Look beyond market noise to unlock China's growth
Market sentiment on China has become especially fragile of late amid fears over near-term growth. However, we see reasons to be positive and urge investors to think longer term and ignore market noise.
Hot topics among our investment teams include zero-Covid policy, US-China tensions, monetary and fiscal easing, the weak economic backdrop, a beleaguered property sector and regulatory oversight.
China's economy contracted 2.6% in the second quarter this year on the back of Covid-19 lockdowns and a real estate sector under severe liquidity stress due to continued government deleveraging.
Of course, these headwinds will likely trigger further monetary and fiscal policy easing, which will support China's economy. Chiefly we expect infrastructure spending and modest interest rate cuts.
In the absence of strong stimuli, we're anticipating a gradual turnaround. Our Research Institute is forecasting year-on-year GDP growth of about 3% in 2022 - below market consensus of close to 4%.
We see authorities have levers to stabilise the property sector, and growing policy support reaffirms Beijing's commitment. Reportedly they're considering a rescue fund to deliver unfinished residential projects. While it may be insufficient to shore up buyers' confidence, it's a step in the right direction.
Further, we expect policymakers to dilute or discard their zero-Covid strategy over time, most likely after the Party's 20th National Congress this year. So we see lockdown effects on growth dissipating.
Similarly we see regulatory pressures easing. At a recent Politburo meeting we noted support for expanding China's universe of digital platforms and standardising supervision. Stable regulation will help to improve investor confidence and could drive multiple re-ratings for e-commerce companies.
Clearly, geopolitical risk is hard to predict and we expect heightened US-China tensions to last for some time. But we view such tensions as periodic and part of an evolving geopolitical landscape.
Our base case is that Beijing will not engage in direct military conflict with Taiwan in the near term. We think cooler heads will prevail in recognition of the heavy cost to economies and global stability.
We believe imposing sanctions on Taiwan would be contrary to Beijing's own economic interests, while more military drills around the Taiwan Strait risk disrupting global supply chains and logistics.
So what might investors expect? Here we outline our investment teams' China views.
It's early for China's economy to show strong signs of recovery on the back of easing measures. So we expect equity markets to remain rangebound in the near term. But we're constructive on the outlook as stimulus measures start to work their way through the system in the second half of 2022.
"We're constructive on the outlook as stimulus measures start to work their way through the system in the second half."
Companies have started reporting their first-half results, with investors now more focused on analysing fundamentals to understand their underlying strengths and weaknesses. Given our focus on high-quality stocks, we're optimistic about the earnings resilience of our holdings.
Valuations also look attractive. The MSCI China A Onshore Index's 12-month forward price-earnings ratio is 11.6x - comfortably below 15.4x for MSCI World and against a five-year average of 12.6x.1
China aims to reduce real estate's contribution to GDP growth due to the sector's high leverage. We have positioned our equity portfolios around the following five themes that we think will enjoy state support and are deemed critical to give China a competitive edge in its economic rivalry with the US:
Aspiration: rising affluence leading to fast growth in premium consumption;
Fixed income team
With inflation not an issue, we expect stronger fiscal policy-easing this year and further rate cuts over the next 12 months. However, we suspect growth in infrastructure investment might disappoint after a strong first half.
Momentum in the property sector is too weak for it to recover this year. Property sales have fallen sharply and will likely stay low amid impaired consumer confidence. However, we think state-owned enterprises (SOEs) in the sector with continued access to funding are well-placed to outperform.
Additionally, with the rollout of more co-ordinated government support, we see potential for stabilisation among large, well-established privately owned enterprise (POE) developers.
More generally, Chinese SOEs have enjoyed healthy demand in recent months and we expect them to retain strong government support, although we remain cautious about valuations. We think onshore SOE spreads will remain tight in coming months.
We have been trimming core SOE positions over rich valuations relative to Asian and global peers. For the same reason we underweight Chinese financials in the offshore market, especially big banks.
We also see supportive liquidity conditions for Local Government Financing Vehicles (LGFVs) in the near term, albeit amid growing concerns about the ability of local governments to support them.
Offshore China portfolio positioning:
Onshore China bond positioning:
The world is a highly unusual place today, with this economic cycle different for three reasons: policymakers are seeking to avoid stimulating the economy via the property sector; strict Covid containment measures continue to dampen consumption; and major central banks are tightening policy aggressively to fight inflation, leading to slower global growth.
Whereas in China, where inflation is not an issue, economic growth is in the early stages of recovery after authorities started easing policy this year. Government bond yields are near historic lows, so not outright cheap. But equity risk premia and offshore credit spreads remain attractive.
As a result, although Chinese growth is likely to see sequential improvement in the second half of this year, the strength of the recovery will be weaker than in previous cycles. Monetary policy is likely to remain loose, with credit growth driven more by government than the property sector.
As policymakers seek to balance short-term growth with long-term structural reform goals, we remain long China onshore equity and China duration; cautious on China credit; and we recommend hedging currency risk when investing in China.
In a normal cycle, an early recovery phase is the time to invest in Chinese equity. However, in this cycle we think the recovery will be highly uneven and asset allocators need to pay close attention to potential tail-risk from Covid lockdowns and the property sector. Active stock selection is key.
In a normal cycle, as growth recovery takes hold, the bulk of government bond outperformance should be behind us. However, in this cycle the weak recovery suggests China's central bank is likely to keep liquidity conditions loose, meaning bond yields will remain lower for longer.
In a normal cycle, credit should rally with equities. However, in this cycle we are not confident that policymakers will backstop troubled property developers, which means high-yield credit will remain distressed. Of course, that does not preclude interesting opportunities in investment grade credit.
For currencies, we think CNY can stay resilient on a trade-weighted basis, but weakening external demand and a hawkish US Federal Reserve will put downward pressure on CNY against USD. For global investors, hedging CNY risk is not a bad idea as hedging costs are at their lowest for five years.
Author: Nicholas Yeo, Head Of China Equities;
Funds operated by this manager:
Aberdeen Standard Actively Hedged International Equities Fund, Aberdeen Standard Asian Opportunities Fund, Aberdeen Standard Australian Small Companies Fund, Aberdeen Standard Emerging Opportunities Fund, Aberdeen Standard Ex-20 Australian Equities Fund (Class A), Aberdeen Standard Focused Sustainable Australian Equity Fund, Aberdeen Standard Fully Hedged International Equities Fund, Aberdeen Standard Global Absolute Return Strategies Fund, Aberdeen Standard Global Corporate Bond Fund, Aberdeen Standard International Equity Fund , Aberdeen Standard Life Absolute Return Global Bond Strategies Fund, Aberdeen Standard Multi Asset Real Return Fund, Aberdeen Standard Multi-Asset Income Fund
1 Bloomberg, 26 August 2022