Right now, the negative macroeconomic backdrop seems to be eclipsing fundamentals. But we wonder if and when the curtain might drop, putting corporate fundamentals in the spotlight.
Macroeconomic malaise and a gloomy growth outlook
Chinese equity markets have had a rocky start to the year and the mood on the macro side in China has been pretty bleak. The authorities’ 2022 GDP growth target of around 5.5% looks increasingly ambitious.
Growth faces headwinds from:
1. Zero Covid
Strict lockdowns in Shanghai have dashed hopes that a more targeted and light-touch implementation of “zero-Covid” policy could be sustained.
Given the high transmissibility of Omicron and the Chinese authorities reaffirmation of their Covid strategy, it’s difficult to rule out further disruptions to economic as the year goes on.
2. Regulatory pressures
Last year was characterized by severe regulatory ructions in China. And this process is still playing out, particularly across real estate. But on the upside, we don’t think that the impact from regulatory crackdowns will be as harsh in 2022 as they were in 2021.
The broader property sector, one area most severely impacted by the shifting regulatory perimeter, represents an estimated 30% of China’s national GDP. So, this sector is unambiguously important for the growth outlook. So the question is: Will China be able to put real estate on firmer ground?
There are still alarming figures to consider. For example, the value of buildings sold was down 26% year over year in March, and new starts are down 22%.1 However, year-over-year growth rates can mislead as well as illuminate. Considering the levels of activity relative to their seasonal norms shows an improvement in sales since October and points to a tentative stabilization in new construction.
Moreover, while a “big bang” stimulus is incompatible with de-risking real estate, we have seen a drip feed of smaller policy measures. This could suggest that the worst is behind us.
Markets have also had to digest:
1. Equity de-listing
While this isn’t as noteworthy as the two macroeconomic factors outlined above, this year, the US Securities and Exchange Commission (SEC) included five Chinese ADRs2 on a list of companies that it may de-list from the US. This contributed a significant market sell-off in March. We’re surprised that this triggered such a strong market reaction as de-listing pressures are not new.
The ADRs have already prepared by listing in Hong Kong in terms of secondary listing. And at the government level, China is still talking to the US about access to some of the audit papers for those companies in question, so they may be able to avoid de-listing. Hence, this may have amplified other jitters in markets, but is hard to motivate as a persistent headwind.
2. The war in Ukraine and China’s relationship with the West
In February, before Russia invaded Ukraine, China and Russia announced a “no-limits” partnership. This places additional strain on China’s relations with the West, calling into question China’s attempts to position itself as neutral.
Ultimately, it wouldn’t be a good economic choice to side strongly with Russia. Trade between the US/EU and China is 20 times the size of trade between China and Russia. Russia’s whole economy is the same size as the economy of just the Guangdong province in China.
Moreover, China is attempting to become the world’s largest economy, which we think could happen around 2033 — all the more reason for China not to put all of its eggs in Russia’s basket.
But long-term opportunities remain
In spite of the themes weighing on China, we’re still optimistic about Chinese equities as a long-term investment option. The market turbulence in Chinese equity markets so far this year appears to have come about based on sentiment — not fundamentals. This is, in our view, a good sign for Chinese equities in the long run.
The four factors we outlined above have caused market sell-offs throughout the past year or so. In November 2021 and March of this year, Covid lockdowns sparked sell-offs in the consumer discretionary sector, for example. There was a sell-off in the healthcare sector at another time in response to regulatory impositions in late 2021.
As a result, the quality factor has suffered. It’s worth remembering though, that while quality companies might not be the flavor of the week in China, these companies still present compelling longer-term opportunities. Fundamentals are paramount and the companies with strong fundamentals, whether they fall within the growth, value or quality factor, are the most likely to be able to stand up tall once the macro dust settles.
Not only are quality companies most likely to withstand market disruptions in the end, but they’re also relatively cheap in light of these macroeconomic events weighing on Chinese equity markets. The Chinese equity market is way below its historical average. On top of this, 2022 earnings-growth expectations the Chinese equity market are still very respectable at 14%.
Within Chinese equities, we think that there are five investment themes that may be well positioned for further growth:
1. Aspiration
We expect the Chinese consumer market to grow 400% to $30 trillion by 2050 (Chart 1). This could create huge demand for premium services and higher-end goods, both foreign and domestic.
Chart 1: Rapidly expanding premium consumer class
Source: aRI, January 2022
2. Digital
China needs to import about $280 billion worth of high-end semiconductors to meet demand. So it’s spending a lot of money to catch up in local production. So on-shoring of semiconductor manufacturing is a compelling opportunity.
There are also opportunities on the software side. Many sectors are digitizing, which is important to China’s goal of innovating. Companies that provide these digitized services could also represent potentially beneficial investments.
3. Green
4. Health
China is aging. The median age is about 37. It will probably go up to about 47 by 2045 or so. But the population isn’t just aging — it’s getting wealthier. Combining these two suggests that the demand for healthcare services could swell exponentially over time, so there’s a case to be made for potential long-term opportunity here.
5. Wealth
As mentioned, China’s population is getting wealthier overall. Many more people may be looking to protect their wealth for future generations. So there may be strong investment opportunities among private banks, for example.
As 2022 continues, we’re sure that China will keep making headlines. But in spite of recent equity market shakeups, we believe that there are fundamental-driven, thematic, long-term opportunities that investors ought not overlook.
1 Bloomberg, April 2022.
2 An ADR, or American depositary receipt, is a negotiable certificate issued by a US depositary bank representing a specified number of shares of a foreign company's stock. The ADR trades on US stock markets. They offer US investors a way to purchase stock in overseas companies that would not otherwise be available.
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IMPORTANT INFORMATION
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.
Investments in real estate are highly sensitive to economic conditions and developments, and characterized by intense competition and periodic overbuilding.