- China’s recovery following its dismantling of zero-COVID has been uneven, with its manufacturing sector lagging significantly.
- Many potential drivers of economic growth – including real estate, consumption, and exports – continue to face multiple headwinds.
- Policy support will be gradual and measured, and investors should not count on this to significantly boost China’s economy.
- Long-term structural issues remain in place, including its push towards a more state-controlled economy, as well as heightened geopolitical risks in the medium to long term.
- We believe markets are underpricing the risks highlighted above, and recommend underweighting Chinese equities. Investors who wish to retain exposure to Chinese equities should consider an A-share allocation instead.
Chinese equities have had a turbulent ride – despite initial optimism over a China reopening beginning in 4Q22, this rebound momentum has since stalled in 2023, with the MSCI China Index at similar levels (HKD 64.2) compared to at the start of the year (HKD 64.5) (Chart 1).
We continue to encourage caution on Chinese equities despite some lingering optimism from the reopening. We think the likelihood of further price corrections remains elevated, especially if the nation’s macro outlook fails to meet investors’ expectations, or if geopolitical uncertainties continue to persist in key segments of the Chinese economy and markets.
Chart 1: MSCI China Index’s rebound momentum has stalled in 2023
1. Economic recovery has been positive but uneven
We believe that the Chinese economic recovery looks extremely uneven despite positive headline data thus far. We encourage investors to avoid over-optimism on the Chinese recovery, as headline data may not show the complete picture of China’s economic recovery.
On the surface, China appears to be on the path to a solid recovery (1Q GDP: 4.5% YoY), but we believe these robust headline figures obscure the uneven nature of China’s recovery. A breakdown of China’s GDP suggests that its growth is primarily led by its tertiary sector (primarily services) with the secondary sector (primarily manufacturing) lagging (Chart 2). Similarly, PMI indicators also point to a lagging manufacturing sector, severely behind its services counterpart (Chart 3). Given the historical importance of the manufacturing sector in China’s GDP growth (historically averaging a 47% contribution to GDP growth), we think this uneven recovery suggests that China’s recovery may be less durable than it seems.
The relative weakness of the secondary manufacturing sector can also be observed through anaemic industrial data. Industrial production has remained significantly below-trend since 2022 (Chart 4), while industrial profits have also fallen -21% YTD (as of April). These data points have generally come in below consensus estimates, contrasting with what we saw with GDP, once again implying an uneven recovery in China with a fragile manufacturing sector.
Chart 2: China’s growth is uneven and led mainly by tertiary industry (services)
Chart 3: PMI figures indicate that manufacturing continues to trail services significantly
Chart 4: Industrial production since 2022 remains significantly below-trend
2. No clear drivers of growth in 2023
In our opinion, many key drivers of a Chinese recovery remain beset with persistent headwinds. We look at a few below, including real estate, consumption, and exports.
Real Estate: Structural issues persist while confidence has not yet returned
We think that the Chinese real estate sector is unlikely to be a key growth driver in the coming years as it remains mired in uncertainties. This is especially important as real estate has historically accounted for over 20% of China’s economy on average.
Many domestic property developers were hit hard by the implementation of “three red lines” in 2020, as the policy made it difficult for smaller and more indebted developers to gain additional financing, exacerbated by slowing demand for housing in the same period. While property defaults have slowed from 2022, conditions remain challenging with many developers failing to make debt repayments this year as well. Furthermore, homebuyers continue to lack confidence that developers can deliver their pre-sold properties – it will take a long time for them to complete these projects and restore confidence in the sector.
Economic data also suggests persistent weakness in the sector, with real estate investment and building starts still seeing significant negative YoY growth (11th consecutive month for the former) (Chart 5). Commercial real estate sales data also remains mixed, with sales by floor space falling -1.8% YoY as well. Given that authorities have already made multiple efforts to support the sector (e.g. its “three arrows” policy in Dec 2022), we think that such persistent weakness and continued defaults may be a sign of a more structural malaise within the real estate sector.
Chart 5: Real estate indicators indicate a sluggish property sector despite a rebound
Consumption: Don’t expect revenge spending to carry economic growth
As we highlighted in our previous article on the Hang Seng Tech Index, we believe that investors should not solely rely on Chinese consumption to carry growth this year. The much-anticipated revenge spending has failed to materialise substantially following the relaxation of zero-COVID measures last year, and household savings continue to increase, perhaps suggesting Chinese households are growing increasingly cautious and have a higher willingness to save (Chart 6). This is also reflected in consumer confidence, which has rebounded slightly, but remains significantly below pre-COVID levels (Chart 7).
In addition, China’s headline CPI remains muted and continues to trend downwards, suggesting a weak post-COVID consumer recovery. In fact, headline inflation figures have now come below or in line with estimates for nine months in a row (Chart 8).
Related article: Boom to Bust: A gloomy future for Chinese tech stocks
Chart 6: Chinese consumers continue to save more, rather than “revenge spend”
Chart 7: Chinese consumer confidence remains weak
Chart 8: Chinese inflation continues to trend downwards and surprise to the downside
Exports: A bright spot so far, but don’t expect this to last
We acknowledge that exports (approximately 20% of GDP) data has been a bright spot for China so far (+15% YoY [USD terms] in March), but caution this may not last.
Geographically, exports were mainly carried by ASEAN (+35%). However, we see cracks appearing in other markets: exports to North America declined by -8%, while the “resilient” growth in exports to Europe (+14%) was mainly carried by Russia (Europe-ex-Russia: +5%). From a geographical level, exports show that growing macro headwinds and geopolitical tensions are already starting to take effect for key export markets (Chart 9).
Cracks in China’s exports can also be seen from the “new export orders” sub-index in official NBS PMI data (April: 47.6). This index, which tracks foreign demand for goods produced by China, has slipped back into contractionary territory, and we think it is only a matter of time before headline exports figures (a lagging indicator) catch up with this reality.
Related article: A painful and perilous economic recovery awaits China. Buyers beware.
Chart 9: Exports to North America and Europe are already slowing down
3. Policy support will be gradual and measured
We believe policy should remain mildly accommodative but measured, with authorities focused on prioritising state goals over economic growth.
On the monetary front, we do not foresee any big moves from policymakers anytime this year. While credit creation has increased recently to support growth, as shown by the uptick in credit impulse, overall levels remain somewhat depressed (Chart 10). We think policymakers will keep to their intention of not flooding Chinese markets with excessive liquidity (“flood irrigation”) as they have reiterated multiple times in recent years. Without a meaningful pickup in credit growth, a strong China recovery may be hard to achieve.
On the fiscal front, we expect policy to remain mildly accommodative. On a broad level, the NPC is targeting a slightly larger budget deficit (3%) compared to the previous year (2.8%), implying only a mild increase in fiscal ammunition. More importantly, local governments continue to face debt repayment issues – this is important because local governments account for an outsized proportion of overall fiscal spending (2018 IMF paper estimate: 85%).
Fitch has recently labelled 10 provincial-level regions as more susceptible to refinancing pressures (Feb 2023), while Guizhou has also recently asked Beijing for debt assistance. With land sales revenue (a large funding source for local governments) remaining sluggish due to a weak property sector (Chart 11), and state goals shifting towards prioritising a reduction in debt burdens, we think that fiscal constraints on a local level would greatly limit the amount of fiscal stimulus by China this year.
Chart 10: Even after the recent bounce, China's credit impulse remains somewhat depressed when viewed across history
Chart 11: Land sales revenue – a key funding source for local governments – remains sluggish
4. Long-term structural issues likely to persist
Apart from near to medium-term macro concerns, we reiterate that longer-term structural issues will likely linger in the backdrop.
As alluded to in the previous section, authorities appear to be pushing China towards a more top-down state-controlled economic growth model, marking a sharp divergence from the market-friendly policies in the previous decades that propelled China to its unprecedented growth. An example would be the government’s acquisitions of “golden shares” in Alibaba and Tencent this year, as well as in Weibo previously. As state goals take increasing precedence over profitability, we believe long-term economic growth may be compromised.
We are also concerned about the potential geopolitical impact on China’s growth potential, especially with its increasing assertiveness on the global stage. We believe there are direct and indirect implications as a result. A direct implication would be increasing vulnerability to retaliation. An example would be the high-end chips sanctions implemented by the US and its allies, which threaten to impair the development of advanced technologies requiring these high-end chips. A more indirect implication would be the hastening of reshoring and nearshoring of manufacturing operations away from China, as companies seek to diversify their exposures to reduce geopolitical risks.
Markets and consensus estimates appear to be overly optimistic
We believe that Chinese equities could be weighed down by the macro and structural concerns highlighted above, and markets are currently pricing in an overly optimistic scenario. Consensus estimates indicate forecasts of strong double-digit earnings growth from FY23 to FY25, which we believe is not in line with economic fundamentals.
We see room for downward earnings revisions. This is in line with analysts’ tendency to be optimistic on China equities’ EPS which often leads to downward revisions across the year (averaging -6%) (Chart 12). We forecast single-digit earnings growth for Chinese equities in the years ahead, especially if macro and structural headwinds start to materialise.
Chart 12: Chinese equities have historically seen negative revisions to consensus estimates throughout the year
Recommend underweighting Chinese equities – look for more attractive opportunities elsewhere
To summarise, we recommend investors trim their exposure to Chinese equities and underweight the region, especially as we believe markets and many investors remain overly optimistic on Chinese equities at the moment. Using our fair P/E ratio of 10X, we estimate a potential downside of -10% for the MSCI China Index by FY25 (Chart 13, Table 1).
For Chinese equities to mount a sustained comeback, we believe it will require more than a few months of positive economic surprises. Many of its issues are structural in nature, including (i) the push towards greater state control taking precedence over profitability; and (ii) geopolitical concerns weighing not only on exports but also on the long-term development of advanced technologies. As a whole, we would need to see a significant shift in policy direction back to lessened state control, as well as a significant reduction in geopolitical risks, before turning positive on Chinese equities.
Investors who still wish to invest in Chinese equities today should therefore consider aligning their portfolios with China’s priorities. We have a preference for A-shares within Chinese equities, which benefits from policy tailwinds, as they typically have a larger allocation to state-linked enterprises, companies in favoured industries, and state-linked enterprises.
For instance, the top holdings of the iShares Core MSCI China ETF (HKD - HKEX:2801) (USD - HKEX:9801) include many big-tech names which we believe are no longer in favour with authorities (compared to the previous decade). In contrast, funds with an A-share focus like the E Fund CSI 300 ETF (SSE:510310) and the Allianz China A Shares Fund typically include domestic champions like Kweichow Moutai (partially state-owned) and CATL (EV batteries – a state priority). As the state occupies a growing role in the economy, we believe the latter two funds would be better picks within the Chinese equity space compared to the former.
Chart 13: MSCI China Index Price Performance and EPS
Table 1: MSCI China Index Projections 2023 - 2024
| MSCI China Index (HKD) | FY22 | FY23 | FY24 | FY25 |
| PE Ratio (X) | 16.8 | 12.6 | 11.8 | 11.1 |
| Expected Earnings Growth YoY | -7% | 4% | 6% | 6% |
| Forward Earnings Per Share | 4.9 | 5.1 | 5.4 | 5.8 |
Projected
Fair Price (based on a fair PE Ratio of 10X) |
- | - | - | 57.6 |
| Potential Upside from Today (%) | - | - | - | -10% |
| Estimated Dividend Yield (%) | 2.4% | 2.5% | 2.7% | 3.1% |
| Source: Bloomberg Finance L.P., iFAST compilations, iFAST estimates. Data as of 02 May 2023. | ||||
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