There has been a raft of grim economic statistics emerging from China. This week brought news that retail sales had dropped over 11% year on year, well behind economists’ expectations. Industrial production, which economists had expected to rise in spite of the new Covid restrictions, dropped almost 3%.
This has been reflected in stock market performance. The average China fund is down 23% over the past six months, giving up the majority of their gains since 2019. At the heart of this weakness is a question over whether the long-term growth trajectory of China is as assured as it seemed in the face of rising geopolitical tensions, slowing growth and a revival of Covid restrictions.
There is always a natural pessimism about China. Investors don’t tend to believe the government’s growth figures, they panic over opaque debt levels and they fear the willingness of the government to interfere in key strategic sectors, such as technology or education.
However, there can be little doubt that the country was slowing even before these recent statistics. In the most recent World Economic Outlook, the IMF downgraded its growth forecast for China by 0.4 percentage point to 4.4% for 2022.
It said: “The combination of more transmissible variants and the strict zero-Covid strategy in China has led to repeated mobility restrictions and localised lockdowns that, together with an anaemic recovery in urban employment, have weighed on private consumption.
“Recent lockdowns in key manufacturing and trading hubs such as Shenzhen and Shanghai will likely compound supply disruptions elsewhere in the region and beyond. Moreover, real estate investment growth has slowed significantly. External demand is also expected to be weaker in light of the war in Ukraine.”
Innovative but heavily dependent on US intellectual property
This is undoubtedly a gloomy prognosis. There are other concerns around deglobalisation and how it may hit the Chinese technology sector. As the free flow of trade between the US and China stalls, there is a risk of ‘technological decoupling’.
Oxford Economics says: “In a scenario where heightened tensions between the West and China leads to technological decoupling, the impact on China would be (significant), causing growth to slow by almost 0.3 percentage points over the medium term.” China has benefited significantly from US intellectual property, to which it is now unlikely to have access.
However, none of these problems may prove to be as bad as the current pessimism towards China merits. Oxford Economics points out that China is an important innovation centre in its own right with a stock of R&D as large as major advanced European or Asian economies – although less than half the size of the US.
Regulation has been seen as a threat to the longer term growth of innovation, with the government seeking to address the ‘disorderly expansion of capital’; but Sophie Earnshaw (pictured), investment manager in the emerging markets equity team at Baillie Gifford, points out that regulating large technology companies is a global not a local issue.
She said: “China is just the first country to make inroads. Also, the vast majority of regulations so far are broadly sensible. The distress has been not the regulation itself, but how it’s communicated to the market and there is a growing recognition that platform regulation needs to be better signalled and less disruptive.
“The government realises that the private sector, growth, job creation and the digital economy remain vitally important for China’s continued development. They are keenly aware that private companies in China provide the majority of technological innovation, GDP growth and job creation.”
Central bank still has levers left to pull
China’s support of Russia is undoubtedly a concern and could inflame tensions with the US further. However, the country has said it respects the sovereignty of Ukraine. The Chinese government is attempting a balancing act between its principles and the importance of Russia as a strategic partner. The jury is still out whether it will navigate this path successfully, but it seems disinclined to sacrifice its economic growth to support Russia.
The adherence to zero-Covid has looked naïve in the face of the super-transmissible Omicron variant. Vaccination rates are rising and the country has just approved its first foreign anti-viral drug, but Earnshaw adds: “While this is a concern, it is more of a short-term issue than a long term structural challenge. In a macroeconomic sense, China remains relatively robust.”
In particular, China has a trump card. Inflation remains low and the central bank still has the capacity to loosen monetary policy if it needs to do so. If has already started: it cut policy rates in January 2022 to support the recovery and has indicated its willingness to do more.
Earnshaw identifies “big risks and big opportunities”. The MSCI China index is now trading at 10.5x forward earnings, compared to 16.2x for the MSCI World index. She says Chinese equities are currently on the ‘biggest valuation discount since the global financial crisis” compared to US equities. This would seem to present an opportunity, but there may be more pain to come while the current geopolitical shake-out occurs.
Chinese stock markets have always been subject to dramatic falls and impressive gains. Earnshaw says: “Being able to look through short-term volatility is incredibly important as is a willingness to commit capital for five to ten years or longer.”
China is not about to retire from the world stage, but there are still risks that could unnerve investors in the short-term.
The real question is whether investors still believe in the growth of China in the long-term. Certainly, the drivers of Chinese growth appear to remain in place, with the middle class likely to grow from 400 million to 700 million. Generation Z consumers are likely to be the driving force of this consumption upgrade, and they like local brands.
This is creating opportunities for domestically-listed companies on a scale not seen elsewhere. Infrastructure development, particularly digital infrastructure, is also growing. There may be more volatility ahead for China, but that does not dim the opportunities arising from its scale, speed of growth and innovation.
