Downgrading China: New economic regime and rising geopolitical tensions bode ill for China's future

• While we have been bullish on China, the structural shifts set in motion by President Xi’s consolidation of power at the top have led us to become more defensive on Chinese equities.

• Now, more than ever, China is unlikely to turn away from its draconian zero-Covid policy. With no end in sight, China’s economy will likely take more hits.

• Under President Xi’s leadership, China will accelerate its shift to a top-down state-controlled economy. Not only will China enter a low-growth period, the long-term profitability of private companies are now at risk, while the risk of policy mistakes will also be higher.

• China’s foreign policy stance will likely be more assertive, with President Xi likely steering China’s away from reconciliation with the West and increasingly adopt a harder line against Taiwan, ushering in a dangerous new era of hostility between the US and China.

• We believe that Chinese equities now warrant a significantly higher country risk premium. As such, we have downgraded Chinese equities from 4.5 Stars to 2.0 Star “Not Attractive”.

As the curtains fell on the 20th National Congress of the Chinese Communist Party – a highly choreographed event that will determine the country’s leadership for the next five years – China’s worst-kept secret was finally revealed: President Xi Jinping’s mandate has been extended for an unprecedented third term.

President Xi’s third term as leader came as no surprise to investors, but his picks for the party’s powerful seven-member Politburo Standing Committee were largely unexpected. For decades, the Standing Committee has been a check on the leader’s power through a long-standing power-sharing structure that ensured it was made up of politicians from all factions of the party. This time round, the top echelon of the party has been stacked with President Xi’s allies, making him the most powerful leader since Mao Zedong.

While we have been bullish on China over the past few years, the structural shifts – both within and outside China – set in motion by President Xi’s consolidation of power at the top have led us to become more defensive on Chinese equities. As such, we have downgraded Chinese equities from 4.5 Stars to 2.0 Stars “Not Attractive”.

We explain our rationale in this article.

Why we were previously bullish (and what has changed)

Previously, our conviction for Chinese equities stemmed partly from the country’s policy backdrop that remained accommodative relative to the developed world. Even as we felt China was unlikely to budge from its zero-Covid policy, lockdowns have been increasingly targeted, and implemented with consideration given to the potential economic impact. Importantly, valuations were cheap, with risks in China’s equity market largely discounted by markets.

No longer. With the further consolidation of power by President Xi, some of our previous assumptions have been invalidated.

Now, more than ever, China is unlikely to turn away from its draconian zero-Covid policy. In the lead up to the National Congress, the People’s Daily, a state-run newspaper, endorsed the zero-Covid policy as a sustainable strategy that stabilises the economy and protects lives. During the National Congress, President Xi doubled down on the stance that zero-Covid has saved lives and vowed to continue the stringent set of policies. The large-scale building of quarantine centres and isolation facilities in China also point to a more permanent zero-Covid stance.

With no end in sight, China’s economy will likely take more hits. The government could try to soften the economic blow by rolling out more aggressive stimulus, but the impact will be limited so long as zero-Covid remains entrenched, as an uncertain economic outlook will dampen both business and consumer confidence.

Furthermore, China’s next Premier – the second-ranking party member traditionally charged with leading the economy – is Li Qiang, a zero-Covid advocate who oversaw Shanghai's grinding two-month lockdown earlier this year and is a close ally of President Xi. With him at the helm, it is likely that zero-Covid will weigh heavily in his decision-making as he attempts to balance the trade-offs between lockdowns and economic growth. Any expectations of China rolling out stimulus measures on a scale large enough to revitalise the economy are far-fetched at this point.

Granted, the valuations of Chinese equities are cheap by historical standards, especially after the sharp sell-off following the conclusion of the National Congress. However, as we explain below, President Xi’s consolidation of power at the top has set in motion structural shifts that have negatively altered the long-term investment case for China.

Shift to top-down state-controlled economy

China’s embrace of a free market economy and private enterprise has led to decades of high economic growth. That is changing. Even as President Xi has committed to economic openness in his past speeches, he has been pushing the country sharply in the opposite direction. Under his leadership, China has eschewed a free market economy in favour of a top-down state-controlled economy that demands businesses conform to the aims of the Chinese Communist Party.

At the centre of this state-controlled model are state-owned enterprises (SOEs). While SOEs have often been criticised for their lack of efficiency, President Xi sees the state sector differently. In his eyes, SOEs are the backbone of the national economy, providing public services, stabilising the economy during periods of volatility, and supporting the government’s various strategic objectives. As such, it is unsurprising that SOEs are dominant in key industries and have been at the forefront of the government’s drive to develop key technologies, such as semiconductors.

Over the years, President Xi has placed an even greater emphasis over the years on mergers between state-owned firms, with some state-owned mega-firms being established in recent times. In his work report at the National Congress, the president emphasised the importance of ensuring that “state-owned capital and enterprises get stronger, do better and grow bigger.”

The increasing role of SOEs, however, means that the private sector has less room to prosper. In fact, President Xi has long held reservations about the private sector, which he sees as driven by unrestrained greed and has strayed far from party values. This is why China has been reasserting state control over the private sector, taking board seats and setting up party committees in private companies that give the government an increasing say over corporate strategy. Clearly, the government intends to carve out a greater role for the Communist Party in the private sector, allowing them to mobilise private sector resources to achieve national objectives.

The shift in the business climate and the diminished role of the private sector have been most obvious in China’s crackdown on its technology sector, deeming it to have gained too much influence. Once idolised as national champions on the world stage, companies like Alibaba and Tencent are now a shadow of their former selves. The message is clear: state-owned enterprises are now favoured. For private companies to thrive, they now have to fall in line with party priorities, or risk facing irrelevance.

China’s shift to a state-controlled economy has several implications.

First, China’s economy will likely enter a low-growth period. While the government has not ditched economic growth as a priority, it is likely that the balance of priorities will be shifted towards security (the word ‘security’ appeared 91 times in President Xi’s work report). Second, the long-term profitability of private companies are at risk, as state goals are now more important than profits. Third, with Xi likely to face even less opposition than during his first two terms, the risk of policy mistakes will be higher. Some of his policies already have unintended consequences, including a property market crisis and rising youth unemployment.

Geopolitical tensions with the West escalating dangerously

We are entering a new age of geopolitics, with the world becoming increasingly multi-polar and where peace may no longer be a sure thing. At the centre of it is rising US-China tensions. On one hand, the US is seeking to contain China, whose power and influence have been increasingly perceived as a threat. On the other, China is increasingly desiring a central role in the global world order, commensurate with its economic and military power.

This rivalry has escalated dangerously in recent times, with the US banning the sale of advanced semiconductor chips to China in order to contain its technology and military ambitions. The restrictions will likely expand beyond semiconductors, with Biden’s administration contemplating further bans on artificial intelligence and quantum computing software, as well as other emerging technologies that could have national security implications. Earlier in August, Nancy Pelosi’s visit to Taiwan triggered an unprecedented military response from China.

As President Xi begins his third term, he will likely do it with greater assertiveness in international relations, guided by a view that sees an increasingly hostile world bent on containing China’s rise: “drastic changes in the international landscape, especially external attempts to blackmail, contain, blockade, and exert maximum pressure on China”, as his work report puts it. As such, President Xi will likely steer China’s away from reconciliation with the West and increasingly adopt a harder line against Taiwan, ushering in a dangerous new era of hostility and economic tit-for-tat between the US and China.

This seismic geopolitical shift will also reshape global supply chains, as rising tensions have stoked distrust that is changing views on China’s reliability as a trade partner and supplier, causing countries to reassess their economic dependence on China. Multinational companies – already hamstrung by strict zero-Covid measures – are also caught in the crossfire of rising US-China tensions. With China an increasingly challenging place to do business in, it is likely that more multinational companies will shift their production facilities away from China in order to spread operational risks. Already, big companies like Google, Microsoft, and Apple are slowly moving manufacturing away from China.

As China becomes increasingly isolated from the world, its economy faces stagnation.

Factoring in a higher country risk premium

Would any of these structural trends change in the near-term? Very unlikely, as the lack of an obvious successor among the members of the Standing Committee suggests that President Xi could be eyeing a fourth term as well, which means he could stay in power for the next ten years and beyond.

With China now turning away from a free market economy in favour of a top-down state-controlled economy, as well as an increasingly fraught bilateral relationship with the US, it is our view that China’s economy will likely enter a low-growth phase, and that the underlying fundamentals of Chinese companies have deteriorated permanently.

We believe that Chinese equities now warrant a significantly higher country risk premium, and we have downgraded our fair price-to-earnings ratio (PE ratio) for Chinese equities from 14.5X to 10.0X to reflect this. We have also downgraded the earnings outlook for Chinese companies to factor in the expected hit to earnings as a result of a further slowdown in the economy. Based on these assumptions, the upside potential for Chinese equities is now only a meagre 3.1% over the next two years. As such, we have taken the difficult decision to downgrade Chinese equities from 4.5 Stars to 2.0 Star “Not Attractive”.

At this point, it would be unwise to invest in Chinese equities hoping that the situation would eventually improve (it likely won’t). As we’ve already experienced over the past year, every time investors got hopeful, any stock market rebounds were immediately snuffed out by renewed uncertainties. This time round, it will take a lot more patience and courage (as well as concrete proof that China’s economy is not heading in the direction we expect it to) before investors consider “buying the dip” in Chinese equities.

Chart 1: Earnings forecast and price performance of the MSCI China Index

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

MSCI China Index	FY21	FY22	FY23	FY24
PE Ratio (X)	18.3	9.2	9.8	9.7
Expected Earnings Growth YoY	3.3%	(8.3%)	(6.3%)	0.4%
Earnings Per Share (EPS)	5.67	5.20	4.87	4.89
Potential Upside from Today (%) (based on fair PE Ratio of 10.0X)	-	-	-	3.1%
Source: Bloomberg Finance L.P., iFAST Compilations. Data as of 31 October 2022.

China is no longer attractive. Invest in these markets instead.

We no longer see China as an attractive market to invest in, and recommend investors to underweight Chinese equities in their portfolios. Similarly, Asia ex-Japan and emerging markets, both of which have a high geographical concentration in China, have also become less attractive. The long-term investment case for our previous recommendations, including China tech and Asian high yield, especially the offshore bonds issued by Chinese developers, have similarly been affected. 

For investors who have a high concentration of Chinese equities in their portfolios, it may be prudent to opt for a more gradual reduction in China exposure (rather than a reduction at one fell swoop) to avoid getting caught flat-footed in any short-term rebounds.

Where else should investors turn?

At the asset class level, we now have a preference for fixed income over equities, as we are starting to see attractive value emerging within this asset class. While the focus this year has been on the sharp decline in global equity markets, fixed income markets have also suffered a brutal sell-off this year, with global bond yields climbing to levels that were last seen during the global financial crisis (Chart 2). On top of that, the valuations of bonds have turned much more attractive as compared to equities.

Chart 2: Bonds are offering more attractive yields today

Besides, with earnings estimates for developed market equities still looking overly optimistic and the macroeconomic backdrop fraught with uncertainties, we believe adopting a more defensive positioning in our portfolios is warranted at this point. Our downgrade of Chinese equities also means that there are now even less investment opportunities within the equity space.

With fixed income, our preference is for short duration bonds as short-term bond yields have moved significantly higher as compared to long-term yields, implying that investors can receive alluring yields without having to take on greater duration risk. The Nikko AM Shenton Short Term Bond SGD, LionGlobal Short Duration Bond Cl A Dis SGD, and the United SGD Fund Cl A Acc SGD are all suitable options. An unconstrained bond strategy, such as the Allianz Global Opportunistic Bond Cl AMg Dis H2-SGD, is also viable as it allows for a better management of interest rate risk in this tough environment.

Within equities, the US and Japan now stand out as more attractive options compared to Chinese equities. Furthermore, given our expectations that inflation is likely going to be higher for longer, value stocks and commodity-linked equities will be amongst the winners. The shift of production away from China will also benefit several economies and regions, including ASEAN, which investors can consider for their supplementary portfolios.

For investors who still wish to invest in China, it is now more important than ever to align their portfolios with China’s priorities: that means investing more in SOEs and companies that operate in favoured industries (e.g. green energy, electric vehicles, and advanced manufacturing). Most of these companies are found in the A-shares market, which should be relatively more resilient compared to the offshore market where foreign investor confidence remains fragile. It is worth noting that the A-share market should continue to enjoy policy support given President Xi’s desire to develop a robust onshore capital market to boost tech fundraising. As such, the investment opportunities within China are likely found only in the onshore markets.

Table 2: Recommended products

Market / Sector	Recommended Product
Global bonds	Allianz Global Opportunistic Bond Cl AMg Dis H2-SGD
Short duration bonds	Nikko AM Shenton Short Term Bond SGD
	United SGD Fund Cl A Acc SGD
	LionGlobal Short Duration Bond Cl A Dis SGD
US Value	JPMorgan Funds - US Value A (acc) USD
Japan	JPMorgan Funds - Japan Equity A (dist) SGD
Commodity-linked equities	Blackrock Natural Resources Growth & Income A2 USD
ASEAN	Principal ASEAN Dynamic Fund Class SGD

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.