Part 1 of 3. The Tactical Case for China
With 2022 coming to an end, global equity investors will be happy to bid farewell to what has been one of the most challenging years in the past two decades. The global repricing of risk assets as a result of tighter monetary policies emanating from most major central banks has not spared any equity market, but few have done worse than China’s stock market (Figure 1). The country has been hit by a trifecta of poor economic policy decisions, a large dose of political uncertainty, and the gradual deleveraging of an overextended housing market, which by some accounts is responsible for a third of the country’s economic activity. To make matters worse, the relentless pursuit by the government of its draconian zero-Covid policy that has shut down entire cities and regions for months at a time, has caused a huge decline in consumer confidence, a sharp rise in unemployment, and in general cast a spell of national malaise among its citizens that they had not felt in recent memory.
On a USD basis the CSI 300 Index, a benchmark of China’s largest companies listed in Shanghai and Shenzhen, is down 28% in the last year (and 29% year-to-date through Nov. 18th), while the MSCI China Index, which along with domestic listings also includes companies domiciled in China but listed offshore in Hong Kong and the U.S., has lost 35% in the last 52-weeks (and 29% year-to-date). Despite all the above (or, actually, because of the pessimism caused by it), it might be time for global investors to reconsider allocating funds to China, especially given that its correlation to global stock markets has been declining in recent years, making it an attractive diversifier in equity portfolios (Figure 2). Below we present the tactical reasons why we think it’s time to build a position in Chinese equities as we head into the New Year, and especially as we look ahead to a renewed economic environment in China in the spring.
Figure 1. Performance Summary, MG New China ESG vs. Select Benchmarks
|Annualized Total Returns (USD)||MG New China ESG||CSI 300||MSCI China||S&P 500||MSCI World ex-US||MSCI EAFE||MSCI EM|
|Drawdown From Peak||-44.6%||-40.5%||-58.2%||-17.7%||-21.8%||-22.9%||-35.6%|
Inception date of MG New China ESG Index was Dec. 31, 2007. YTD figures are through October 31, 2022. All figures are based on USD total returns. Sources: MarketGrader, FactSet.
Figure 2. Rolling Correlations Between MG New China ESG Index and Select Benchmarks
Sources: MarketGrader, FactSet.
Monetary Policy Support
The major reason behind this year’s repricing in risk assets has been the rapid rise in interest rates, particularly in the United States, in response to price inflation not seen in 40 years. This has not only affected all asset classes globally, but it has also lent significant strength to the US dollar, prompting an exodus to US assets, which has been punishing to global equities. As major central banks across the world play catch-up to the Federal Reserve, the single biggest exception among major economies is China, where financial conditions continue to ease. And while it’s unlikely that the country will return to the debt-fueled stimulus playbook of the past, the country’s modest inflation (see Figure 3) has allowed the PBoC (People’s Bank of China) to lower its Reserve Requirement Ratio 125 bps in the last year, as illustrated in Figure 4. Thus, it is likely that China will be the only major global economy easing financial conditions in 2023, providing the sort of stimulus not available to other large economies in the short-term.
Figure 3. Current and Projected Consumer Price Index for Select Countries, 2022 & 2023
Figure 4. China’s Reserve Requirement Ratio, 2012-2022 (PBoC)
Sources: Trading Economics, People’s Bank of China
While easier monetary conditions are likely to stimulate China’s economy in 2023, no single policy will have a greater positive effect on the country’s growth than the gradual recalibration of the government’s zero-Covid policy and the ensuing reopening of the economy. China’s consumption has cratered in 2022 because of the government’s draconian lock-down policies, with consumer confidence reaching all-time lows (Figure 5). Following a remarkable recovery in the second half of 2020 when it appeared the country had successfully navigated the worst of the pandemic, retail sales of consumer goods went on to post record year-over-year growth numbers in 2021. This proved to be a false dawn for consumers and investors, as the government started to gradually shut down entire cities in late 2021 and throughout 2022, decimating the country’s consumer economy. Retail sales of consumer goods fell more than 11% in March of this year compared to the year-earlier period, and are still in negative territory, as seen in Figure 6. With only consumer staples categories in positive territory as of October (Grain, Oil & Food up 8.3% and Beverages up 4.1%), it’s clear the Chinese consumer is holding back from most forms of discretionary spending (Household Appliances sales are down 14% and Clothing sales are down 7.5%). This suggests a snapback is likely to be significant, giving the country’s GDP a much-needed boost.
Figure 5. China’s Consumer Confidence Index, Sep. 2002 – Sep. 2022
Source: Federal Reserve Bank of St. Louis, Consumer Opinion Surveys: Confidence Indicators: Composite Indicators: OECD Indicator for China.
Figure 6. China’s Retail Sales, Nov. 2017 – Oct. 2022
Source: National Bureau of Statistics of China
Household Savings at Record Levels
One of the factors that make us most bullish on Chinese equities in the near term is the record level of household savings stashed in the country’s banks. While Chinese are renown savers, with estimates putting household savings as a percentage of gross national product around 40%, much of this money has in the past often remained in the banking system as savings accounts or has ended up as investments in real estate, which Chinese have always viewed as a safe store of value and source of steady investment returns. This time may be different for a few reasons. First, housing has lost its luster as the country’s store of value following the sector’s implosion, which began as far back as 2020, when the government began its real estate deleveraging campaign, as we wrote last year. The collapse of some of the country’s largest real estate developers left Chinese citizens shaken amid concerns that many could lose their deposits on housing units that are yet to be built. And while it’s very unlikely the government will allow this to happen, what is clear is that the days of easy credit to the sector and of Chinese savers using the sector as their retirement plan are largely over. This leaves hundreds of millions of savers with few options to generate decent returns as they build a retirement nest egg outside of the country’s capital markets. We have written before about how pension reform might finally lead to a large migration of household savings into the stock market. In the most immediate future however, we do expect some of these excess savings to find their way into the country’s stock market, which is still 95% owned by Chinese nationals.
A more immediate effect of the glut in savings in China will likely be a burst of consumer spending once the country fully reopens; or at least once the government provides better guidance about a hybrid approach by which, like the rest of the world, China will learn to co-exist with Covid. According to Evercore ISI, a reopening could unleash 5.4 trillion yuan ($760 billion) in year-to-date extra household savings, supporting discretionary spending and direct investments in the stock market. Figure 7 illustrates the pace at which the growth rate in savings deposits has clearly outpaced the growth in the money supply since the outset of the pandemic.
Figure 7. Savings Deposits Relative to Money Supply, China Sep. 2012 – Sep. 2022
Source: People’s Bank of China
Covid Policy Clarity on the Horizon
While much attention was given to the consolidation of President Xi Jinping’s power atop the Chinese Communist Party following the Party Congress in October, what matters most for investors in the near term is the government’s ability to focus once again on running the country. In this respect, no matter has been more pressing than moving past the damaging zero-Covid policy pursued by President Xi to date. It is therefore not surprising that having consolidated power at the conclusion of the Party Congress, the government immediately published a list of 20 specific measures designed to gradually move the country past zero-Covid and towards a more sensible and tolerable mitigation policy. While the “optimization” measures resealed by the government were filled with the usual official platitudes and boilerplate statements about “putting people and their lives above everything else,” what is clear is that the government has laid the foundation towards a policy of co-existence with the virus that will mitigate the crushing impact the current policy has had on the economy. Some of the highlights of the announcement include the following:
- The move was made to … minimize the impact of the epidemic on economic and social development.
- The new measures include cutting the COVID-19 quarantine period for close contacts and inbound travelers …
- Secondary close contacts will no longer be identified …
- Those who had visited the high-risk areas will be subject to a seven-day home quarantine instead of seven days of centralized isolation as previously required.
- Those who had offered services at high-risk posts in areas under closed-loop management will undergo five days of health monitoring at home, instead of seven days of centralized isolation or seven days of home quarantine.
- The circular required more efforts in enhancing medical resources and accelerating the reserve of drugs related to COVID-19 treatment.
- Vaccination against COVID-19 should be advanced in an orderly manner, it said, adding that the coverage of booster vaccination should be stepped up, especially for the elderly.
- The document urged redoubling efforts to rectify one-size-fits-all approach and excessive policy steps, and to strengthen services to ensure those in quarantine have minimal interruptions to their lives.
The point about vaccination for the elderly is striking, considering it comes a year after effective mRNA vaccines were rolled out globally, which proved to be the turning point in allowing most countries to implement co-existence guidelines in their own Covid fights. Notably, China’s domestic vaccines have proven to be much less effective than Western versions. Additionally, its has been widely reported that the country does not have enough ICU beds to deal with outbreaks comparable to what the U.S. and Europe experienced, while almost 60 million Chinese over the age of 60 are still in need of booster shots. The recent agreement between the Chinese government and BioNTech of Germany will most likely be followed by other similar arrangements that will allow Western vaccines and therapeutics to be either imported or manufactured in China for domestic consumption. This will go a long way towards further “optimization” of the country’s Covid policies, clearing the path for a full reopening of the economy. This full reopening will most likely occur in the spring, when the worst of the winter season is in the rearview mirror, and when it does, we do expect a significant uptick in consumer spending.
These tactical reasons when combined with longer-term factors such as a partial decoupling of China from the rest of the world and the reshoring of supply chains that we’ll discuss in part 2 of this series, warrants a serious consideration of Chinese equities. In addition, we believe that a normalization of China’s economic activity is likely to benefit China’s new economy sectors more than traditional old economy sectors tied to fixed asset investment, manufacturing, and exports.
 Top of the Market’s Mind: Listed in America, Sold to China. Evercore ISI, Nov. 20, 2022.
 “China releases measures to optimize COVID-19 response.” The State Council, The People’s Republic of China.