China Stocks: Inflation Could Spark 20% Rally

Chinese stocks may experience a significant upward trend, with UBS Securities Asia Ltd. forecasting a potential 20% gain. This projection is based on the expectation that rising inflation will translate into improved corporate earnings. A survey of UBS analysts indicates that a growing number of Chinese companies are planning price increases this year due to escalating input costs, coupled with signs of improving excess capacity.

Analysts suggest that a reflationary environment would foster a re-rating of valuations and stronger earnings-per-share growth, which could drive the MSCI China Index higher. They note that the market's reaction to rising prices is likely to be positive, given current low expectations for inflation and understated positioning in inflation-sensitive stocks. This optimistic view contrasts with a recent market downturn, where the MSCI China gauge slid 5% in February.

While the outlook is largely bullish, analysts acknowledge a potential downside. If companies are unable to raise prices due to sales pressure, earnings expectations may be lowered, leading to a 7% to 10% decline in China stocks. Historically, sectors like materials, financials, and property have performed well during periods of reflation, with potential beneficiaries in China including certain consumer sectors.