Investors’ confidence in Chinese equities has been severely tested over the last year. Growth in China has deteriorated due to the government’s zero-Covid policy, increased regulation, weakness in the real estate sector and fiscal consolidation. The official GDP growth target of 5.5% for 2022 now seems hard to achieve. Chinese stocks have fallen sharply and valuations are now low, by historical standards.
Are investors' concerns justified, or does the current situation offer an attractive investment opportunity for longer-term investors? We believe some of the risks are beginning to diminish and that the stock market is attractively valued.
Covid remains a risk for the time being. The highly contagious Omicron variant recently caused the highest level of infections in China since the outbreak of the pandemic. The authorities implemented restrictive lockdown policies, with serious consequences for economic growth. At the beginning of April, 400 million Chinese were affected by lockdowns. The implementation of these measures has led to a significant slowdown in growth. Retail sales, for example, are down 11% year-on-year (y/y) and road freight traffic nationwide has contracted significantly since the beginning of the Omicron wave (Exhibit 11). Supply bottlenecks have also returned with full force and are likely to have global repercussions.
Exhibit 11: Lockdowns due to China’s zero-Covid policy are impacting the economy
Road freight activity and new Covid-19 cases
We expect some improvement in the situation by October or November, given President Xi’s desire to be selected for a third term as the head of the Communist Party. Wide-scale lockdowns are not sustainable, although removing them quickly might risk overwhelming the health system. The latest data suggests that China still has a relatively low proportion of the elderly who have received booster vaccinations.
A possible route to “living with Covid” centres on increasing the proportion of the population covered by three doses of the domestic vaccine. Individuals could be encouraged by a combination of increased threat of infection and government mobility restrictions on unvaccinated members of the population (similar to Europe’s strategy). This could then support the process of re-opening while the authorities manage the speed according to pressure on the health system. While this process is still likely to be slow, a long period of lockdowns is untenable, in our view.
The tide may also be turning in the property market. Fiscal restraint and tighter regulation in the financial sector led to a slump in real estate market activity and a crisis for some property developers. Real estate investment fell 10.1% y/y in April.
At the regional level, policymakers have begun to ease restrictions on home purchases and lower down-payment requirements. But much more important is the prospect of a more expansive fiscal policy and a supportive central bank that can ease monetary conditions further due to the relatively moderate level of inflation. The supply of credit for the economy is already beginning to recover. Exhibit 12 shows how the momentum in credit growth has been a reliable indicator of stock market performance in China over the past 10 years. The stabilisation in credit growth suggests that the headwind for equities may be receding.
Exhibit 12: Chinese equity performance tends to be correlated with momentum in credit growth
China credit growth and equity performance
Regulation has been another ongoing headwind for the stock market. Information technology, media and online companies were particularly caught in the regulatory tightening. However, recently some positive signs have emerged. In March, China’s State Council Committee encouraged regulators to establish more transparent and predictable policies and in April, the Chinese Communist Party Politburo became more supportive of policies to stabilise growth, with support for infrastructure investment, the property market and internet platforms. As a result, we are more confident that regulation will become less of a headwind.
Offshore-listed companies were particularly hard hit by regulation. On top of domestic regulation, the ongoing disagreement between the US and China over audit firm access to US-listed Chinese ADRs has heightened fears of forced de-listings by 2024. The Chinese Securities Regulation Committee has since announced that it is working on a draft proposal to give US regulators full access to auditing reports of most US-listed Chinese companies. If reached, an agreement would significantly reduce the de-listing risk associated with Chinese ADRs.
Investors have undoubtedly experienced some short-term pain in Chinese stocks, but we think there is an opportunity for long-term gains. After the very weak performance over the last year, the valuation of Chinese equities is significantly below the long-term average. Investors have an opportunity to benefit from long-term earnings growth prospects in China at valuations that already factor in a lot of bad news.