After an initial rally of 60% from late October to late January, Chinese equities have corrected 15% and are now down marginally for the year.
A major positive change to this year’s global economic outlook was China’s pro-growth policy pendulum shift late last year. Back in December, economists expected China to grow only 4.8% this year. Fast forward to today – expectations now stand at 5.5%. This growth upgrade has lifted indirect beneficiaries of China’s recovery, such as European luxury companies (with some names up over 50% since 3Q and continuing to hit all-time highs this year). However, MSCI China is now down 0.8% year-to-date, a sizable underperformance of 970 basis points (bps) versus global equities. When will Chinese markets react to China’s improved economic prospects? A lift in consumer and private business confidence, combined with upgraded corporate earnings expectations, would boost investors’ confidence that this nascent economic recovery has room to run. Given China’s over 30% weighting in the MSCI Emerging Markets index, this would boost emerging markets (EM) more broadly – allowing it to go from laggard to leader this year.
Back in February, we argued that China was unavoidable for investors this year due to the arrival of the COVID reopening boom, the unleashing of three years of pent-up demand of 15% of the world’s population, and China’s policy pendulum shift towards the pro-growth side (easing pressures on the real estate sector and boosting private business confidence). Since then, China’s economic data has broadly surprised to the upside, especially household services consumption (food services sales surged 26% year-over-year in March) and the housing sector (contraction eased to 5.8% year-over-year in 1Q versus -10.0% in December). Chinese policymakers’ official 2023 GDP goal of “around 5%” is now seen as a floor rather than a ceiling.
However, Chinese equities have not responded as strongly as the economic data alone would suggest. After an initial rally of 60% from late October to late January, Chinese equities have corrected 15% and are now down marginally for the year. The initial rally had brought valuations back to average levels - and investors are now asking for a buffer to compensate for the question marks around how long the economic recovery will last (in addition to ongoing geopolitical tensions). For investor confidence to pick up, three other confidence turnarounds need to take shape:
- Improvement in private business confidence: While 1Q GDP was strong, a notable area of sluggishness was private investment which grew only 0.6% year-over-year (versus 10.0% in the public sector). Action by policymakers to reassure the market of its stance in supporting the development of the private sector would be key.
- Further recovery in consumer confidence: Consumer confidence has started to recover this year, but income expectations and willingness to consume remain below average, raising questions about how much consumption will broaden beyond restaurants and domestic travel. An improvement in the labor market, spurred by an improvement in business confidence, would be key.
- Upgrade to corporate earnings expectations: While the economic data has surprised positively, Chinese earnings estimates have moved up only 2 percentage points this year. Strong 1Q earnings results, combined with upgraded guidance from management, would be a welcomed confirmation of economic trends and provide a lift to full year earnings estimates.
Given China’s 33% weight in EM equities and its important role for EM economies, a boost to Chinese markets would boost EM equities more broadly. While it may take some time, we do expect confidence to improve – or for policymakers to stimulate the economy further if it does not. The key for investing in China is to do so thoughtfully, based on “waves of reopening” (services then discretionary goods) and “beyond reopening” themes (green economy and advanced manufacturing sectors).