As China shifts away from zero-Covid, its stock market has rallied near 30%. Will it last?

Even as China said it will no longer track people beyond close contacts of Covid-19 infections, the task is getting harder as cases surge. There are currently close to two million close contacts under medical observation, far more than during previous outbreaks (Chart 3).

Chart 3: More Covid-19 close contacts have been quarantined as cases surge

All these have stunted economic activity and consumer confidence. Sales of movie tickets, a gauge of people’s willingness to go out and about, plunged 70% year-on-year to an 11-year low in November as more than 60% of the country’s cinemas remained closed, according to figures from ticketing platform Maoyan. Subway traffic in China’s four largest cities by GDP i.e. Shanghai, Beijing, Shenzhen, and Guangzhou, was down by 32% year on year in November (Chart 4). A measure of road freight in the week to 4 December fell for the third consecutive week, and was 39.7% below its level the year before. Domestic flight activity has also dropped sharply in the past two months.

Chart 4: Mobility in China’s four largest cities by GDP has been significantly curtailed

On paper, China has eased its Covid-19 measures. In practice, a large proportion of the economy remains subjected to lockdowns. The economic cost of China’s Covid-19 policy may rise yet further.

Positive impact from reopening will not be felt immediately

Even as China announced sweeping changes to its resolute zero-Covid regime, it is unclear if the government has a clear strategy in place for a safe and planned opening up to the world. If anything, the recent measures were likely a temporary response to quell the increasing public backlash against zero-Covid, as China has not undertaken the preparations necessary for a safe reopening.

Since the start of the pandemic, several countries have also attempted to implement zero-Covid. These include Australia, New Zealand, and Singapore. However, instead of using zero-Covid as a way to completely stop transmission of the virus within the country, the policy was used to buy time until vaccines were deployed, antiviral drugs were adequately stockpiled, and healthcare resources were expanded to cope with the inevitable surge in infections. Once their populations were protected, most zero-Covid nations started to open up to the world.

Not China. China has squandered the whole of 2022, refusing to undertake the preparations that would be needed for a safe reopening.

While China’s overall vaccination rate is high, its elderly population – the group that is most vulnerable to serious illness and death if infected – remains under-vaccinated, with just 40% of those over 80 years old having had booster shots. To put this in perspective, 90% of those over 80 in Singapore have received booster shots. China has also not approved the use of the more effective mRNA vaccines, which have been found to be more effective than the inactivated vaccines currently being used.

Importantly, China’s healthcare system is currently not equipped to handle an inevitable surge in hospitalisations. At this point, China has fewer than four intensive care unit (ICU) beds per 100,000 people. This is much lower than the 30 ICU beds per 100,000 in the US. A rapid opening at the start of winter could swamp China’s healthcare system and bring about the waves of deaths that the party has so far boasted of avoiding.

Even if China is able to ramp up its vaccination drive and healthcare resources within a short period of time (it wouldn’t), a deep-rooted fear of Covid-19 presents yet another roadblock. For the past three years, the Chinese media has portrayed Covid-19 to be such a dangerous virus that China needs to be locked down to combat it. State media has also often played up the side-effects of foreign vaccines and emphasised the death tolls in the West. As such, fear of the virus is ingrained in the population.

In recent weeks, as rumours spread that that Shijiazhuang was about to lift most of its restrictions, the city was gripped by fear and panic, as parents voluntarily kept their children home from school, consumers stocked up on necessities, and there were few people on the subway.

While China has started to change its tone on the virus – Vice Premier Sun Chunlun has recently downplayed the severity of the Omicron variant – any increase in deaths will certainly impede that effort. In order to convince people to live with Covid-19, China will need a whole new public communications campaign.

All these will take time. Even if China were to end its zero-Covid policy immediately, the positive economic effects would not be felt straight away. Capital Economics estimates that the shift away from zero-Covid would only benefit China’s economy in 2024 and beyond.

Short-term rebound in property market is unlikely

Besides retreating from its draconian zero-Covid policy, China has also unveiled sweeping measures over the month to support its embattled property sector. On 11 November 2022, the banking regulator and the central bank announced 16 measures designed to relieve the credit crunch in the property sector, ensure completion and handover of projects to homeowners, and prevent a fresh wave of defaults. The latest set of measures amounts to China’s strongest signal yet that its crackdown on the sector may finally be over.

Success is far from guaranteed. This is not the government’s first attempt at reviving the property sector. In fact, authorities have implemented a flurry of support measures over the course of 2022. Despite all these measures, the property market continued to deteriorate.

Furthermore, China’s property market is plagued by a confidence crisis. Homebuyers are not even convinced that developers have the ability to deliver the properties that have been pre-sold. Across China, hundreds of millions of square metres of housing projects remain unfinished. Just 60% of homes that were pre-sold between 2013 and 2020 have been delivered. As such, prospective homebuyers have been reluctant to part with their hard-earned savings for a home they may never see.

It will take time for developers to finish the uncompleted projects for which homeowners have already paid, especially if they first need to be restructured. It will also take time for a steady stream of completions to restore confidence in the property market.

That’s not all.

Even if prospective homebuyers are confident that a property they purchase will be completed, they may not feel confident enough about their own financial situation, given the uncertain economic outlook and falling home prices (Chart 5). To make matters worse, more homebuyers could delay their purchases as they wait for prices to fall further, creating a vicious cycle where falling demand for property causes home prices to fall even further.

Chart 5: Home sales and prices have been falling

As such, we do not expect home sales (and home prices) to recover in the near-term. This will have negative implications for China’s economy. As housing accounts for almost 60% of household assets in China, falling property prices would have a negative impact on household wealth and consumption.

 (Related article: Downgrading Asian high yield: Why we aren’t taking this risky bet anymore)

Still unconvinced with Chinese equities

While a bullish consensus for the Chinese equity market is emerging on Wall Street, with renewed optimism on China’s reopening, we remain unconvinced.

Even as China has eased its zero-Covid policy, its economy is still suffering, with a large proportion of the economy still under lockdowns. Furthermore, if China opens up too quickly, it risks a catastrophic loss of lives. The positive economic effects from the reopening would not be felt straight away. A confidence crisis in the property market also means a short-term recovery is unlikely.

There are also lingering long-term issues. China’s shift to a top-down state-controlled economy could usher in a low-growth period and imperil the long-term profitability of private companies. 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.

As such, we reiterate our view that China is no longer an attractive market to invest in. We maintain our Star Ratings for Chinese equities at 2.0 Star “Not Attractive”, and recommend investors to underweight China in their portfolios.

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. Any short-term rebounds should be seen as an opportunity to reduce exposure. Given the strong rebound in Chinese equities over the past month, this could be the right time to reduce.

Chart 6: Earnings forecast and price performance of the MSCI China Index

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

Where should investors redeploy their capital?

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. 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. An unconstrained bond strategy is also viable as it allows for better management of interest rate risk in this tough environment.

(Related article: Stocks are no longer the only option – here’s why fixed income is coming back to focus)

Within equities, we prefer the US and Japan. 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. We also favour Latin America and ASEAN equities. ASEAN, in particular, is poised to benefit from the shift of production away from China.

(Related article: ASEAN: Resilience in a sea of uncertainty)

Table 2: Recommended products

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.