China’s bad news just keep getting worse, but the risk is worth taking

• For China, the bad news just keep getting worse. Despite the sharp sell-off since our last update, we remain convicted in our investment case for China.

• Our conviction for Chinese equities stems partly from the country’s policy backdrop that still remains accommodative relative to the developed world.

• China is unlikely to budge from its zero-Covid policy. While new restrictions are still possible, a crucial difference is that future lockdowns should be much more targeted, and implemented with consideration given to potential economic impact.

• Moreover, we believe investors may have been too pessimistic on the earnings outlook for Chinese companies, with risks in China’s equity market largely been discounted by markets.

• The valuations of Chinese equities look attractive, with a lot of negatives already priced in. We project a 62.9% upside potential over the next two years.

Chinese economic policymakers have had a difficult time juggling competing priorities. They have been trying to keep Covid-19 infections and deaths low, maintain financial stability, while ensuring sufficient growth to maintain social stability.

For President Xi Jinping, the challenges just keep multiplying.

The property crisis that started with the collapse of real estate giant Evergrande has taken a turn for the worse in recent times. For the first time ever, aggrieved homebuyers across China are threatening to halt mortgage payments if developers do not resume work on their properties. The mortgage strike has spread to at least 320 projects in 100 cities, according to a crowdsourced document spreading online. Some suppliers, too, have threatened to stop paying their bank loans unless developers first pay them what they are owed.

There have also been flare-ups in Covid-19 cases across the country, with outbreaks reported in Shenzhen and Hainan. Shanghai also adopted fresh curbs to rein in new infections, including a snap lockdown at an Ikea outlet in Shanghai that sent shoppers fleeing and screaming in an effort to get out of the building before the doors were locked.

China has also signalled that it may miss its annual economic growth target of 5.5%, indicating that the target merely serves as a guidance, rather than a hard target. An official statement from the government only called for the "best outcome" possible for economic growth, while sticking to a strict zero-Covid policy.

As such, it was unsurprising that the strong rebound in Chinese equities in June has fizzled out almost as quickly as it began, with the MSCI China Index plunging -9.9% in July (in SGD terms) to become one of the worst performing equity market so far in 2022 (Chart 1). Despite the sharp sell-off since our last update, we remain convicted in our investment case for China.

We outline our reasons in this article.

Chart 1: China is one of the worst performing stock market under our coverage

(Related article: Upgrading Chinese equities: If there is ever a good time to enter China’s stock market, it is now.)

Policy backdrop remains accommodative, in stark contrast to developed world

Our conviction for Chinese equities stems partly from the country’s policy backdrop that still remains accommodative relative to the developed world. China has been ramping up efforts throughout 2022 to revive its economy and boost market confidence. These included interest rate cuts, issuance of special bonds for infrastructure investment, tax rebates, and a cut in vehicle taxes.

More recently, the People’s Bank of China (PBOC) has responded to weaker economic data with surprise interest rate cuts, lowering the rate on its one-year policy loans by 10 basis points to 2.75% and the seven-day reverse repo rate from 2.1% to 2%. It was the first time since January that those rates had been cut, and more cuts could be coming given that China’s recovery remains fragile.

In terms of fiscal policy, the government has set up a state investment fund worth CNY 500 billion to spur infrastructure spending. More support is likely on the way, as authorities are considering bringing forward the local government special bonds quota for 2023 to 4Q 2022 in a bid to accelerate infrastructure spending.

There was also fresh support for the property sector, as the government has instructed state-owned China Bond Insurance Co Ltd to provide guarantees to a number of private property developers issuing bonds, adding to signs of official support for an industry grappling with a debt crisis and slumping home sales.

(Related article: Lost your money investing in China property bonds? Here’s why you should continue to hold on.)

China’s “verbal intervention” has also continued. In a meeting with top officials from six major economic provinces that account for about 40% of China’s economy, Premier Li Keqiang vowed to “reasonably” step up policy support to stabilise employment, prices and ensure economic growth, while also urging the officials to bolster pro-growth measures.

It is also worth noting that China is easing its monetary policy at a time when major central banks are tightening theirs. This markedly different monetary stance has been enabled by comparatively very low inflation in China (2.7% year-on-year) compared to the US (8.5% year-on-year).

While China is unlikely to hit its 5.5% growth target this year, this does not mean that China is abandoning economic growth altogether. China is still expected to grow by 3.8% this year – producing incremental economic output equivalent to the size of Poland – sluggish by its own standards but a level most countries would envy. By comparison, the US economy is only expected to grow by 1.7% this year.

Zero-Covid policy likely will remain, but will become more pragmatic

China is unlikely to budge from its zero-Covid strategy, with leaders remaining determined to prevent the spread of the virus. For an indication of China’s extreme vigilance against the virus, look no further than the pandemonium at an Ikea outlet in Shanghai, where panicked shoppers rushed for the exits after the revelation that a close contact of a six-year-old boy with an asymptomatic case of Covid-19 forced authorities to lock down the store.

However, we wish to highlight that the scale of the outbreak is less severe this time round. Even as China's Covid-19 cases have surged to a three-month high, with 3,757 daily infections reported across China (as of 14 August 2022), it remains a small fraction of the tens of thousands of daily cases recorded at the peak of the outbreak in April (Chart 2).

Chart 2: Daily Covid-19 cases have spiked, but remains less severe than April’s peak

Despite the official rhetoric that the government will not change its zero-Covid policy, China has actually been adjusting and softening its stance since 2021, moving subtly from a strict approach that pursues zero infections towards what they now call "dynamic zero", a less restrictive approach that aims to contain outbreaks in the shortest time possible.

In recent times, China has also taken steps to ease its Covid-19 border restrictions. Not only did it reduce quarantine times for inbound travellers by half, China has also shortened the length of suspensions for inbound airline flights that carry passengers infected with Covid-19.

Furthermore, the government has been highlighting the need to achieve greater balance between growth and Covid-19 containment measures. In May, Premier Li Keqiang summoned about 100,000 officials to an unprecedented video conference and urged local officials to better balance Covid controls and economic growth. This message was again highlighted in a meeting of the Politburo in July, during which policymakers emphasised the “need to look at the relationship between virus prevention and economic growth”.

On the ground, there are signs that policymakers have been making good on their pledges to balance growth and Covid-19 containment. This was evident in Shanghai, where widespread lockdowns have been eschewed in favour of more targeted control measures to snuff out the recent flare-up in cases. While the spontaneous lockdown of an Ikea store in Shanghai was certainly extreme, we note that mobility in Shanghai has not been significantly curtailed, with public transport still up and running (Chart 3).

Chart 3: Mobility in Shanghai has not been significantly curtailed

While new restrictions are still possible, a crucial difference is that future lockdowns should be much more targeted, and implemented with consideration given to potential economic impact.

Extreme pessimism towards Chinese equities

Moreover, we believe investors may have been too pessimistic on the earnings outlook for Chinese companies, with the earnings estimates for MSCI China Index in 2022 having already been slashed by -16% this year. This is in stark contrast to the US equity market, where earnings estimates for the S&P 500 Index have seen upward revisions this year despite mounting macroeconomic risks (Chart 4).

Chart 4: Earnings estimates for MSCI China Index look overly pessimistic

As such, we believe that the risks in China’s equity market have largely been discounted by markets, and that there is scope for earnings to surprise from here. Alibaba (HKEX:9988) reported better-than-expected earnings and sales for its most recent quarter despite rising economic headwinds in China. While Tencent (HKEX:700) missed earnings expectations, there were positive signs that its business may be turning the corner, with management saying that advertising in its nascent short video platform could become a “substantial” revenue source in the future.

More importantly, we believe the worst of the regulatory crackdown on China’s tech sector may be behind us, with regulators hinting over the past few months that they may ease their scrutiny of the tech sector. In late-June, Boss Zhipin and Full Truck Alliance resumed new user registrations following a nearly one-year suspension for cybersecurity review, another sign that China is wrapping up its sweeping crackdown on internet platforms. During the Politburo’s meeting in July, regulators reiterated their intention to normalise regulation in the sector, and “promote the orderly, healthy and sustainable development of the platform economy”.

While the shadow of delisting risk continues to hang over Chinese equities, it is unlikely to have a significant impact on fundamentals in the long-term. Moreover, less than 8% of Chinese equities owned by US investors are held by investors that cannot trade in Hong Kong, according to Goldman Sachs estimates. On the plus side, Chinese companies that upgrade their listing status to “primary” –  as what Alibaba intends to do – will gain access to the Stock Connect program, which will allow companies to tap into mainland China’s vast investor base.

At this point, sentiment towards Chinese equities is one of extreme pessimism, with investors struggling to look beyond China’s present headwinds and just want nothing to do with China anymore. This is a sign that the market is not too far from the bottom.

Valuations remain undemanding

Besides, the valuations of Chinese equities certainly look attractive, with the MSCI China Index having fallen to multi-year lows. The MSCI China Index is trading at a PE ratio of 8.9X 2024 estimated earnings. Applying our designated fair PE ratio of 14.5X on EPS projections for the next two years, we project a 62.9% upside potential over the next two years.

Chart 5: Earnings forecast and price performance of the MSCI China Index

Table 1: EPS and upside projection for the MSCI China Index

Putting everything together, we believe there are compelling reasons to be optimistic on Chinese equities. With a lot of the negatives already priced in to the markets, a further easing of regulatory pressures and a policy backdrop that still remains accommodative means that there is scope for Chinese equities to outperform.

Investors who wish to seek exposure to the Chinese equity market can consider the JPMorgan Funds - China A (acc) SGD or the iShares Core MSCI China ETF (HKEX:2801). For a pure-play exposure to China’s tech sector, investors can consider the iShares Hang Seng TECH ETF (HKEX:3067).

Table 2: Recommended products for exposure to Chinese equities

Long-term case for China remains intact

It’s hard to ignore China.

China is the second largest economy in the world, constituting about 18% of global GDP. It also has the largest consumer market in the world. China is perhaps the only country where domestic companies can become global leaders just by selling to their own population. The country’s significance in global trade is underpinned by its position as the largest exporter of goods in the world.

Despite the remarkable increase in China’s global economic weight over the years, China remains under-represented in portfolios, with Chinese equities constituting only 3.5% of the MSCI AC World Index. As such, the sell-off in Chinese equities has created an attractive entry point for a market that will become an important part of global equity benchmarks over the coming decades.

Moreover, as geopolitical tensions push the US and China to untangle their economic interdependence, investors will likely need deliberate diversification across countries, warranting a standalone allocation to Chinese equities.

Importantly, investing in China is a long-term endeavour. While there are certainly reasons to be cautious, investors who can look beyond the short-term headwinds will be able to access longer-term growth in China as it transits to an innovative economy.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in iShares Hang Seng Tech ETF.