China’s 50% rebound: it’s not just about Covid

The market response to the lifting of zero-Covid and other policy developments in China has been extremely positive. The MSCI China Index has rallied 52% in US dollar terms from 31 October to 19 January. Over the same period the currency, the renminbi, has advanced by 7% against the US dollar.

The communications services and consumer discretionary sectors, which are the largest weights in the MSCI China Index, have been among the top three performing sectors in the rally. These include the internet companies, some of which have soared by 90%, driven by the combination of reopening sentiment and a fall in regulatory concerns.

How Covid controls reversed so rapidly

The pace of the lifting of China’s zero-Covid policy (ZCP) has been as swift as it has been sudden. Debate as to when zero-Covid would be reversed continued throughout 2022, but consensus was that this would not be until spring 2023, and then only gradual. The degree of surprise at the speed of reopening is evident in market performance.

Against this backdrop, the outlook for economic growth this year has picked up. Market risk appetite has not only been boosted by the news around reopening, with the policy outlook also seeing some improvement.

Signs that Covid restrictions could be lifted sooner than expected came in late November, a month after the National People’s Congress (NPC) cemented President Xi’s position as leader for an historic third term. With the Omicron variant driving a rise in infections almost nationwide, further tightening in lockdown and quarantine measures had led to protests in several major cities.

Unexpectedly, the government announced that its Covid policy was moving to a new stage and mission, citing the lower fatality rate from Omicron. Covid restrictions began to be eased in December, including the removal of a negative PCR test requirement for travel on public transport, a lifting of closed-loop working practices for truck drivers, and a ratification of home quarantine for those with mild symptoms.

In early 2023, restrictions have been further eased, with international travellers no longer subject to testing on arrival or quarantines. The border with Hong Kong SAR has also reopened without restrictions.

As has been seen elsewhere in the world, the reopening has been accompanied by an exit wave of Covid cases and sadly a rise in deaths. With the speed of the reopening and the virus believed to be circulating at very high levels, activity levels initially fell further as sickness rates rose and others socially distanced.

Mobility data for various cities showed a plunge in traffic congestion after restrictions were eased. However, this has bounced back quite sharply as the chart below illustrates in Beijing.

Reopening impact on external accounts

The reopening of China’s borders to international travel will open the door to renewed international tourism. This may well be beneficial for other regional economies; pre-pandemic there were over 150 million Chinese travelling overseas each year. Outbound tourism will not help the external accounts or the currency though.

The current account surplus was already facing some pressures. After expanding through the pandemic, boosted by the rise in demand for exports, this is already unwinding. A revival in outbound tourism, domestic economic recovery, ongoing diversification of global supply chains and export pressure as external demand softens seem likely to bring the current account surplus down.

The growth outlook for 2023 is picking up

Economic growth in China slowed to 2.9% year-on-year in Q4, down from 3.9% in Q3, but ahead of consensus expectations for 1.8%. This divergence in expectations reflects a more resilient domestic economy. Full year growth for 2022 was 3%, well short of the government’s growth target of 5.5% and, with the exception of 2020, was the weakest for several decades.

GDP growth is a lagging indicator though, and the focus now is on the post-Covid recovery. Schroders’ economics team had already forecast a cyclical upturn in 2023, with GDP growth of 5.0% anticipated. However, recent developments push this towards the team’s rapid re-opening scenario, in which growth rebounds to 6-7%.

The relaxation and removal of Covid restrictions, some of which had been in place since the outset of the pandemic in 2020, will provide a boost to domestic economic activity. In the immediate term the lunar new year holiday may distort some of the high frequency activity indicators, but the direction of activity should be positive. The jettisoning of the ZCP removes an impediment to the effective transmission of policy stimulus and we expect consumption to rebound, supported by pent-up demand, high savings and improving employment and confidence.

In contrast with much of the rest of the world, inflation is not a concern for China. The headline rate was 1.8% year-on-year in December, below the 3% target rate. Low inflationary pressure has provided China’s central bank with space to cut its policy rate, the loan prime rate, over the past year.

The government has been providing targeted fiscal support, including measures to stabilise the property sector such as cuts to mortgage rates for first time buyers. In November a 16-step plan was unveiled, comprising financial support and the extension of loans to enable distressed developers to finish existing projects. There is now speculation thatfurther measures are being readied, including a potential easing of the ‘three red lines’. This was imposed in 2020 to effectively limit levels of debt that real estate developers were permitted to hold.

This domestic recovery will also run alongside a downturn in exports. Global growth and trade are slowing and this will be a drag on Chinese exporters this year.

Is the policy outlook shifting gear?

The lifting of the ZCP has been positive for the economy and financial markets, but there has been more for markets to digest on the policy front.

The Central Economic Work Conference (CEWC), held in December, emphasised the need to boost domestic demand. It also sent a signal in favour of private enterprise. In particular, anti-trust language was dropped from the post conference communique; a move which is seen as favourable for internet companies that have been subject to greater regulatory pressures in the past few years. To underscore this message, President Xi was also quoted in the People’s Daily emphasising his previous support for private enterprise at the CEWC.

On the geopolitical front, long-term strategic competition with the US is likely to be an ongoing issue. However there have recently been moves to improve relations and avoid a further escalation in tension. Presidents Biden and Xi met for the first time in person at the G-20 Summit in Indonesia in mid-November. This was only President Xi’s second international trip in the past few years (he visited Kazakhstan and Uzbekistan in September). While acknowledging the strategic rivalry, the two leaders agreed to form working groups to focus on specific issues. Renewed signs of diplomacy are a welcome development.

Since this meeting the US accounting regulator, the US Public Company Accounting Oversight Board (PCAOB), has announced that it secured full access to inspect and audit firms in China for the first time in history. This had long been a contentious issue and one that impacted the valuations of affected stocks due to the risk of Chinese American depositary receipt shares de-listing in the US under the “Holding Foreign Companies Accountable Act”. While access or the position of the PCAOB could change in the future, this is a clear positive.

Long-term risks remain

The government is aiming to reach middle developed economy status, and to double GDP by 2035. Economic growth has been slowing over the past decade, facing drag from stalling globalisation and the trend for supply chain diversification, while rising labour costs have made China less competitive in low end manufacturing. Demographics are becoming a drag with the working age population already in decline and the total population reportedly peaking in 2022. Urbanisation still has further to go but is more advanced at around 65%, and demographics will also impact real estate, which is already a high share of GDP. Meanwhile, investment in infrastructure is also unlikely to continue at the pace seen in recent decades. Leverage is elevated. Finally, China is facing the “middle income trap” and needs to continue to move up the value chain and grow its intellectual and human capital.

In response the government is targeting slower but higher quality growth. Its “dual circulation” strategy aims to reduce dependence on imported technologies and external demand. It is therefore more domestically focused, both in terms of consumption and import substitution or self-sufficiency in various technologies. The target involves reducing reliance on food and energy imports, with the latter linked to China’s pledge to reach carbon neutrality by 2060.

There are various challenges and risks to consider though. Policy has recently pivoted to growth and China would appear to want to stabilise relations with the US. There are, however, concerns about the extent to which power has been centralised and consolidated by President Xi and the degree to which this leads to a reduction in policy debate and potential policy volatility. While the latest announcements have been well-received, the market will also likely remain cautious of an ongoing risk of intervention in the private sector.

Geopolitics will be an ongoing risk, and differences with the US are hard to reconcile. Concern about the rise of China is a bipartisan issue in US politics, but with the Republican party gaining control of the House of Representatives more hawkish legislation towards China may be prioritised. Meanwhile, in the technology sphere, export controls and other sanctions seem likely to remain in place and could widen. Trade tariffs, implemented under the Trump administration also remain in place, but could be one area of discussion if recent diplomatic efforts progress. The pandemic highlighted the risks of supply-chain concentration in China, and a trend towards nearshoring, or supply chain diversification, is another risk for exporters.

Valuations

Looking at z-scores, a measure of how far valuations are from the historical mean, China is cheap on a number of measures, most notably price-book and 12-month forward price-earnings. However, the degree of cheapness is not as significant as can be found in various other EM.On a combined z-score basis, incorporating, trailing price-earnings, 12-month forward price earnings, price-book and dividend yield, China is cheap relative to history. However, there are other markets on more attractive valuations. It is a similar picture with the currency. The renminbi is only slightly cheap on a real exchange rate basis versus its long-term average, though it is over 10% cheap when compared with the average over the last five years.

Our view on China

The impact of the ZCP has weighed on economic growth in China for some time. Regulatory pressures in recent years, together with property woes and ongoing geopolitical tensions had only compounded this negative outlook.

We have tempered our negative view on China through 2022, given valuations, asynchronous policy support and the expectation that the ZCP was unsustainable.

The sudden easing has been a surprise. Our expectation was that the process would most likely commence in the first half of 2023 and that it would be more gradual as new domestically delivered vaccines would first be deployed to lift vaccine penetration, especially amongst the elderly.

The removal of Covid restrictions, coupled with signs that the government is pivoting to refocus on economic growth, is supportive of a rebound in growth. The market has moved rapidly, but valuations remain reasonable and the earnings outlook for domestic-oriented sectors in particular is improving.

Given these developments we have become neutral in our outlook. Encouraging signs in the diplomatic arena are also positive for near-term sentiment, but geopolitical tensions remain a risk to monitor closely. The export sector may also remain under pressure as global growth slows, and stock selection remains complex in certain sectors. The extent of the recovery in real estate remains a source of potential upside surprise.