The first major step

Amid this year’s heavy macro news, where inflation has dominated newspapers’ headlines, China has still been a hard story to miss. The country has endured a regulatory tightening period which has acted as both a structural and cyclical headwind to the country’s macro situation. Chinese assets have reacted in a similar manner to what would happen in most developed markets: equities and government yields moved lower. This is where we are as we approach 2023: the macro situation is dire, important regulatory tightening has been implemented and asset prices are discounting more risks than opportunities. The ruling Chinese Communist Party’s 20th National Congress seems to have indicated that this difficult context is well understood and has become a source of concern. In our view, this is the first major step to improving the situation for Chinese assets, notably equities, for the following reasons.

 

A trough for the macro downturn?

From a macro standpoint, China has been in a difficult position, as evidence by the decomposition of our growth nowcasting indicator (figure 1). The Chinese macro cycle has been subdued for some time: it peaked in May 2021 and since then has exhibited a continuous decline. Slicing and dicing the subcomponents making up Chinese growth, figure 1 highlights how all of these are currently at a low level. The housing market, which accounts for a third of China’s GDP, is in a particularly difficult situation. Production expectations (such as the different Chinese PMIs) point to continuing low growth conditions. For recent quarters, this situation has been partially offset by two factors: consumption and external demand. Consumption showed signs of a recovery in 2022, but peaked in late October and is retreating again as lockdown measures were implemented once again. External demand is currently vulnerable to tough US and Eurozone central bank policies and the signal shown on the chart highlights that this final element of economic growth is starting to give way. Whichever way we look at it now, all of China’s growth engines are running cold – but this is possibly a reason to hope for an improvement as it will inevitably lead to a strong moderation of the current regulatory tightening period, providing hope for the Chinese economy and its assets.

 

Figure 1: Decomposition of the LOIM Chinese growth nowcasting indicator

Source: LOIM, Bloomberg

 

The Congress that is changing everything

The Chinese Central Government does now seem to be paying attention to this difficult economic conditions and the recent 20th National Congress provided significant evidence of this. Prior to the event, there were three main drags on China globally: the zero-Covid policy, the reshaping of internet regulations and the necessary property market deleveraging. The macro symptoms described earlier are all consequences of these three factors, and their joint dynamics are now weighing on political decision-making. Since the Congress, there has been a whirlwind of positive news specifically addressing these factors:

• Covid relaxation: the removal of PCR tests, permitting home quarantining and an acknowledgement that the Omicron strain is less severe have opened the door to the re-opening of the Chinese economy. This will naturally support consumption in the coming quarters.
• Internet regulations: a new mobile gaming license has been approved, as has a capital injection for Alibaba’s financial unit, and a proposed USD 1 billion fine for Ant Financial (which would pave the way for it to be properly funded as a financial company) are all significant steps towards improving the Chinese technology sector, which has been a major drag on most equity indices.
• Finally, property sector deleveraging is now being seen for what it is: a major systemic risk for an economy which is heavily reliant on it. This message appears to have been heard by the ruling party, as well as by the central bank, and new rounds of stimulation and rate cuts are on their way: adding to the potentially positive prospects for Q1/Q2 next year.

Investors have been aware of this scenario for some time. In our view, the fact that the recent Congress has shown signs that Chinese leaders are acknowledging the dire situation, and are ready to help with it, changes everything.

 

A downside floor

This message is even more important given Chinese assets have discounted a lot of bad news, but not much good news. This is a classic upside/downside investment situation: with the current change in political stance, the downside is now being given a “floor” by political and monetary authorities. The upside is naturally “yet to come”, but the fact that its pricing is not yet being incorporated into the Price/Earnings (P/E) ratio of Chinese equities is quite blatant now. Figure 2 compares MSCI China’s P/E to the level of 5-year rates. As with any equity index, both are empirically inversely related: lower rates mean higher P/E. The specificity of the Chinese market is the lag between rates and P/E: lower rates take about 10 months to impact P/E levels. With that in mind – and given the low levels of Chinese P/Es (at around 10) – it is hard not to see the situation as an investment opportunity, with the potential for P/Es rising to 15 once again.

 

Figure 2. Chinese equities’ PE vs. 5-year rates (inverted)

Source: Bloomberg, LOIM