While wearing masks and keeping your distance from your relatives was a major inconvenience for most of us while we waited for vaccines to be rolled out, this is nothing compared with the intensely draconian regulations that China adopted to keep its “zero-Covid” target intact. Being forcibly sealed in your apartment block, sent to a mandatory isolation centre or taking tests to enter the supermarket to buy a packet of noodles puts the UK’s haphazardly enforced regime into perspective.
Whatever the public health merits of China’s approach – and many of these are also debatable – zero Covid has had a major dampening effect on the Chinese economy, as disruption has continued long after other countries have normalised their day-to-day lives. Policymakers in China are left with unpalatable decisions: open up now and risk waves of Covid patients overwhelming the healthcare system, or maintain the status quo in the face of rising anger and economic damage. The events of early December suggest the leadership has moved decisively in favour of the former, having started to ease restrictions shortly after the wave of protests seen last month. We will know the definitive answer to this conundrum soon enough, but stock market investors in China are already starting to bet that the Chinese leadership will have no option but to open society further next year.
Even prior to that, it is certainly true that the attrition in the Chinese stock market indices, in both Shanghai and Hong Kong, had left investors wondering whether a value punt on China is now the smart move, given that the price/earnings ratio of the Shanghai Composite (SSE) is at an all-time low of just 12 – at least one standard deviation below the long-term average. After the likes of Goldman Sachs and JPMorgan both recently pointed towards value in Chinese equities, the Shanghai Composite Index has performed well, gaining 11 per cent in little over a month and recovering from its year lows. However, the fact remains that, aside from the difficulties surrounding zero Covid, an awful lot needs to go right next year for the market’s faith to be rewarded.
Economic turnaround?
There is some evidence that China has started to deal with the fallout from the collapse in the property sector. Infrastructure spending seemingly stayed buoyant during 2022, which should give the economy some leeway while the property sector’s dodgy loans are cleared up. This is mainly why analysts have been marking up China’s economic growth forecasts. For example, analysts at Schroders, which has a specialist Asia and emerging markets team, upped previous forecasts for GDP growth from 3 per cent to 5 per cent, though 5 per cent in Chinese terms still represents an underperforming economy. Even Schroders qualifies its analysis by saying that while the economy should stage a cyclical recovery next year, the driving force of the country’s performance will be political, rather than simply economic.
But there will also be outside factors that can help both China and its stock market. Firstly, if US interest rates peak next year, a weakening dollar will begin to help liquidity in emerging markets. Chinese equities, along with every other non-dollar denominated indices, have suffered from the outflow of funds finding their way into dollar accounts as interest rates have risen. Therefore, a reversal will bring an immediate technical boost for Chinese stocks.
The other point to consider is whether China can effectively export its way back to prominence as its covid controls are relaxed and workers get back to the factories. This is likely to be more difficult than 20 years ago because of a fundamental change in how people view unfettered trade, or more specifically the length and resilience of supply chains. The point was brought into focus by the pandemic, and the war in Ukraine now has many countries reassessing whether their reliance on specific companies and countries for key components like microprocessors is necessarily a good thing. The US is proactively pursuing a policy for bringing home key production for microchips, while investing heavily in research & development.
At the same time, the US has also restricted access to sensitive technology, such as developments in the AI space, that could be transferred to or used by China. While not formalised into anything as official as a boycott, the possibility that China will struggle to export goods in the volumes it desires next year because of changing attitudes towards its political ambitions is still one possible outcome. The reality is that the principle of unfettered free trade is under sustained pressure.
Where to look for value
Investors have the option of simply buying a tracker fund and following an index like the MSCI China, effectively waiting to see whether they can benefit from the profits that a cyclical economic recovery should bring. If stock pickers want to try their luck with active funds or even individual Chinese companies, then Schroders has a few useful guidelines for 2023.
In short, sectors that will benefit from onshoring into China include IT and green energy, while Schroders reckons that construction machinery and materials will benefit from buoyant infrastructure spending. In addition, lower valuations for healthcare companies have also brought that sector onto the value radar. The asset manager even thinks that the notoriously frothy ecommerce sector has traded down to levels that have eliminated its premium. Next year, the asset manager predicts the sector will trade more like consumer cyclicals – ie in line with its potential for earnings growth, rather than anything beyond that.
For a number of reasons, then, 2023 is going to be a key year for China, one which is likely to determine a whole range of key economic, geopolitical and investment questions. If nothing else, times will certainly be interesting, which or may not be a Chinese curse.
