Market sentiment on China has become especially fragile of late amid fears over near-term growth. However, we see reasons to be positive and urge investors to think longer term and ignore market noise.
When it comes to China, hot topics among investors include the country's zero-Covid policy, US-China tensions, monetary and fiscal easing, the weak economic backdrop, a beleaguered property sector and regulatory oversight.
China’s economy contracted 2.6% in the second quarter this year on the back of Covid-19 lockdowns and a real estate sector under severe liquidity stress due to continued government deleveraging. Of course, these headwinds will likely trigger further monetary and fiscal policy easing, which will support China’s economy. Chiefly, we expect infrastructure spending and modest interest rate cuts.
In the absence of strong stimuli, we’re anticipating a gradual turnaround. Our Research Institute is forecasting year-on-year GDP growth of about 3% in 2022 — below market consensus of close to 4%. Chinese authorities have levers to stabilize the property sector and growing policy support reaffirms Beijing’s commitment. Reportedly, they’re considering a rescue fund to deliver unfinished residential projects. While it may be insufficient to shore up buyers’ confidence, it’s a step in the right direction.
Further, we expect policymakers to dilute or discard their zero-Covid strategy over time, most likely after the Party’s 20th National Congress this year. So we expect that the effects of lockdowns on growth to dissipate in the future.
Similarly, we see regulatory pressures easing. Rhetoric around regulations in the digital sector, for example, has improved, which bodes well for the expansion of China’s universe of digital platforms and standardizing supervision. Stable regulation would help to improve investor confidence and could drive multiple re-ratings for e-commerce companies.
Clearly, geopolitical risk is hard to predict and we expect heightened US-China tensions to last for some time. But we view such tensions as periodic and part of an evolving geopolitical landscape.
Elsewhere, our base case is that Beijing will not engage in direct military conflict with Taiwan in the near term. We think cooler heads will prevail in recognition of the heavy cost to economies and global stability. We believe imposing sanctions on Taiwan would be contrary to Beijing’s own economic interests, while more military drills around the Taiwan Strait risk disrupting global supply chains and logistics.
So what might investors expect? Here we outline our outlook on China and how it might impact different asset classes.
Equity
It’s early for China’s economy to show strong signs of recovery on the back of easing measures. So we expect equity markets to remain rangebound in the near term. But we’re constructive on the outlook as stimulus measures start to work their way through the system in the second half of 2022.
“We’re constructive on the outlook as stimulus measures start to work their way through the system in the second half.”
Companies have started reporting their first-half results, with investors now more focused on analyzing fundamentals to understand their underlying strengths and weaknesses. As investors consider these results and analyze fundamentals, we maintain that the most prudent approach to Chinese equity markets is to hone in on high-quality companies.
Valuations also look attractive. The MSCI China A Onshore Index’s 12-month forward price-earnings ratio is 11.6x — comfortably below 15.4x for MSCI World and against a five-year average of 12.6x.1
China aims to reduce real estate’s contribution to GDP growth due to the sector’s high leverage. We believe that monitoring the following five themes, which may enjoy state support and are all deemed critical to give China a competitive edge in its economic rivalry with the US, are worth watching:
- Aspiration: rising affluence leading to fast growth in premium consumption
- Digital: we see a bright future for cybersecurity, cloud, software-as-a-service and smart homes
- Green: we’re optimistic about renewable energy, batteries, EVs and related infrastructure
- Health: fast-growing disposable incomes could drive demand for healthcare products and services
- Wealth: rising prosperity points to growth for consumer finance, investment services and insurance
Fixed income
Because inflation isn't an issue in China, we expect stronger fiscal policy-easing this year and further rate cuts over the next 12 months. However, we suspect growth in infrastructure investment might disappoint after a strong first half.
Momentum in the property sector is too weak for it to recover this year. Property sales have fallen sharply and will likely stay low amid impaired consumer confidence. However, we think state-owned enterprises (SOEs) in the sector with continued access to funding maybe well-placed to outperform.
Additionally, with the rollout of more coordinated government support, we see potential for stabilization among large, well-established privately owned enterprise (POE) developers.
More generally, Chinese SOEs have enjoyed healthy demand in recent months and we expect them to retain strong government support, although we remain cautious about valuations. We think onshore SOE spreads will remain tight in coming months.
In our view, valuations may be rich among SOEs relative to Asian and global peers. We believe the same of Chinese financials in the offshore market, especially big banks. We also see supportive liquidity conditions for local government financing vehicles (LGFVs) in the near term, albeit amid growing concerns about the ability of local governments to support them.
Multi-asset
The world is a highly unusual place today, with this economic cycle different for three reasons:
- Policymakers are seeking to avoid stimulating the economy via the property sector
- Strict Covid containment measures continue to dampen consumption
- Major central banks are tightening policy aggressively to fight inflation, leading to slower global growth
But in China, where inflation is not an issue, economic growth is in the early stages of recovery after authorities started easing policy this year. Government bond yields are near historic lows, so they're not outright cheap, but equity risk premia and offshore credit spreads remain attractive.
As a result, although Chinese growth is likely to see sequential improvement in the second half of this year, the strength of the recovery will be weaker than in previous cycles. Monetary policy is likely to remain loose, with credit growth driven more by government than the property sector.
As policymakers seek to balance short-term growth with long-term structural reform goals, we see compelling opportunity among long China onshore equity and China duration, remain cautious on China credit and believe that there could be benefits to hedging currency risk when investing in China.
In a normal cycle, an early recovery phase could be a good time to invest in Chinese equity. However, in this cycle we think the recovery will be highly uneven and asset allocators need to pay close attention to potential tail-risk from Covid lockdowns and the property sector.
Typically, as growth recovery takes hold, the bulk of government bond outperformance would be behind us. In this cycle though, the weak recovery suggests China’s central bank is likely to keep liquidity conditions loose, meaning bond yields will remain lower for longer.
In more market cycles, credit would likely rally with equities. But right now we're not confident that policymakers will backstop troubled property developers, which means high-yield credit will remain distressed. Of course, this does not preclude interesting opportunities in investment grade credit.
For currencies, we think CNY can stay resilient on a trade-weighted basis, but weakening external demand and a hawkish US Federal Reserve will put downward pressure on CNY against USD. For global investors, hedging CNY risk may not be not a bad idea because hedging costs are at their lowest for five years.
Conclusion
Overall, we see investment opportunities in China. But it's important that investors keep a careful eye on the themes that could impact equity and bond markets.
1 Bloomberg, August 26, 2022
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