principal component of CSI 300 returns, had one of its strongest showings ever, and came in February 20 at three standard deviations above its long-term mean. That’s a significant move, and it suggests stronger investor confidence in high-tech profitability.
Several circumstances conspire to keep equity valuations lower in China than in most major markets.
The American boycott of high-end chipmaking technology as well as the most powerful AI chips designed by US manufacturers forces China to duplicate foreign products at substantially higher cost. In the most visible case, Semiconductor Manufacturing International Corp. (SMIC) produced high-end 7-nanometer chips for smartphones and AI processors using the older lithography machines that China is allowed to buy. The unit cost of home-made chips is almost certainly much higher than in the West.
Add to these costs the negative wealth effect of the property market slump, the lingering effect of Beijing’s regulatory pressure on Internet companies, and weak growth in world trade, and Chinese stocks have had a miserable year. To be sure, the S&P’s performance is overstated by the bubble in a half-dozen AI stocks. The small-cap Russell 2000 Index is still 20% below its peak.
Chinese large-cap A-shares in the CSI 300 Index are trading about one standard deviation below their three-year average, while the S&P 500 is trading at one standard deviation above its three-year average.
China’s consumer sector will continue to lag due to the continuing impact of lower property prices. High-tech industry will remain the focus of Beijing’s largesse and the telecom sector seems to be the clearest harbinger of improving investor expectations.