From COVID lockdowns to a property crisis, China’s economy suffered major shocks in 2022. But as the world’s most populous nation rapidly reopens its economy, we believe China will present attractive opportunities—particularly for investors who are prepared to understand its nuances.
The recent accelerated reopening following COVID lockdowns could provide a dramatic boost to the Chinese economy and risk assets this year, in our view. Stocks have bounced back to life, yet have only recovered a small amount of last year’s losses (Display). And according to consensus forecasts, Chinese corporate earnings are now expected to outpace both developed- and emerging-market peers in 2023.
Yet beyond the potential near-term catalysts, investing in China requires a strategic appreciation of the short-, medium- and long-term outlooks for the economy and how the policy framework operates across time horizons. With this perspective, we can better understand how the policy framework provides stability over time while allowing flexibility for social, economic and market-related adjustments.
It can also help identify investment trends. In equities, for example, we’re seeing a more balanced array of opportunities that includes not just the growth style that has dominated to date, but also a value approach focused on high-quality companies with attractive valuations.
The trend is likely, in our view, to be long term, but investors can access it now. Our research suggests that the best place to do so is in the domestically focused A-shares market, rather than the more internationally oriented and much smaller H-shares market. Value stocks in the A-shares market have recently outperformed growth stocks after several years of underperformance (Display).
To put this in context, let’s look first at China’s economic prospects.
Public-Private Tug of War: The Short-Term Economic Outlook
Challenges related to COVID and the housing sector could persist into 2023. For example, the ongoing surge in COVID cases is weighing on the short-term economic recovery. But looking ahead, we think a rapid peak in infections will support a sharp private consumption rebound, which could become a primary driver of the growth recovery. China’s households have indeed accumulated a significant amount of excess savings since the beginning of the COVID crisis, and those who have recovered from infection will be more willing to resume outdoor activities. This will benefit several retail activities, from shopping malls to restaurants to travel and duty-free shopping.
What’s more, we think supporting growth is still the government’s top priority. This was confirmed in the recent Central Economic Work Conference and has been underlined by the faster-than-expected shift to a reopening regime and further efforts to stabilize the housing sector—actions that should mitigate two major sources of downside risk.
Our baseline forecast for GDP growth in 2023 is 5.1%, helped by a favorable base effect and a shift in the growth mix. With the economy’s accelerated reopening, we expect private demand to improve sequentially, as household consumption gradually returns to pre-COVID trend levels, in contrast with the strong rebound seen in developed markets.
While government-driven investment growth should normalize from 2022’s high levels, we expect it to remain supportive until organic drivers become sufficiently robust to sustain overall growth. By contrast, export dividends, which have supported China’s economic growth over the last three years, have begun to fade. Exports will probably remain sluggish amid the global slowdown.
Given this picture, consumer inflation in China should remain benign (Display). Core CPI may trend higher due to China’s faster re-opening, but we don’t think it’s likely to rise to levels seen in developed markets, given the limits to any potential rebound in household consumption and minimal effects from supply chain bottlenecks. As a result, authorities should be able to continue with the stimulus policies.
Longer-Term Outlook: Xi Thought Shapes the Investment Landscape
Over the long term, of course, the ideology of President Xi—known as Xi Thought—is the overriding force behind China’s structural policy and outlook. This was underscored recently at the National Party Congress (NPC), during which Xi secured an unprecedented third term in office.
Xi’s secure position will help promote the kind of growth he aims to achieve, in our view. That means driving innovation, supporting manufacturing, lifting income per capita, reducing wealth inequality and pursuing further market reforms. The bottom line? While growth targets could become more flexible in coming years, sustainable long-term growth remains critical to China’s plan for a stable and more equitably wealthy society.
China’s trajectory is not unique: other Asian countries, such as South Korea and Taiwan, have followed similar paths in the last two decades. Growth slowed and their governments, in the interests of social justice, became more interventionist (though less so than China’s).
But it’s remained possible to invest successfully in those countries by carefully selecting stocks based on rigorous fundamental analysis. Similarly, the key to investing in China’s maturing economy, in our view, lies in both reading policy correctly and seeking out company-specific opportunities that are aligned with the policy direction.
Identifying Policy-Driven Opportunities
Policies with medium- and long-term horizons are particularly interesting for investors. At the NPC, the government reaffirmed further restrictions on property speculation, the pursuit of common prosperity and security.
While the investment implications of a crackdown on property speculation are self-evident, the pursuit of common prosperity raises the likelihood of inheritance and property taxes—and an increase in social safety net measures such as affordable housing and better social services.
Security, in the Chinese context, has external and internal dimensions. It refers to geopolitical risks (such as relationships with the US and its allies, and with Taiwan) as well as internal strategic security, through independence in energy and technology.
Heightened geopolitical risks are a significant concern for investors. Yet some external geopolitical risks have eased, for example, concerns about the delisting of ADRs while some internal strategic issues can have positive implications, in our view. We expect them to translate into increased investment in solar and wind energy generation and a continued focus on domestic semiconductor manufacturing.
China’s goal of carbon neutrality by 2060 is an important long-term policy direction. Alternative-energy enterprises and businesses in the electric-vehicle supply chain should be on investors’ radar, together with companies aligned to other policy areas.
How can investors turn these policy-driven opportunities into investments?
Focus on A-Shares, Policy-Aligned Sectors and Fundamentals
For equity investors, the best place to look, in our view, is the domestically focused A shares market. Compared to the internationally favored H shares market, it’s bigger (with more than 4,600 stocks compared to less than 300 for the H shares market) and less exposed to geopolitical risks. The A shares market also offers more companies poised to benefit from the domestic policy framework.
Consider the focus on sustainable growth, which involves regulatory support for state-owned enterprises (SOEs) and a redistribution of profits to consumers. This will make it harder to find high-growth opportunities in, for example, internet and biotechnology stocks. But sectors dominated by SOEs—such as financials, materials or traditional retail—will become more attractive.
As well as taking policy-driven opportunities into account, investors must consider the impact of lower long-term economic growth on Chinese companies’ profitability. When viewed through a value lens, investors can identify companies with more resilient profitability potential trading at attractive valuations. And sometimes, policy and company fundamentals can intersect in surprising ways that creates a sweet spot for contrarian investors.
For example, China’s 2021 regulatory tightening of private education triggered widespread declines in the sector. However, one SOE that had a monopoly on textbooks bucked the trend. Its sales of test-preparation materials soared, because students still needed to take exams.
The value approach can also work independently of policy considerations. An A share company best known as a maker of monosodium glutamate also had a share of the global market in xanthan gum, a thickening agent used in everything from salad dressing to oil drilling. As the global oil price rose sharply, so did its profits.
China Offers Opportunities and Diversification
China has become a slower-growth and more policy-directed economy. Investors who hanker for the old high-growth days might be disappointed, but such a glass-half-empty attitude, in our view, could mean that they miss out on what China has to offer.
Capturing the opportunities requires an appropriate mindset—one that sees less break-neck growth as offering the advantage of sustainability, and clearly articulated and judiciously applied policy as offering stability. It also requires an investment strategy that is alive to opportunities created by policy directives and discovered by rigorous fundamental research and careful stock selection.
China remains uniquely China. As a jurisdiction and investment market that marches largely to its own drum, it continues to be a valuable source of diversification for global equity allocations.
- John Lin
- Portfolio Manager—China Equities