China Monthly update: What’s behind the recent reversal of the China equity market?
Aidan: In our last conversation, you hinted at the MSCI hitting a bottom in mid-March. Between then and end-June, the index indeed rallied almost 30%. But since the July, selling pressure has resumed and MSCI China is off 10% from the high. What in your view is behind the recent reversal of the market?
Will: It’s been about 3 months since we last sat down, and market volatility aside, not much has changed in my opinion. And I think that is the underlying issue. Most of us were hoping for signs of change, starting with the easing of the zero-COVID policy that has been so detrimental to the economy. While we are not seeing full city lockdowns, current policies of persistent mass testing and spot lockdowns remain costly and disruptive.
The property market started to show signs of sequential improvement after Shanghai came out of its lockdown. However, news of home buyers wanting to stop mortgage payments added further strain on an already fragile sentiment. Supportive policies for the sector so far have been more local and not addressing the key issue which is a crisis of confidence. There is still a massive concern around the survival of many private developers and that has been a source of market volatility.
Lastly, the key message from Beijing now is not to expect big stimulus for the rest of this year and they are willing to be more flexible with respect to achieving the GDP growth target set prior to the current wave of COVID challenges. This message was disappointing to us and to the rest of the market.
Will: A critical catalyst for the turning of the market sentiment is economic fundamental. Aidan, what’s your outlook for the economy and Beijing’s policies?
Aidan: So after a modest rebound of growth in May and June, the economy has run into stiff headwinds again. The drivers are the usual suspects – COVID flare-ups that have spread to more provinces than in April and May; deepening housing market woes, with house sales and starts declining further; and more recently a severe heatwave hitting a number of provinces, causing power shortages and rationing. So a renewed weakness in economic activity has plagued the markets.
The outlook of the economy is highly dependent on the duration and severity of the growth shocks, and Beijing’s response to mitigate the shocks. Provided the outbreak does not lead to more draconian measures across the country, the property turmoil does not trigger a systematic disruption, and the power shortage is short lived, we think the economy still stands a chance for a modest recovery in H2.
The strength of that recovery, however, will be highly contingent on Beijing’s policies. The recent interest rate cuts and fiscal supports suggest that we may be at the cusp of a new round of policy easing. Even although the scale of the announced measures still falls far short of arresting growth headwinds, they should help to support sentiment at the margin. There is a lot more that needs to be done by the authorities to cultivate a recovery in the remainder of the year.
Aidan: The elevated uncertainties make short-term trading in the equity market difficult, but Will, you have long been an advocate for the need of global investors to gain strategic footprints in Chinese equities. Has that view changed by the recent events? And if people do invest, is right now a good time to do so?
Will: Our view has mostly remained the same for Chinese equities, and that the worst point of sentiment probably occurred back in March and April. In terms of valuation, we are currently slightly below historical average, but well above the negative1 standard deviation level witnessed during Spring. So I’d characterize that as the sentiment isn’t great, but at the same time, I don’t sense a great deal of panic as the headlines may suggest.
That said, recent events have caused us to scale back our 2H outlook a bit. Which conversely sets up 2023 quite well, in my opinion, especially after 2 years of poor performance from Chinese equities. The key issues are:
First, how does the zero-COVID policy evolve as we exit this year and if we want to be optimistic, potentially after Party Congress set for mid-Oct.
Second, when do we start to see more substantial support for the property sector. The RMB200bn policy bank loans just announced last week to help troubled developers finish their projects is a big step in the right direction after many months of just talks but no actions.
The third is how can China reignite the animal spirit to spur credit demand and investments
In terms of strategy, we’ve been very selective. On one hand, we’ve been adding to cheap growth…and these are companies that are priced as ex-growth and where we believe the market is wrong. We are finding many of these opportunities in the internet sector for example. On the other hand, we are looking at industries with favorable multi-year policy tailwinds and well positioned companies that may have been sold off in the recent market turbulence. An example of this is in the clean energy space where many Chinese companies will clearly be beneficiaries of the Climate Bill from the U.S. as well as domestic net-zero commitments.
We are long term positive on China as it remains one of the most dynamic economies in the world with many structural drivers. It is hugely under-owned by global investors, which is usually a signal that a bottom is near. It is also on a different monetary cycle, making it less correlated to developed market equities. Sure, there are issues, but I think we are more likely to see things improve over the next 12 months.
If we are right, and that China is approaching its cyclical trough, then now is the time for investors to start building Chinese equities exposure, ahead of the recovery next year. Near term news flow may create volatility that result in prices that are favorable to long term returns.
Will: Aidan, from a macro standpoint, what are key events to watch and risks that may unsettle markets in the remainder of this year?
Aidan: In terms of key events, all eyes are on the 20th Party Congress. Even for those, who do not normally care much about China politics, they still need to watch it carefully as the personnel and policy changes at the Congress, and subsequent events, can be very consequential for the economy and financial markets.
In fact, one may argue that many of the problems facing the economy, that we just discussed, are not a result of natural causes. The ebb and flow of the short-term economic cycle has been greatly influenced by Beijing’s “zero COVID” policy. The housing market correction was policy induced at the start, and Beijing’s actions now bear the key to resolve it. On all these issues, the importance of policy cannot be overstated. That’s why many investors look to the Party Congress for signs of a potential policy reset to redirect economic development and restore market confidence.
In that regard, I think the Congress can be a source of either hope or disappointment. If the top leadership fails to convince investors of China taking a correct course of development, or falls short of addressing some of the key concerns, that’s where the hope can evaporate, and markets can capitulate.
That is not our base case. We hold a cautiously optimistic view on the Party Congress and China’s future development, but investors need to be aware of the elevated uncertainties.