What’s behind market volatility in China?

In the last week, equity markets in mainland China and Hong Kong Special Administrative Region have experienced a rout, and a subsequent rally in the past two days.

At the close on 15 March, the MSCI China Index was down close to 25% month-to-date, and almost 30% year-to-date. This is now back to below -20% YTD at the close on 16 March, and markets have continued to rally today.

What triggered the selloff?

1. US regulatory news for US-listed Chinese stocks

The initial market weakness followed an announcement from the US regulator, the Securities and Exchange Commission (SEC), in relation to US-listed Chinese companies.

The SEC confirmed the first five companies to face delisting if they do not provide access to accounting data to audit regulator, while noting that others could be added as they report financial results.

This has been a contentious issue for some time and relates to the Holding Foreign Companies Accountable Act. The moves marked the beginning of a process which could take up to two years to implement. If it proceeds as outlined, it could impact up to 270 companies. This is in effect old news but the announcement, together with other global developments, appears to have led to a reappraisal of these risks.

2. Covid resurgence and new lockdowns

Hong Kong Special Administrative Region (SAR) has seen a sharp rise in daily new cases of Covid-19 due to the spread of Omicron. To a lesser extent this has also been seen in mainland China in recent weeks, but the economic impact could be greater.

The authorities have responded by imposing lockdowns in certain cities. This includes the major economic hub of Shenzhen, initially for a period of one week. Shenzhen is a major electronics manufacturing hub  Should these lockdowns be more prolonged, these could cause more significant disruption and exacerbate global supply chains.

These developments cast major uncertainty over the timing of a potential lifting of the “zero-Covid” policy in China.

3. Elevated geopolitical concerns stemming from Russia’s invasion of Ukraine

Russia’s invasion of Ukraine has prompted a re-evaluation of geopolitical risks more broadly. Over the weekend, US reports that Russia had requested military assistance from China to support its invasion of Ukraine added to foreign investor concern.

4. Deterioration in the economic outlook

Schroders global economic forecast is moving in a more stagflationary direction. This could get even worse if oil prices rise further and supply chain disruption persists, as a result of the extensive set of sanctions imposed on Russia   

China will not be immune from this impact. Indeed, markets are pricing in tougher times ahead, given the combination of the Covid resurgence and the deterioration in the global outlook. 

David Rees, Emerging Markets Economist:

“There are at least three reasons to think that China’s economy will be subdued in the months ahead. Firstly, manufactured exports, which have been the key driver of growth over the past two years, look set to slow. The global economic outlook is looking increasingly stagflationary. This suggests that rising inflation, notably for basics such as food and energy, will start to choke off demand for manufactured goods. Second, Covid cases in China are rising sharply, to the extent that they are now the highest since the initial phase of the pandemic in early 2020. The rising number of cases is likely to cause a great deal of disruption. Third, there has so far not been a significant loosening of policy.

Why markets have since rallied

In response to the freefall in markets, Vice-Premier Liu He, and economic advisers to President Xi, pledged to take measures to support the economy and markets. It followed a special meeting of the state council’s Financial Stability and Development Committee.

Liu indicated that Chinese regulatory authorities had held a constructive ongoing dialogue with US counterparts to resolve the issues in relation to US-listed Chinese stocks. In addition, he reassured investors that the aim of the government is to preserve the stable and healthy growth of Chinese Internet platforms and uphold their global competitiveness. Finally, he specifically mentioned the importance to China of the stability of the Hong Kong financial markets.

Financial markets rallied sharply in response to these announcements.

What is the outlook from here?

Robin Parbrook, Fund Manager, Asian Equities:

“This week’s sharp sell-off in Chinese internet companies is down to a number of factors. Among those is the increasing amount of regulation. For example, recently we’ve seen some internet companies cutting the merchant fees they charge for their services, while others are facing fines for breaching money-laundering regulations.

“This is all part of an ongoing pattern of the state having a larger influence over internet companies. In China, we have long had a stock market where the investment focus of many of the constituent companies is aligned more with state priorities than a goal of maximising long-term shareholder returns. This has clearly applied to most state-owned banks, utilities, telecom, and energy stocks for some time. However, it is also now increasingly applicable to some of the large internet companies, and this is happening at a faster pace than anyone expected.

“These developments are not good news for stock markets and foreign investors. We believe the move to state/policy-directed investment will make shares in the companies affected less attractive.

“Then there are other factors influencing the overall market, such as the recent rise in Covid cases and the continuation of strict lockdowns as a response. Another uncertainty is China’s relationship with Russia as the war in Ukraine unfolds.

“All of this leads us to be relatively cautious on Chinese equities despite the falls. We do not view China as uninvestible but clients need to be aware parts of the market are less attractive structurally and risks are elevated at the moment. We’d note that smaller companies and A shares are less affected by the above factors as they tend to either be less visible due to their size and/or are more domestically focused.”

Maggie Zheng, Fund Manager, Chinese Equities:

“China’s zero-Covid policy and its impact on domestic demand and consumer confidence remain key headwinds. The apparently weaker efficacy of Chinese vaccines and low levels of immunity mean that the current strict policies will likely continue. With borders remaining shut, any consumption recovery will need to be supported by the domestic market for now.

“Encouragingly, we have seen a slight shift in stance from economic policymakers, who recognise the need to underpin growth this year and stabilise the property market. The tightening of industry regulations also appears to have moderated.

“If we were to see a decisive easing of liquidity to the property development sector and a pick-up in credit growth, possibly alongside an easing of industry regulatory scrutiny, then there is scope for sharply improved sentiment in the China market. 

“Valuations of Chinese equities are now back to the recent troughs observed in March 2020 (Covid) and December 2018 (heightened US/China tension). However, patience will be needed in the face of the near-term risks.

“In the meantime, diversification and a balanced approach in terms of exposure to value/growth factors are warranted, given that markets will likely remain volatile. We continue to favour domestic Chinese consumer-facing businesses with strong brand value and pricing power. We also like technology names that are set to benefit from China’s “new infrastructure” initiatives (industrial automation trends, 5G rollout as well as the rising demand for renewables). Among economically-sensitive stocks, we like certain materials companies which should benefit from demand-supply imbalances. Among financials, Hong Kong banks should benefit from rising rates in the US.”