Has pessimism peaked on China?
Despite the current weakness, the outlook for China could be brighter in 2023 and the economy could rebound, albeit from a low base.
Chinese growth is currently weak. The credit impulse, the 12-month change in new lending as a share of GDP, reached a low in the final quarter of 2021 and typically leads economic activity by six to nine months. However, China’s zero-Covid policy has impeded the prospects for an economic rebound in 2022. The need for lockdowns has led to ongoing weakness in the property sector, impediments to manufacturing and logistics, rising unemployment and a deterioration in consumer confidence.
These factors have compounded the impact of increased regulatory pressures over the past 12 months. Meanwhile, geopolitical concerns persist, and the outlook for trade has deteriorated as policy tightening globally is likely to lead to a slowdown in economic activity.
This has pressured China’s equity market. The MSCI China Index is down by more than -21% in US dollar terms so far this year, and in the past 12-months has fallen -37%, as at 23 May 2022. More recently, renminbi depreciation has dragged on dollar returns, with the currency down -4.3% year-to-date versus the US dollar.
However, the outlook for China could be brighter in 2023. Unlike many other countries, policy stimulus is being applied and if the zero-Covid policy leads to fewer restrictions, the economy could rebound from a low base. Emerging market investors are underweight China, according to industry surveys, and the equity market has cheapened. Given the right conditions, we could see the market perform well, so is it time to become more constructive?
When will China’s zero-Covid policy be unwound?
China won praise for successfully containing domestic spread of Covid-19 in 2020. Since then, strict travel quarantines have been held in place, along with ongoing domestic monitoring. At the same time, China has fully vaccinated 87% of its population; that is those who have completed the initial vaccination protocol, as set out by the manufacturer (typically two doses).
However, the arrival of the Omicron variant has complicated the outlook. Omicron has proven to be far more infectious than previous variants of Covid-19, and been able to evade previous containment measures. While daily new cases are far lower than in other large countries such as the US, the authorities have remained focused on eradicating domestic spread under the zero-Covid policy.
This has led to the imposition of full lockdowns in various cities, including in Shanghai. The chart below shows the evolution of rising daily new cases this year, and the subsequent easing in case numbers in Shanghai after lockdowns were imposed.
After six weeks in lockdown, there has been some easing in Shanghai, as cases have fallen. However, the experience of Omicron in other countries suggests that the risk of new lockdowns in other cities may be prolonged. At the time of writing, daily new cases in Beijing are rising. Measures to contain the spread of the virus may well remain rigorous and in place for some time. We understand that at least 15 cities are requiring citizens to take a PCR test every 48 hours in order to move about freely.
Why is the zero-Covid policy is still being deployed, and how long might it remain in place?
Every country which has lifted Covid-19 restrictions has seen a subsequent wave of cases, and sadly deaths. A replication of these outcomes in China could result in a significant number of deaths, given its size. What might make this impact more severe is the fact that while the average double vaccinated share of the population is more than 80%, this figure is lower in the more vulnerable elderly population. According to data released in March, for example, only 51% of those aged 80 and over in China had received two doses of the vaccine. While those aged 80 and over represent less than 2% of the total population, this is still around 25 million people.
China has already developed and delivered its own Covid-19 vaccines using traditional technology. It is also developing its own mRNA vaccines, with two in clinical trials. Their success is not guaranteed but assuming these pass testing, a roll out is not likely to have delivered vaccines to vulnerable groups until 2023.
The upcoming National Congress in October is another factor which could result in the retention of the zero-Covid policy, due to a desire to avoid disappointing healthcare outcomes before an important political event. Also worth bearing in mind is the fact that cases of Covid have increased through winter seasons, which could complicate a potential easing at the end of this year.
President Xi recently reiterated his commitment to the zero-Covid policy, and heavy investment in testing facilities suggests that it will persist in the near term. However, anecdotally there appears to be a push to increase vaccination rates amongst the elderly. Other countries in Asia which initially successfully controlled Covid-19 are moving to treat Covid as endemic. It may become an economic imperative that China follows the same path.
How has economic activity been impacted?
The official GDP growth data shows that economic growth made a reasonably strong start to 2022, with growth rising to 4.8% year-on-year (y/y) in Q1, from 4.0% in Q4. However, more recent high frequency indicators have shown pronounced weakness, both in survey data and underlying activity, due to a large extent by the introduction of lockdowns.
Manufacturing PMI fell to 47.5 in April, from 49.5 in March (a reading below 50 indicates contraction), while non-manufacturing PMI dropped to 41.9 from 48.6, pulled down by the impact of lockdowns and rising unemployment. Industrial production was down -2.9% y/y in April, from +5% previously, while retail sales dropped by -11.1% y/y, from -3.5% previously.
This should come as no surprise, given that the areas of China that have been under lockdown restrictions account for around 31% of total GDP. As well as the severe impact on economic growth, the restrictions are affecting travel and supply chains.
The property sector continues to be a drag on growth. The top 30 largest property developers, for example, have seen sales plummet by more than -50% so far this year. Policy and regulation had weakened sales, as the government has been focused on reducing the risk stemming from excessive debt levels held by developers, and improving the affordability of housing. The zero-Covid policy restrictions have further pressured sales.
However, there has been some policy easing. The government clarified its “three red lines” policy, imposed in 2020 to effectively limit levels of debt a property company is permitted to hold, to permit new bank lending to developers for construction and M&A. It also cut some mortgage rates and increased mortgage disbursements. In addition, developers have been given more access to pre-sale funds in escrow accounts. However, the most over-leveraged developers remain under pressure, with several Hong Kong Special Administrative Region (SAR) listed companies delaying annual reports and seeing auditors resign.
On the trade side, export growth in US dollar terms has continued to slow and decelerated to 3.9% y/y in April, from 14.7% in March. Export growth had been above 20% y/y for most of the past 12-months. The sharper slowdown in April relates to the Covid-19 lockdowns and the fact that truck movements were down significantly. Import growth has been essentially flat in March and April, from a level of at least 15% over the past year. The trade surplus increased to $51.1 billion in April.
Is the business cycle set to turn?
An important indicator of the business cycle in China is the credit impulse, which is the 12-month change in new lending as a share of GDP. The MSCI China Index typically follows the credit impulse with a lag of three to six months. After reaching a low in Q4 of 2021, shown in the chart below, the credit impulse has turned up. A change in the zero-Covid policy which removes the risk of persistent and broad-based lockdowns would enable stimulus to take effect and the economy to recover.
Could more support be on the way?
The Chinese authorities set an economic growth target of around 5.5% for 2022. The current weak economic conditions mean that this target will be difficult to reach, so there has been a rising focus on the prospect of additional support measures.
A number of statements of support for the economy and markets have been made in recent months, and the government has reiterated the growth target. There has been encouragement to build infrastructure and a relaxation of measures towards the real estate sector, as described above. A car subsidy plan has also recently been announced, although there has been modest follow-through in other areas. A key question is the extent to which limited fiscal room and a likely desire to limit the extent of credit growth constrain the size of stimulus.
The central bank, the People’s Bank of China (PBoC), cut its reserve ratio requirement for banks by 25 basis points (bps) in April to 11.25%, in response to slowing growth. Along with the China Banking and Insurance Regulatory Commission, the PBoC has instructed five leading asset management companies and banks to help 12 developers by purchasing their liabilities (for restructuring) or funding M&A. Regulators encouraged small and medium-sized banks to lower their deposit rates by 0.1%. In addition, the central bank is due to set up a financial stability fund, and taxes on small and medium-sized enterprises (SMEs) are due to be cut from 25% to 20%. These moves follow various rate cuts from the central bank earlier this year.
Last week the PBoC announced that the five-year loan prime rate (LPR), set by a panel of banks, will be lowered by 15 bps to 4.45%. It follows a cut of 5 bps in January. Lower borrowing costs should be beneficial for households, as most floating mortgages are tied to this rate. The move emphasises the authorities’ willingness to support the property market, but with the one-year LPR remaining unchanged, it suggests that support will remain targeted.
Why has the currency depreciated?
The renminbi has been weak versus the US dollar in recent months, having previously been resilient. The deterioration in terms of trade, in combination with US dollar appreciation, and a sizeable depreciation in the Japanese yen, have been the main drivers of its depreciation.
The currency remains strong in trade-weighted terms and depreciation against the US dollar could have further to run as policy eases and if external accounts deteriorate.
How have regulatory risks evolved?
The intensity of regulatory pressure appears to have reduced. Recent government statements have called for regulatory investigations to be concluded and have referred to a transition towards a normalised regulatory framework. In addition, local governments have been encouraged to support real estate policy based on local situations. Regulation has been driven, in part, by a desire to address popular concerns of societal fairness, and the goals of improving common prosperity and addressing high debt levels are likely to remain core tenets of government policy. However, in the near term, growth may be the higher priority.
Geopolitics remains an important area to monitor, and there are various facets to this. Strategic competition between the US and China is likely to persist. We expect to see a degree of supply chain diversification through time, and we may see increasing economic polarisation. Russia’s invasion of Ukraine, launched soon after it signed a long-term friendship pact with China has further complicated international relations. In the medium term, it seems likely that Russia’s greater dependence on China can be to China’s advantage, but this risks further exacerbating tensions with the US.
What about the global situation?
China took export market share during 2020/21 as the zero-Covid policy initially enabled the economy to normalise in advance of many other countries. Now China is facing material restrictions on activity in the face of a more infectious variant, while other countries are normalising.
Consequently, China may see a loss of market share in trade, in addition to seeing trade pressured as tighter policy globally leads to a weaker economic environment. As a net commodity importer, China has also seen a deterioration in terms of trade as commodity prices have risen.
Are valuations attractive?
Aggregate equity market valuations, on a combined basis shown in the chart below, for China are becoming more interesting. There is some variation within the market, although this is slightly less pronounced following the correction in growth stocks.
Looking at forward price-earnings and price-book ratios, China is cheap relative to history, albeit less than one standard deviation away from its historical average. On a dividend yield basis, the market in aggregate is slightly more expensive relative to history.
On a relative basis, the MSCI China’s forward price-earnings ratio of 10.3x is at a discount to the MSCI Emerging Markets Index ratio of 11.6x, as at the end of April. However, return-on-equity for the MSCI China Index has fallen to 13.7%, compared to 15.1% for the broader index.
How has our view evolved?
China is a market which we have not favoured for some time, and various clouds continue to overshadow the outlook. Although an inflection point could be on the horizon, predicting the timing is complicated by the factors we have discussed.
Aggregate valuations have started to attract our attention, but are not significantly cheap relative to history, and the economy remains weak. The authorities have applied some stimulus but the effectiveness of this will continue to be impeded while the zero-Covid policy remains in place. In addition, regulatory pressures and geopolitical tensions persist.
However, China is a consensus underweight and there is already considerable negativity surrounding the market. If China can move away from the zero-Covid policy we could see the domestic economy rebound from a low base, supported by the ongoing application of stimulus. We will be watching carefully how expectations reset, for further policy action and for signs that post-Covid normalisation is a rising possibility.