The Chinese Year of the Tiger started on 1 February 2022. The tiger is considered to represent ‘great strength and forcefulness’. Certainly, investors will be hoping that something will galvanise the Chinese economy and stock market this year following a lacklustre 2021 – but there are still questions over whether the country will be able to harness its tiger power in the year ahead.
Last year was tough for Chinese investors. The country’s stock markets have been falling since the early part of the year, when the country’s policymakers clamped down on some of its major companies, particularly the online education sector, and the dominant property sector weakened.
The fall has been compounded by the general weakness of the Chinese economy, which grew only 4% in the fourth quarter of the year. The average China/Greater China fund was down by more than 10%.
David Jones, chief market economist at Capital.com, says: “The market is back to near pre-pandemic levels. The Evergrande problems created a significant hangover for Chinese stocks. The economy is still growing, but at its slowest pace for a year and not in line with expectations.”
Few of the problems that held back the Chinese economy in 2021 have been resolved. Raphaël Gallardo, chief economist at Carmignac, sees three significant headwinds to growth in the year ahead: the first is the country’s zero-Covid strategy, which continues to hamper trade and force shutdowns, the second is the downsizing of the housing sector and the third is the reliance on exports.
He says: “The zero-Covid or ‘dynamic containment strategy’ is hard to sustain and has become more and more costly. It is impossible to reverse while the country doesn’t have effective vaccines.”
The government has refused to authorise the western-developed MRNA vaccine. It has its own vaccine in phase-three trials, but this is unlikely to be available before the third quarter.
Operating as normal
In the meantime, according to Elizabeth Kwik, manager of the Aberdeen China A Share Fund, there is little sign of a change of policy from the Chinese government.
“There is an acknowledgement that it is impossible to have zero cases at all times, but still they try to contain outbreaks. They haven’t moved to the stage of ‘living with’ the virus as we’ve seen in other countries,” she explains.
“That said, over the past two years, they have managed to adapt within the zero-Covid approach. Where there is an outbreak they try to lockdown the local area, and a lot of China is operating as normal.”
On the housing sector, the Chinese government has made it clear that it considers property to be for housing and not for speculation and has taken measures to cool the market. These measures are largely responsible for the problems among some over-indebted Chinese property developers, such as Evergrande.
In its latest Global Housing and Mortgage Outlook, Fitch Ratings predicts a decline of 3-5% in China’s housing sector in both 2022 and 2023. With the market already slower in 2021, this is a marked contrast with the buoyant gains witnessed in recent years.
Fitch expects more developers will default on loans but also increased government intervention. Kwik adds that the government won’t simply let the sector slide: “They have given local governments a lot of leeway to manage local property markets and give them support where they need it.”
The final problem, says Gallardo, is the reliance on exports: “The rebound in industrial production has been massive, but retail sales volumes have been lagging. China has been importing the fiscal stimulus Americans were receiving – US consumers have been spending the money on imported goods from China. This needs to be rebalanced and the Chinese are nervous.”
Goal of common prosperity
Much of the recent rebalancing in the economy, the attacks on the internet companies and the withdrawal of support for the property sector has been as a direct result of the Chinese government’s explicit pursuit of ‘common prosperity’.
Ostensibly, this is a worthy aim, with China hoping to avoid some of the disruptive wealth imbalances that have been created in western societies, while also avoiding the crowding-out of innovation by large dominant companies.
However, it has also seen policymakers willing to pick fights with companies that appear to threaten the country’s social goals. For investors, this has brought unexpected risk and many are reluctant to invest in Chinese markets, particularly the domestic A-shares sector.
Kwik believes common prosperity won’t be pursued to the exclusion of economic growth. She says: “Common prosperity remains a very important theme for China, so redistributing income was important, but it’s still a secondary consideration compared to the long-term economic advancement of the country.
“The recent loss of momentum is not permanent – the government still has plenty of levers to pull to support growth and they have started to do so.”
It is also worth noting that Chinese policymakers have dealt swiftly with a lot of problems the west has yet to tackle, such as the social harms from technology companies. The Chinese government has been better than, say, Russia, in recognising that it governs by mutual consent and therefore needs to look after its citizens by driving growth, but also ensuring wealth is fairly distributed.
Gloom or boom?
While the Chinese economy continues to face headwinds, this doesn’t mean it will be another gloomy year for the stock market. The strength of the economy and the performance of the stock market have typically only had the loosest relationship.
Rob Burdett, joint head of the BMO GAM multi-manager people team, says: “China is cheap against its historical measures. Yes, there are risks around the effects of zero- Covid and the fact that power is increasingly consolidated. However, the markets are priced for some of the risks. Evergrande is well-known and doesn’t look like it will bring down the bond market as feared.”
The investment trust sector is perhaps the clearest indication of this relative cheapness. All the trusts in the sector are at a discount of 5% or higher to net asset value. The Baillie Gifford China Trust has moved from a 15% premium in January 2021 to a 7% discount today. Kwik points out the market is now trading at a significant discount to the MSCI World after a lot of indiscriminate selling during the past few months.
However, while markets may look cheap in aggregate, the falls have been concentrated in some of China’s biggest companies, such as Alibaba and Tencent. These are a large part of the major indices and have made the falls look worse than they are. Areas such green energy, where there is abundant government support, have not been subject to the same selling pressure.
This means there aren’t bargains as such but, according to Kwik, there are opportunities: “The ecommerce and internet sectors aren’t out of the woods, but in our view the biggest policies have been handed out. We don’t believe the aim of the government is to hinder these companies’ growth.
“Innovation is part of China’s growth plan – they need it for a prosperous society. As such, there is a lot of value emerging, but it won’t be smooth sailing.”
The Aberdeen China A Share Fund is focused on five key themes: aspiration, digital, health, wealth and green, all of which are aligned with government policy objectives. Kwik says they have been picking up opportunities in areas such as semi-conductors, which had previously been too expensive.
The rotation from growth to value over the past two months – similar to that seen in western markets – has also created some interesting ideas.
There is also regeneration in the Chinese market. It has become increasingly clear the US will no longer let China get rich on the wealth of US consumers. The trade deficit is unsustainable, and it is politically uncomfortable as well.
While this could be a risk, Burdett points out the Chinese are increasingly developing their own brands rather than buying, say, European luxury goods. A policy of self-reliance has forced Chinese companies to innovate, bringing new companies to market.
The problem for investors is that many of these companies are listed on the domestic A-shares market. It is plausible that investment here becomes more difficult as tensions rise between the US and China. The A-shares market also has a lot of retail investor participation and can be volatile.
A catalyst for change?
Jones is gloomy about the prospects for a turnaround in Chinese markets: “I can’t see a catalyst for change. Europe and the US did well last year, which helps the Chinese economy. This year is likely to be tougher for both regions and it is difficult to see China thriving in that environment.”
Gallardo is more optimistic. He believes policymakers are well aware of what risks the economy is facing and are already acting to address the problems.
“China has already started to ease. It started with cuts in the reserve requirement ratio, and we expect another range of cuts after the next National People’s Congress. We also see another round of fiscal stimulus based on tax cuts and infrastructure. China may not have headwinds to growth right now, but help will be on the way very quickly.”
Kwik adds: “Policymakers are choosing to focus on higher-quality growth and, in particular, they are choosing to prioritise economic self-sufficiency Although the pandemic has weighed on consumption for the past two years, sluggish retail sales still create a large increase in absolute terms. “The short term brings some considerable headwinds, but the long term hasn’t really changed.”
With inflationary pressures largely absent in China, there is more flexibility to put liquidity in the system and for policymakers to support the economy. For investors, the situation is opaque. There are a lot of short-term problems for the economy, and it is difficult to see global investors returning to the stock market in a hurry.
On the other hand, valuations look much more appealing than a year ago and the long-term picture for China hasn’t changed. It is still likely to grow in global economic dominance and be an increasingly powerful presence on the world stage. Volatility is inevitable, but it has some appeal for investors with patience.
This article originally appeared in the February edition of Portfolio Adviser Magazine.
