Moving beyond COVID-19
Since the party congress in October, Beijing has worked towards addressing the two key issues that have dragged China’s economy and market lower over the past 18 months. Firstly, there has been a clear pivot in the COVID-19 policy. Secondly, the launch of 16 measures to support the property sector is expected to help the sector recover. China’s leaders have also planned a full agenda to meet with foreign leaders to address and stabilise the geopolitical situation.
Economic cycle at unique stage
For investors considering where to allocate capital, China stands out, not least as it has low levels of inflation which is in stark contrast to all other major economies. While the Western world contends with rising rates and quantitative tightening, China is moving in a different direction implementing accommodative monetary and fiscal policies to underpin economic growth. Remember, China’s economic challenges today are not the result of rampant inflation, they are the result of a zero-COVID policy allied to a self-induced property slowdown. We see an improvement in both of these two areas. The spike in cases brought about by China’s reopening will lead to short-term pain in the economy, as indicated by weak PMI in December. However, we think the pace of recovery may also be faster than the market is expecting. After Chinese New Year, economic activities could be largely back to normal. The reopening will likely provide a major boost to domestic consumption and private investment.
China’s stable inflation outlook provides a favourable backdrop for liquidity. If we take the credit impulse as an indicator of China’s monetary cycle, the People’s Bank of China started to tighten in mid-2020 as the economy recovered strongly from the initial COVID-19 lockdown, contributing to the slowdown seen over the past 18 months. The credit cycle turned at the beginning of 2022 when China began to loosen the margin. However, monetary policy has not flowed through to the real economy because of the extended COVID-19 lockdowns as well as property market issues. As these issues are expected to improve in 2023, the credit multiplier is likely to strengthen.
With institutional holdings of Chinese equities at the lowest they have been in over five years and cyclically adjusted valuations far below average, we believe the risk/reward ratio is favourable. China’s corporate profits were suppressed in 2022 due to COVID-19 and the property decline. However, the consensus is expecting China’s 2023 earnings per share (EPS) growth to accelerate to 10 per cent from 2 per cent in 2022. On the other hand, global EPS growth (MSCI All Country World Index) is expected to decelerate from 7.5 per cent in 2022 to 3.7 per cent in 2023. We think China is in a unique economic cycle and we expect corporate earnings to accelerate meaningfully in 2023.
China remains an essential part of the global supply chain
China’s supply chain strength is robust despite all the concerns on decoupling. Foreign direct investment into China has increased by about 20 per cent year-to-date in 2022. China’s manufacturing CAPEX in 2021 accounted for over 60 per cent of the global total, and manufacturing output accounted for 30 per cent of the global total, record-high percentage shares in both cases.
China has lost its share in labour-intensive industries such as apparel, furniture, and electronics assembly. On the other hand, the country has been quickly gaining share in technology-intensive areas like auto parts, electronic components, and other equipment (such as those related to electronic vehicle batteries, smart grid and fracking). China’s demographics have turned from tailwind to headwind, but its education/engineering dividend is just starting. Annual new STEM (science, technology, engineering, and mathematics) graduates in China are higher than for OECD (Organisation for Economic Cooperation and Development) countries combined.
Selective decoupling has been seen in strategic high-tech industries, such as leading-edge semiconductors, biotech, and potentially electric vehicles. This may slow down China’s development in certain areas, such as high-performance computing and artificial intelligence. On the other hand, the concerns on supply chain security have helped to accelerate local substitution in power, semiconductors, analog technology, and medical devices.
Market leadership expected to broaden
We believe China remains a fertile hunting ground with tremendous longevity and, like the rabbit, it is important that investors remain agile and fast-moving. We expect market leadership to broaden, and investors should look beyond the well-known mega-caps to identify potential future winners. Themes that we are following closely include seeking out the best growth opportunities in China that will emerge stronger from the economic downturn. Examples include online recruitment, shopping mall operators, and hotel chains.
Additionally, we also find ample opportunities in businesses with idiosyncratic drivers that are doing well despite the weak macro environment, such as auto parts and industrial companies levered to energy transition, shipbuilding, and oil field services.
With better visibility on COVID-19 and property market outlook in 2023, we expect various domestic-related sectors, including consumer discretionary, business service, and advertising, to accelerate toward the second half of the year. These are areas where we tend to find companies with very strong business models, and we expect to find more attractive opportunities in these areas as the economy improves.
Wenli Zheng, portfolio manager of the China Evolution Equity Strategy, T. Rowe Price
