On January 22nd, China waved goodbye to the tiger and moved into the Year of the Rabbit. According to Chinese tradition, the year of the rabbit is “likely to be calm and gentle”, raising hopes among investors for a strong recovery in 2023, following a volatile year in 2022.
During the majority of last year, China saw weak performance of its stock market due to several events: widespread COVID lockdowns, regulatory concerns, escalated tensions with the US over Taiwan and ongoing property sector woes.
However, Chinese equities have been the star performer of late and are now up over 50% from their low in late October. This has been on the back of the dramatic and unexpectedly rapid U-turn on the government’s zero-Covid policy in December. As well as this significant development, the less aggressive approach by the Chinese authorities both to market regulation and to the West has boosted sentiment. Although they have faced a current surge in infections due to their COVID policy change, the latest data (if you believe it) showed the Chinese economy to be holding up better than first feared.
So, what does our current portfolio allocation to China look like and where do we see further opportunities, or risks, appearing for for investors?
Xi Jinping
Xi Jinping, the current Chinese president, was given a third and record-breaking presidential term during the communist party congress. Between 1982 and 2018, the constitution stipulated that the president could not serve more than two consecutive terms. However, in 2018, he scrapped the presidential two-term limit, allowing himself to rule indefinitely. Some now expect the 69-year-old leader to try to stay in power for life or until the decision is taken out of his hands.
Whilst some things may change with the election of Xi for a third term, some things will probably remain the same. China is still the second-largest economy in the world, after the US, when measured by nominal GDP. Due to rising incomes and steady wealth creation, living standards in China have improved for a significant portion of the population. Moving beyond the basic necessities, people are willing to pay more and upgrade to premium goods and services. This leads to strong growth and higher revenues for Chinese consumer companies and the broader economy. However, Xi is aware that the Chinese population expects things to continue to improve, and he needs to deliver on economic growth. We saw over the covid zero policy that if enough people are desperate enough and stand up to government forces, even in China, the people will have their say and can influence government policy.
There was an initial equity sell-off following Xi’s pending re-election announcement back in October. However, the immediate sell-off in Chinese and Hong Kong stocks seemed to us to be a disappointment in the lack of specific news, at the time, about the ending of the zero-COVID policies, a lack of conciliatory tones over Taiwan, and an emphasis on Xi’s ‘common prosperity’ policy. This policy has largely negative connotations for markets seen as it does to increase the risks of the Chinese pseudo-capitalist economic model.
The immediate market reaction was all speculation surrounding future policies. Ironically the fact that Xi has manoeuvred himself into such a strong position with little to no pushback expected from any of his handpicked group of loyalists to any of his policies, he will have the ability to get things done. This might not be good news for anybody who doesn’t toe the Xi party line, but his policies, for better or worse, will be enacted swiftly and decisively.
Ending COVID Lockdowns
Xi often makes market movement announcements unexpectedly, leaving investors like surfers waiting to catch a wave. An example of this came on December 7th, when China announced it was lifting its most severe COVID policies following the landmark protests. If they have mild or no symptoms, Chinese citizens with COVID can now isolate at home rather than in state facilities. They also no longer need to show tests for most venues and can travel more freely inside the country.
The most significant benefit for the Chinese people is not the economic impact but rather the ability to lead a more normal life. Almost every sector of the Chinese economy will benefit from the end of the harshest lockdown regime experience in any country during the pandemic.
An unknown quantity for the global economy is the inflationary impact of a fully reopened China and what that will do to commodity and energy prices. We think the inflationary pulse will be sustained and of a greater magnitude than the consensus, which is one reason we remain bullish on both the commodity and, more specifically, the energy sectors. From an investment point of view, we haven’t heard anything that changes China’s investment thesis in the medium to longer term.
Specific Sector Winners and Losers
Chinese companies have invested in research and development (R&D) to move up the value chain. Improved technological capabilities will inevitably lead to better quality products and more efficient processes, which generally means higher profits.
Almost simultaneously with the 20th communist party conference, the US announced far-reaching new restrictions on selling semiconductor technology to China. Whilst this is a headwind of uncertain consequences for China in the short term, it will push them towards accelerating technological independence, a goal many countries aim for after the supply chain lessons of the pandemic era.
While we are not qualified to talk about which companies will be affected by the new US rules, what is certain is that there will be new winners and losers in areas such as semiconductors and the plethora of companies which depend on them. This is potentially one of the areas where active managers can add or destroy alpha as they work out who the winners and losers might be.
Compared to global peers, industry-leading companies are smaller in size. Additionally, many Chinese companies are becoming more competitive in the overseas market and are gaining market share. This suggests that Chinese companies have the potential to become more prominent over time.
People’s Bank of China (PBoC)
The PBoC is cutting interest rates, as opposed to the developed world, raising them because China is in a different part of the economic cycle. In broad terms raising interest rates is bad for risk assets and cutting rates is supportive of them.
Just last week, China’s central bank pumped a record amount of short-term cash into the banking system as demand rose following the removal of the COVID restrictions and ahead of the Lunar New Year holidays.
The People’s Bank of China added a net 1.97 trillion yuan ($291 billion) of cash via open market operations, a record high, according to data compiled by Bloomberg. That’s more than nine times the size of the previous week’s injection.
Non-correlated assets have become increasingly hard to find as most global central bank policies have driven bond and equity performance in the same direction, as unprecedently seen in 2022. However, China has low correlations to other global equities, meaning Chinese equities often move either in a different direction from other global equities or with a China-specific level of magnitude.
A Degree of Risk
As ever, there are areas for concern or reasons to be cautious. We remain mindful of several risks to our positive thesis on China’s assets but would note that all investment comes with a degree of risk.
There has been news that China recently saw its population decline for the first time in sixty years. This highlighted the significant demographic challenges it faces over coming decades from an ageing and shrinking population following the one-child policy, which was in place for some 35 years.
It substantially reduces China’s potential growth rate, but this is a concern for the longer term. Over the coming year, at least, Chinese equities are well placed to continue to outperform many of their global peers. They remain inexpensive relative to countries such as the US, and growth should rebound as the economy reopens, unlike Western economies, which will do well to avoid a recession.
In the case of China, we think the three primary and immediate risks are:
- The leaders, in whatever guise, fail to back up their more market-positive rhetoric with hard policy support.
- The situation with Taiwan escalates and affects China’s and other nations’ trading policies. For example, over $ 3 trillion of trade is estimated to pass through the Taiwan Straits each year. Although a blockade or worse would harm international trade, it would also considerably impact China’s economy.
- COVID cases soar to the extent that the government decide to reverse their decision on their lockdown policy and reimplement draconian measures.
So, in summary, we believe an allocation to China is prudent from a diversified portfolio perspective and a pure investment opportunity. We are aware of the risks as we see them, but we must also be mindful of the opportunities.
It is important to highlight that whilst we have increased our use of explicit China funds, the country still only makes up 6.06% of our Core MPS portfolio 4 (18/01/2023). To put this into perspective, our current North American holdings in the same portfolio are 15.19% (30/01/2023).
This communication is designed for informational purposes only and is not intended as investment advice. These investments are not suitable for everyone, and you should obtain expert advice from a professional financial adviser. Please note that the content is based on the author’s opinion at the time of writing/publish date. Our views and opinions regarding certain investment themes and topics can alter over time as the macroeconomic background changes and other industry news is made publicly available, this is not intended as investment advice.
Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise, and investors may get back less than they invested.
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IAM 40.1.23
