Under the Macroscope—A nimble bull in a China shop

Here are my latest observations:

In short, over the past six months China’s reopening has not delivered the growth that President Xi Jinping and his government favor, and so policy is beginning to shift. As reported in the media, China is mulling a new property-market support package and regulators are considering a new basket of measures, including reducing down payments in some non-core areas of key cities, further relaxing purchase restrictions, as well as refining and extending policies announced in the “16 financial measures” from November 2022.¹ In addition, media reports indicate that the Chinese authorities are guiding big banks to lower deposit rates by 10 basis points (bps).² That preceded the People’s Bank of China’s announcement of a 10 bps cut in the seven-day repurchase rate from 2%.³ The move may be small, but it conveys their intent to boost growth. Finally, the State Council recently reiterated its commitment to support the production and adoption of electric vehicles (EVs) through extending the purchase tax reduction and promoting the construction of high-quality charging infrastructure.

Additionally, fiscal policy will be eased in a targeted and measured fashion. Beijing understands that government support is required to stem an erosion of domestic confidence in the recovery. Local and foreign investors are closely watching policy responses as the government makes decisions crucial for China’s medium-term growth and wealth creation.

Finally, investors should also note changes at the regional level, above all at the six “economically strong provinces.” These six provinces account for about 45% of national gross domestic product (GDP)⁴ and make up nearly 60% of the national total for foreign trade.⁵ They include the coastal, export-heavy provinces of Guangdong, Jiangsu, Zhejiang and Shandong, as well as the landlocked provinces of Henan and Sichuan. These provinces have their 2023 GDP growth target at 5%-6%.⁶ Investors, in other words, should look beyond Beijing and Shanghai.

Bears have a point, but bearishness is overdone

Those in the bearish camp are flagging deflation risks, record high youth unemployment, scant signs of foreign direct investment (FDI) recovery, and elevated US-China tensions that are hindering bilateral trade and cross-border investment flows.

Some foreign investors are now questioning China’s role as a contributor to global economic growth. Those concerns appear exaggerated, in our opinion. True, between 2013 and 2021 China’s average contribution to global economic growth exceeded 30%, ranking first across the world, a level that probably cannot be sustained.⁷ But in doing so, China leapfrogged to a large economy and a major force in world GDP. By 2021 China’s GDP accounted for 18% of world output, up from 11% in 2012.⁸ China’s real GDP expanded at an average annual growth rate of 6.6% percent from 2013 to 2021 versus 3.0% for the global economy and 4.1% for developing economies.⁹

The bottom line is that the well-being of China will play a vital role in the prosperity of the rest of the world. China’s growth during global dislocations this century has cushioned other economies from shocks. Concerns about China’s diminishing role as the global pillar are misplaced. If anything, China is slated to become an even larger contributor to the world economy, passing a fifth of global output in the coming five years. Even rising trade protectionism, which has halved China’s exports (as a % of GDP) from its peak at 40% in 2006, has not hampered China’s contribution to global growth nor its emergence as one of the world’s most powerful economic blocs (alongside the European Union and the United States).¹⁰

What does this mean for Chinese investments?

Thus far in 2023, Chinese equities have been lagging behind not only US markets, but also versus Japanese and German indexes.¹¹ Weaker-than-expected China growth has been a clear drag on mainland share price performance, as have been significant downward revisions in corporate profits.¹² The Chinese equity market has derated this year.¹³

But as a consequence, Chinese stocks have also already factored in a lot of bad news. For instance, based on our calculation, the Chinese equity market now discounts more than an 80% probability of recession. That probability is based on the MSCI China Index forward price-to-earnings (P/E) ratio of 10.8x, which is now below the median ratios of previous market stress periods, including the global financial crisis (13.4x), the COVID-19 pandemic (13.3x) and 2022 (11.7x).¹⁴ Similarly, the Chinese credit markets are pricing in recessionary risks, reflected in the wide credit spreads in the one-three years and five-10 years maturity ranges.¹⁵

With a fair amount of negative news already priced in as well as the pending policy stimulus, we anticipate a 2023 second-half recovery for Chinese markets. The recovery is likely to happen in stages.

It is worth recalling that optimism about COVID reopening at the end of last year led to foreign portfolio inflows worth US$25 billion in the first five months of 2023.¹⁶ But interest waned as the economy stuttered, triggering outflows of US$2.4 billion in April and May.¹⁷ As policy becomes more supportive, we expect renewed interest in the market as growth and profits expectations turn up and against the backdrop of what we consider attractive valuations.  

Equity investment opportunities are apt to tilt toward manufacturing, especially in industrial equipment, and in the banking sector. In our analysis, industrial equipment should benefit from a probable rise in capital expenditure as the economy improves. For banking, we believe stable earnings and strong asset quality accompanied by attractive valuations are key supports.

Finally, we would be remiss if we did not note that the global economic outlook is also improving. Signs of falling inflation without sharp economic slowdowns in the United States or in Europe are bolstering global investor sentiment. Policy rates are nearing their peak in the United States, with Europe not far behind. In our opinion, the global profits recession appears to have bottomed, with upward revisions now the norm in most regions.

We believe China and Chinese equities will likely benefit from these developments. It is becoming increasingly evident to us that the narrow base of equity leadership, which dominated market performance in the first half of 2023, is giving way to greater global participation. With China at the nadir of its business and profits cycle, but also offering what we consider compelling valuations, it is well poised to join the broadening global equity market recovery that could be a hallmark of the second half of 2023.

Conclusions: Do not fear the bull in the china shop   

The “bull in a china shop” tends to be associated with fragility of the surroundings and the presence of clumsiness.

But that is not the same as being an equity bull in the shop that is the Chinese equity market. We believe that appropriate policy support—coordinated between the central and regional governments—should make the disappointments of China’s recovery that have plagued its equity market thus far this year a thing of the past. An improving global outlook is also supportive, as is a growing willingness of investors to broaden their horizons.

In this sense, we welcome the bull in the China shop. There is value to be found in traipsing around its assets.