Chinese stocks have plummeted this year on concerns about trade war and China's slowing domestic economy, but some investors now say excessive pessimism has created a buying opportunity.
At the same time, some investors worry that the bigger casualty from the trade war will be the renminbi, if Beijing decides to use the exchange rate as a weapon to counteract US tariffs.
The CSI 300 index, which tracks blue-chips traded in Shanghai and Shenzhen, rebounded this week, including a 3 per cent gain on Friday, even after the White House imposed a fresh round of tariffs on $200bn of Chinese exports. The decision to set the tariff rate at 10 per cent rather than 25 per cent, as previously discussed, sparked the relief rally, investors said.
But Chinese shares are still priced extremely low. Following this week's rally, the trailing 12-month price-to-earnings ratio for the CSI 300 closed on Friday at 12.3, after hitting its lowest weekly close since 2014 at 11 on September 14.
"China stocks are stuck between two opposing forces. Beijing's deleveraging campaign and the escalating trade dispute are weighing on earnings, but share prices have fallen so far that a major earnings downgrade is already priced in," said Frank Benzimra, head of Asia equity strategy at Société Générale in Hong Kong. "Chinese equities are now a value trade."
Indeed, some bargain hunting has already occurred in recent weeks, led by foreign investors buying into mainland shares through Stock Connect, the trading link connecting bourses in China and Hong Kong.
A glance at the sector composition of the CSI 300 shows why the market impact of trade war may be less headline-driven than investors expect. Banks and other financial institutions, which are not directly affected by tariffs, are weighted most heavily, comprising 46 per cent of the index by market capitalisation.
The next largest sector, at 11.5 per cent, is industrial companies, which are also largely insulated from the impact of US tariffs. Four of the six largest companies in this category are railway-equipment producers that mostly sell within China and export to developing countries. The other two are also domestically focused: China State Construction Engineering and Shanghai International Airport.
Overall, China's stock markets remain dominated, at least in terms of market cap, by state-owned enterprises, which contributed only 10 per cent to China's total exports last year, according to customs data.
"Some retail investors have probably engaged in irrational dumping of shares. A lot of listed companies mostly rely on the domestic market. For them, the impact of the trade war mostly comes from investor sentiment," said Tao Yu, partner and equity investment director at Brilliance Asset, a Beijing-based hedge fund.
"The market is definitely at a relatively low point, so the long-term opportunity for institutional investors right now is pretty good, but there is still uncertainty in the short term," said Mr Tao. "It's always going to be difficult to judge the market's absolute low point."
Though the longer-term impact on the stock market may be limited, some investors fear that, if the conflict continues to escalate, Chinese policymakers may dump US Treasuries and cheapen the renminbi as a form of retaliation.
The relatively small scale of Chinese imports from the US makes this option look more plausible, since Beijing is already running out of imports on which it can impose tariffs on a tit-for-tat basis.
On the currency, however, this risk is mitigated by Beijing's worry about disorderly renminbi depreciation and capital flight. A tumultuous period of renminbi weakness during 2015-16 demonstrated that, once unleashed, market expectations of renminbi depreciation can be difficult to rein in.
On Wednesday, Chinese premier Li Keqiang reiterated previous pledges that China would not intentionally devalue the renminbi. Beyond oral assurances, the People's Bank of China has taken several steps in recent weeks to shield the renminbi from depreciation pressure.
Rodrigo Catril, forex strategist at National Australia Bank in New South Wales, said that, while Mr Li's remarks were encouraging, "this doesn't necessarily mean that China will prevent the renminbi from weakening if market forces push the currency lower".
An even more extreme scenario would be Beijing's use of its US Treasury holdings as a trade war weapon, to wound the US by dumping bonds to push up dollar interest rates.
But such action could turn out to be self-punishment. China is the largest foreign holder of US Treasuries at more than $1.12tn. If large sales did push up interest rates, China's remaining portfolio of Treasuries would also be devalued.
China also has to invest its large forex reserves somewhere, and it is unclear where the PBoC could re-deploy the proceeds from selling Treasuries, said Bob Michele, chief investment officer at JPMorgan Asset Management in New York.
"From our view, the selling of US treasuries is a very small tail risk," he said. "I think they are trying to be rational in their response without trying to disrupt markets more broadly."