China: Heavily discounted, significant pessimism

While investors should not rule out further volatility and downside, the knee-jerk sell-off in Hong Kong and China equities likely reflects excessive pessimism

HONG Kong and China equity markets have been severely punished after the 20th Party Congress. The Hang Seng Index last Monday (Oct 24) fell by over 6 per cent - the sharpest single-day plunge since the Global Financial Crisis.

We see three reasons for the sharp market reaction after the Party Congress.

First, China's newly announced leadership team signals a high degree of power consolidation by President Xi Jinping, which set off concerns over reduced checks and balances and the risk of policy mistakes evolving into major shocks. Li Qiang, who is seen as a close Xi ally and oversaw a controversial prolonged shutdown in Shanghai this year, is now positioned to be named as Premier.

Second, although President Xi signalled that economic development remains a top priority, his added emphasis on national security and "common prosperity" exacerbated investor concerns over US-China tensions and Taiwan issues. There are concerns that a more socialist-leaning agenda could negatively impact the long-term development and growth of China's private enterprises and free markets.

Third, investors are disappointed by the lack of positive signals during the Party Congress on the zero-Covid policy or support for the ailing property sector. China's zero-Covid policy has been a straitjacket on the Chinese economy and is widely viewed to have gone on for longer than necessary.

We believe that investors should be cognizant of these risks, which deserve to be closely monitored, and that further volatility and downside should not be ruled out. That said, our judgement is that the knee-jerk sell-off in Hong Kong and China equities last week likely reflects excessive pessimism.

Why do we think so?

In view of the significant challenges and risks for China, having a highly unified group of policymakers at this juncture would also lead to more effective policy execution and coordination. In addition, Xi's allies on the Politburo - Li Qiang, Cai Qi, Li Xi - have largely pro-growth track records overseeing China's wealthiest economic hubs, such as Zhejiang, Shanghai, Guangdong and Beijing.

Despite President Xi's theme of "common prosperity" - which attempts to address a growing wealth gap and resulting social issues - there is broad policy consistency in China's "Development First" doctrine, which emphasises economic development. Part of this agenda is to ensure the orderly growth of private enterprises and markets. This - and not so much an ideological pivot towards socialist ideals - is the primary motive behind the regulatory actions in recent years across various sectors, including technology. And in this regard, China's policymakers have signalled earlier this year that its regulatory clampdown on the Chinese tech giants is in its final stages. We view this as credible.

The conclusion of the 20th Party Congress, which primarily focuses on leadership transition issues, will free up policymakers to move on to other priorities and address the significant economic challenges in place. We should expect more details on China's pro-growth policies at the Central Economic Work Conference in December.

Importantly, a key driver of Chinese markets over the next 12 months will be developments related to the zero-Covid policy. With Covid curbs in place, consumption and business confidence are being negatively impacted, and this has reduced the efficacy of policy stimulus thus far to prop up growth. This is particularly onerous given that the property sector, a major pillar of growth in the past, is going through a prolonged period of consolidation. A relaxation of the zero-Covid policy would result in significant economic tailwinds and a boost in investor confidence.

Given the various challenges facing China's economic outlook - including rising youth unemployment rates which are highly undesirable for the party - we expect policymakers to gradually evolve their absolute zero-Covid stance into a dynamic policy trending towards reopening in 2023. This is supported by the latest developments in Hong Kong, which tends to be a forward indicator of China's Covid stance.

In our asset allocation strategy, we remain overall underweight in global equities, primarily through our underweight position in Europe equities. We have a neutral position in Asia ex-Japan and Japanese equities. Within Asia, given the asymmetric risk-reward offered at current depressed price levels, we maintain a long-term constructive view on the Hong Kong and China equity markets. In particular, the Hang Seng Index has fallen to levels seen as far back as 1997, while Hong Kong's gross domestic product in constant US dollar terms has more than doubled over this period. The Hang Seng Index is now trading at a price-to-earnings multiple of 7.4 times, about three standard deviations below its five-year mean.

Within the Hong Kong and China equity markets, we expect investment themes aligned with policy priorities to outperform, including consumption, renewables, electric vehicles and industrial automation. We are selective in the technology space amid rising US-China tensions, which are likely to negatively impact names in the semiconductor sector and likely those related to artificial intelligence and quantum computing areas ahead.

The writer is head of investment strategy, Bank of Singapore.



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