30 Sept 2022
It was little surprise that second-quarter earnings weakened in China after lockdowns impacted economic activity during April and May. The country’s investment outlook has struggled since 2021, reflecting several headwinds from sweeping regulatory reforms, the weak real estate market, to COVID outbreaks. Yet, China’s ample war chest to stimulate the economy will likely drive its macroeconomic policy to continue decoupling from other major markets.
Such divergence has served China well in the recent past. For instance, its policy response has been out of sync with other economies since the start of the pandemic and this contributed to its economy recovering ahead of the rest of the world. It is one of the few major economies with positive real interest rates, with comparatively low levels of inflation – August’s print came in at 2.5% - helped by the government’s avoidance of widespread monetary stimulus. In addition, lower domestic demand from the zero-COVID policy has also proved supportive in curbing inflation.
The People’s Bank of China is supporting the recovery by lowering key lending rates, offering new credit via state-run banks and by reducing the amount of cash banks need as reserves. This contrasts with most other major central banks, which are rapidly tightening rates to deal with elevated levels of inflation. This we believe should lead to a more positive medium-term outlook for China compared to peers.
An intense COVID resurgence would challenge this outlook along with spill-over risks from a weakening global economy. Regarding COVID, China’s strict containment policy to combat the virus has come under question. However, any further outbreaks are likely to prove more subdued than before, given both the increasing vaccination rates nationally – which now stands at 90% - and the more targeted approach employed against the Omicron variant, such as rolling 48-hour lockdowns and large-scale testing as opposed to prolonged blanket lockdowns).
Another potential headwind comes from the property sector. We have seen several bond defaults from stretched developers over the past 18 months, creating unwanted headlines for the Chinese economy. A report from S&P Global Ratings has stated that c.20% of the China developers it rated would be insolvent if they failed to receive additional funding1. Yet it is important to note that difficulties here are related to supply side reforms and are not demand driven. While the government cracked down on developers’ debt-fuelled growth strategies, this has not removed the fact that demand remains robust. Therefore, developers with solid balance sheets, have a longer-term outlook that remains intact, supported by a national urbanisation trend that has been unchallenged for decades.
It has taken China more than 40 years to become the global manufacturing hub it is today, and it’s on track to overtake the US as the world’s biggest economy by the end of the decade. Accounting for about 27% of its GDP, this sector is shifting to premiumisation and efficiency improvements. The pivot from industrial to innovation-led services over the past decade means that China’s growth levers are increasingly driven by technology – the country’s dominant global position in electric vehicle (EV) batteries being one notable example. Ultimately, this should help mitigate the potential demographic burden in the coming decades as the working age population begins to decline given the country’s low birth rate.
Despite the poor sentiment so far this year, we believe the backdrop is attractive. Investors were looking for entry points in May and June – months of strength – which were then offset by the market being caught up in the global macro weakness in July and August. But looking longer-term, opportunities are appearing. Current valuations for Chinese equities stand up well both relative to its history and global peers, with the onshore CSI300 and offshore MSCI China trading at consensus forward P/Es of 10.8x and 9.6x, compared to the U.S. on 16x, Developed Markets on 14.1x and the global benchmark – the MSCI All Country World Index – on 13.6x2.
This is a decent premium on offer for long-term investors – especially given the more settled macro environment in China while developed markets battle inflation. If earnings back this sentiment up during the next earnings season – especially in those sectors set to benefit from heightened consumer spending as lockdowns ease – this could underpin support for a more sustained rebound in share prices.
1 S&P Global Ratings, 2022, „China’s Property Downcycle Won’t End With Policy Easing“
2 Quelle: Goldman Sachs, Factset, I/B/E/S, MSCI, Worldscope. September 2022