China equities have surprised on the upside, but be nimble and agile

AS THE world’s second-largest economy, second-largest bond market, and second-largest stock exchange by market capitalization, positive or negative shocks in China can ripple across the globe, influencing those closest to the epicentre first; but touching even distant markets and economies over time.

Right now, China is facing its most serious set of challenges in a generation. The collective economic damage wrought by its self-inflicted zero-COVID policy; accelerating disinvestment by international companies over rising wages and supply chain security; and a property sector crumbling under the weight of its own debt, have profoundly disrupted China’s long-term growth model and near-term economic outlook.

Paradoxically, it was the scale of the challenge and breadth of the risks facing the economy which encouraged us to go overweight China equities in mid-March. In our view, China was incapable of organically growing its way out of trouble. Rather, the only way to arrest the decline was through massive, policy-induced intervention in the form of fiscal stimulus and monetary easing. And so it has come to pass.

Remain overweight

I had previously written about the size, scale and likely efficacy of China’s stimulus initiative, but suffice to say, initial economic and financial market evidence for the second quarter of 2022 suggests the positive liquidity shock appears to be gaining traction.

Forward-looking macroeconomic indicators – including manufacturing and services Purchasing Managers Indices (PMIs) – have started to trend higher. Measures of mobility of goods and passengers, such as rail freight and traffic, and supplier delivery times (from the manufacturing PMI), show signs of an uptick; and the general mobility of the general population is improving. For example, passengers can now use the high-speed railway between Shanghai and Beijing without let or hinderance, somewhat undermining recent media reports of a renewed COVID-19 crackdown in both cities.

But I temper my optimism by noting that these macro improvements are somewhat illusory, given that these are coming from a (very) low base. Economic conditions in the first quarter of 2022 were so distressed and depressed that the slight bounce witnessed in the second quarter exaggerated the overall (sequential) effect. In truth, China’s recovery is thus far still muted, and any rebound has more to do with simple normalization as day-to-day economic activity gradually resumes.

From a markets’ perspective, however, I remain positive. The good news is not yet fully in the price, in my opinion. China’s economy will continue to grow in the second half of 2022, and earnings – commensurately – will positively respond; as will equity prices. But make no mistake, our overweight position is a tactical trade. We remain nimble and agile investors, seeking to anticipate and then lock in gains at the point when we believe China’s policy-induced upside has run its course.

Q2 review

The end of the second quarter, and the start of the second half of 2022 seem an appropriate time to review China’s markets in general, and the performance of its equity market in particular. Overall, I think it is reasonable to conclude that China’s equity markets have surprised to the upside, outperforming all major markets globally.

It would appear there has been at work among investors a TINA (There Is No Alternative) effect - that is, sharp corrections in developed markets caused by tightening monetary policy have encouraged capital flows back into China equities by foreign institutions seeking refuge from the volatility.

Evidence of the government’s stimulus effect and subsequent TINA mindset among investors can be observed in the performance data. For example, China has seen a sharp second quarter-bounce in price performance across its major benchmarks in both absolute and relative terms.

In particular, our preferred – and recommended – index and sector exposure has performed reasonably well. Since 31 March 2022, the MSCI China Index is up 2.8 per cent; the Hang Seng Tech Index 5.6 per cent; and our Sustainable China theme 9.5 per cent. This compares to declines in the S&P 500, Nasdaq, and MSCI Emerging Market Index of 14.8 per cent, 19.9 per cent and 13.0 per cent, respectively.

Where value lies

An insightful question often asked of me by investors relates to the sequencing and sector choice of our preferred China strategy. The answer is straightforward: We expect China’s tech names (particularly internet platform companies) to be among the first wave of beneficiaries of price appreciation; and subsequently, outperformance by our Sustainable China theme, which we feel should further benefit from infrastructure spending in renewables, smart cities, as well as technology promoting China’s carbon transition.

Let me explain. From 2020 until recently, it was not too much of an exaggeration to describe China’s tech sector has having been firmly in the crosshairs of regulators who sought to promote “common prosperity” at the expense of – what they considered – monopolistic pricing (and unregulated data gathering) by the so-called Tech Titans.

Between 17 February 2021 and 15 March 2022, the Hang Seng Tech Index declined by 68 per cent as policy intervention impacted performance. In March 2022, however, the intervention was “paused”, essentially signalling a resumption of tech fortunes; this has allowed sentiment to improve and prices to appreciate. To the extent that the Index is still 56 per cent from its highs, we still feel there is upside to this trade idea.

In particular, there is no longer a discount between the sector’s price-to-book multiple and its forward earnings, suggesting the market is no longer pricing any future cuts to earnings. And indeed, we are actually beginning to see earnings upgrades for China tech. Compare this to China’s (old economy) banking sector, where a price-to-book ratio of 0.5 times implies further cuts to earnings of 21 per cent, a (level of) discount last seen during the Asia crisis of 1998.

Our Sustainable China investment theme meanwhile offers a path to diversified exposure to the parts of China’s economy best linked to the government’s decarbonization goals. This investment theme is likely to benefit not only from the growth of China’s economy overall, but also from the global shift to new energy. We estimate that this investment theme materially outperformed the Chinese market in 2021, and has firmly benefitted in Q2 from the easing of lockdowns and the announcement of a fiscal stimulus plan with a strong sustainability focus, rising 9.5 per cent, though it is still down 8 per cent in the year to date. We expect the theme to continue to perform well over a multi-year timeframe.

The writer is chief investment officer, Asia-Pacific, Credit Suisse