A painful and perilous economic recovery awaits China. Buyers beware.

• Even though a bullish consensus is emerging for Chinese equities, we prefer to remain cautious as there are reasons to believe that the recent rally may not last.

• With millions of people travelling back to their hometowns for Chinese New Year, the virus will likely spread to the rural areas, where healthcare systems are even less prepared to handle an expected surge in infections. A bigger wave is coming.

• We believe that the recovery in consumption could trail the high expectations placed on consumer spending to supercharge China’s economic growth.

• Besides, there are longer-term structural issues to worry about. Under President Xi’s leadership, China will accelerate its shift to a top-down state-controlled economy. Its foreign policy stance will likely be more assertive.

• We believe a share price correction could be in the offing as economic growth eventually fails to meet lofty expectations. We reiterate our view that China is no longer an attractive market to invest in and recommend investors to underweight China in their portfolios.

Chinese equities have been on a tear in 2023. Since the start of the year, the MSCI China Index has surged by 9.6%, while the Hang Seng Tech Index has jumped by 7.8% (in SGD terms as of 18 January 2023). Both indices have outperformed the global equity benchmark by a wide margin (the MSCI AC World Index has delivered returns of only 3.2% over the same period).

Despite a tidal wave of fresh virus infections, the Chinese government has moved forward with its plans to reverse the zero-Covid policy that it has adhered to for the past three years. In its latest move on 8 January 2023, China reopened its borders to international visitors for the first time and ended quarantine requirements for inbound travellers, dismantling the final pillar of its zero-COVID policy that had largely cut them off from the rest of the world.

Markets welcomed the move, with investors rushing back to Chinese equities as they position for a sharp rebound in economic activity. Sentiment was further boosted by easing regulatory risks and further support measures for the property sector.

All of a sudden, Chinese equities are back in favour. From Goldman Sachs to Morgan Stanley, an increasing number of strategists have ramped up their bullish calls on Chinese assets. But not us. Even though a bullish consensus is emerging for Chinese equities, we prefer to remain cautious as there are reasons to believe that the recent rally may not last.

We explain our rationale in this article.

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An even bigger wave is coming, causing short-term disruptions

Start with the good news: the current wave is likely to have peaked in several major Chinese cities. According to researchers from Ruijin Hospital and Shanghai Jiao Tong University, infections in the urban areas of Beijing, Shanghai, Chongqing, and Guangzhou have already passed their first peak of infections. A sharp rebound in subway traffic in China’s four largest cities by GDP i.e. Shanghai, Beijing, Shenzhen, and Guangzhou, also suggests that infections may have peaked in some urban areas.

However, that’s where the good news end.

China’s current Covid-19 wave has so far been confined to the urban areas, with rural areas remaining largely unscathed. This is about to change. With millions of people travelling back to their hometowns for Chinese New Year, the virus will likely spread to the rural areas, where many people are elderly, immunisation rates are lower than in cities, and healthcare systems are even less prepared to handle an expected surge in infections.

There will be horror.

Based on the latest estimates by independent forecasting firm Airfinity, China is likely to see 36,000 Covid-19 deaths a day during the Chinese New Year holidays, up from a previous estimate of 25,000 deaths a day, placing a significant burden on China’s healthcare system. The firm also estimates that cumulative deaths since December currently stand at 608,000. This is in stark contrast to the official tally of only 60,000 Covid-related deaths since China abruptly abandoned its zero-Covid policy.

An even bigger Covid-19 wave could be coming, causing short-term shocks to labour supply. Already, hospitals and financial institutions have been reportedly battling staff shortages, with workers calling in sick after contracting the virus. Others will take time off to look after their sick elderly relatives, while parents may keep their children home from school, fearing their children may get Covid-19.

Worryingly, China’s abrupt exit from zero-Covid is again disrupting foreign trade, this time due to workers falling sick rather than lockdowns, posing risks not only to its economy, but also to global inflation. Factory activity – China’s traditional engine of growth – contracted for the third straight month in December and at the sharpest pace in nearly three years as infections swept through production lines across the country, with many factory workers and truck drivers down with Covid-19. 

As a result, many manufacturers have been operating way below their capacity, and have been forced to delay or cancel their orders. There is now a real concern that workers heading home for Chinese New Year may delay their return or be forced to quit in order to take care of elderly relatives living far from their factories. 

No doubt, China’s dismantling of its zero-Covid policy was meant to revive the country’s stalled economy. However, the abrupt (and likely unplanned) reversal has so far been counterproductive, contributing to a huge surge in infections that has not only overwhelmed hospitals and crematoriums, but also caused serious disruptions to businesses across many industries. 

The short-term disruptions could yet continue.

Besides, China’s reopening is also ill-timed. The dismantling of its zero-Covid policy comes at a time when the rest of the world is slowing down. By the time this wave ends, the US and Europe could already be in a recession. As such, China’s exports will likely face headwinds in the year ahead. Consumers will have to come out in full force to spend in order to pick up the slack left behind by its export industry.

Recovery in consumer spending could trail high market expectations

One of the key drivers in China’s stock market rally is the expectation that consumption will rebound strongly following the dismantling of zero-Covid. While there is little doubt that consumption will eventually recover, we believe that the actual pace of recovery could trail the high expectations placed on consumer spending to supercharge China’s economic growth. Investors could be left disappointed.

For a start, a deep-rooted fear of Covid-19 remains ingrained in the population. Over 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. Meanwhile, social media images of long queues forming outside hospitals and bodies piling up at crematoriums have added to the fear of the virus.

Furthermore, the government has now left the public to fend for itself as cases surge across China. Amidst a drug shortage, many people have been scrambling to buy antiviral medication on the black market, paying as much as eight times the market price. They also face soaring cremation prices as China’s Covid-19 death toll continues to grow.

All these have hampered consumer confidence. Movie ticket sales during the three-day New Year public holiday, a gauge of people’s willingness to go out and about, plunged sharply by -46% from the same period in 2022, according to figures from ticketing platform Maoyan. While subway traffic in China’s four largest cities by GDP i.e. Shanghai, Beijing, Shenzhen, and Guangzhou, has rebounded strongly in recent times, it remains below pre-pandemic norms (Chart 1).

Chart 1: Mobility in China’s four largest cities by GDP remains below pre-pandemic norms

Even if the current wave dies down, other roadblocks remain. 

China’s property market is plagued by a confidence crisis, with homebuyers not even convinced that developers have the ability to deliver the properties that have been pre-sold. 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.

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 2). 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.

Chart 2: Home sales and prices have been falling

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The jobs market also points to a bleak outlook for consumer spending. Even as China cracked down on the private sector, the country’s largest employer, it has failed to create enough jobs in other sectors to offset the decline. Youth unemployment remains chronically high at 16.7% - that’s three times the national rate – with many young, qualified jobseekers unable to secure employment.

For those fortunate enough to find jobs, they have been increasingly settling for lower pay. The average monthly salary for 2022 college graduates was 12% lower than what 2021 graduates received, according to Chinese online recruitment firm Zhaopin. With another 11.6 million college graduates preparing to join the workforce this year, the labour market stress is likely to worsen.

It seems consumers are more likely to save than splurge in 2023.

Longer-term structural issues remain

Besides, there are lingering long-term structural issues to worry about. As President Xi Jinping consolidates power at the top echelon of the Chinese Communist Party, he is likely to push China towards a top-down state-controlled economic growth model, ushering in a low-growth period and imperilling the long-term profitability of private companies as state goals are now more important than profits. The risk of policy mistakes will also be higher.

Even as the government has signalled that the crackdown on the tech sector is finally coming to an end, recent reports of government entities taking “golden shares” in units of Alibaba and Tencent suggest Beijing is moving to exert greater control over the private sector. Moreover, the tech sector’s fair value has been permanently impaired, with many of the regulations implemented over the past few years still in place, including the opening up of the “walled gardens” that have been a key source of competitive advantage for many of China’s big-tech companies.

China’s foreign policy stance will likely be more assertive, with President Xi steering China away from reconciliation with the West. Even if China seeks warmer relations, the damage has already been done. Under President Xi’s leadership, China’s many years of aggressive “wolf-warrior” diplomacy has damaged the trust and goodwill built up over the years with the West. Countries are now reassessing their economic dependence on China, especially since China has shown a willingness to weaponise its economic might against countries that criticise or disagree with it.

Multinational companies – already hamstrung by strict zero-Covid measures – are also caught in the crossfire of rising US-China tensions. China’s abrupt policy shifts, including its sudden U-turn on zero-Covid, also mean foreign firms are less confident that their operations will not be disrupted. With China an increasingly challenging (and uncertain) place to do business in, many have been willing to pay higher costs to manufacture elsewhere. It is likely that more multinational companies will shift their production facilities away from China in order to spread operational risks.

China will also likely adopt a harder line against Taiwan. Not only has President Xi refused to rule out the use of military force to bring the island under Beijing's control, but the People’s Liberation Army has also reportedly been told to be ready by 2027 to reunify with Taiwan. If a conflict does occur, it could render Chinese equities uninvestible overnight if major economies impose sanctions on China for its use of military force, akin to those imposed on Russia for its invasion of Ukraine. To be sure, the chances of a war are low at this junction, but it is no longer a remote possibility.

Growth could trail market expectations, a share price correction coming

While a bullish consensus for the Chinese equity market is emerging on Wall Street, we remain unconvinced. We believe a share price correction could be in the offing as economic growth eventually fails to meet lofty expectations. Furthermore, the longer-term structural issues afflicting China means Chinese equities now warrant a significantly higher country risk premium and investors may need more of a margin of safety.

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 few months, this could be the right time to reduce.

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.

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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.

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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.