Ben Jones' view on: Will Chinese equities take off again in the Year of the Dragon?

Economic headwinds

China’s economy is facing a number of headwinds: weaker economic growth, a crisis in the property sector and deflation.

The country is also contending with weaker overseas demand because of the trend to nearshoring, where companies bring production closer to home. This was demonstrated in July last year when Mexico overtook China as the US’s largest trading partner.

Mexico has overtaken China as US’s largest trading partner‍

Beijing had hoped Chinese consumers could help strengthen growth, but its zero-Covid policy battered consumer confidence. The effect was then exacerbated by the property crisis. The property sector accounts for about 30% of gross domestic product (GDP), when related businesses are included, and consumers in China have around 50% of their savings in property. Many will have been hit hard by the crisis in the property sector.

The weakness in China’s domestic consumer demand is reflected in falling prices. China is battling deflation, with the most recent figure coming in at -0.3% in December, which was only slightly better than the -0.5% figure in November. This data is heavily impacted by pork prices, which are the largest item in the Consumer Price Index (CPI) basket.

Core CPI, which strips out often volatile food and energy prices, rose 0.6% in December, edging into positive territory but still demonstrating the weakness of demand. China remains a major exporter and its low prices have traditionally helped hold down inflation in other economies. However, this could have the knock-on effect of making Chinese equities less attractive in relative terms. If low prices for Chinese imports help the West tame inflation, this could enable central bankers in the US and Europe to cut rates faster. This is likely to boost returns from Western stock markets, which could make the Chinese stock market look less attractive in comparison.

Annual GDP growth last year was 5.2%, which was in line with Beijing’s target of 5% and an improvement on the 3% in 2022, when the strict ‘zero-Covid’ policy was in force. However, growth is expected to weaken this year, with the average forecast from major US banks being 4.6%. Deflationary pressures meant that nominal GDP grew by 4.6% in 2023, which was lower than Japan, the Eurozone, and the US. Measuring Chinese GDP in US dollar terms actually shows a decline in GDP, as the Renminbi depreciated by over 5% against the dollar.

How is China looking to support its economy?

Last year saw Beijing introduce a number of stimulus measures designed to support the economy. One step was to lower the one-year loan prime rate (seen as the benchmark for new bank loans to households and businesses) from 3.65% at the start of the year to 3.45% by August. In October we also saw a plan to increase government spending to a level of 3.8% above GDP, up from 3% above GDP, which is a level that the Chinese government has previously been reluctant to exceed.

This year we have seen further stimulus measures announced. China’s central bank cut its reserve requirements, allowing banks to lend more money rather than holding it on their balance sheets. In addition, Bloomberg reported on talks about a $278bn *market stabilisation fund, with measures planned including using overseas profits from state-owned-enterprises to purchase Chinese stocks.

Markets were hoping for a rate cut for the one-year medium-term lending facility loans, but this failed to materialise. Beijing may be reluctant to cut rates when it is looking to support the Renminbi, which has been weak against the dollar. However, the market stabilisation fund could help strengthen the Renminbi through the conversion of US dollars into Chinese currency. This could increase the chances of an interest rate cut. Also if, as expected, US rates begin to fall, we could see a strengthening in the Renminbi, which, again, could give more scope for rate cuts. Goldman Sachs expects two further cuts in the cash reserve requirements for banks and two policy rate cuts this year.

Other measures introduced so far this year include restrictions on short selling and a consolidation of the banking industry by merging small rural lenders into larger banks, with the aim of reducing the likelihood of financial stress.

Outlook and positioning

China’s economic stimulus measures have so far failed to reassure markets, with investors seeing them as too small and insufficiently targeted.

However, we believe this support will eventually feed through into the economic data and that the measures announced already this year signal Beijing’s intentions to ramp up policy support. In the absence though of bazooka-style stimulus measures, markets will need to see this support being sustained on a continuing basis.

It is worth emphasising that China is the second largest economy in the world, so this is an equity market that cannot be ignored by investors.

The degree of pessimism over the last couple of years has been such that one could argue the Chinese market is oversold. The forward P/E (Price to Earnings Ratio) for the MSCI China index has fallen to a recent low of 7.9x from a peak of 18.3x in February 2021. Whilst it may be true that a valuation discount is warranted given China’s economic woes, the MSCI China index has fallen almost 60% from its peak.

Chinese equities have fallen sharply‍

We currently have a neutral position on China and hold active funds that can be selective with their holdings.

China is home to many innovative companies, especially in technology and areas related to clean energy such as solar power, electric vehicles and batteries. One Chinese company to which we have exposure in our portfolios is BYD, which recently overtook Tesla as the world’s largest electric vehicle manufacturer. Businesses like this demonstrate the enormous potential of the Chinese economy and the growing ambition of the nation’s companies to compete on a global scale.

While China’s economy and its equity markets face headwinds in the Year of the Dragon, few can doubt the potential of this economic powerhouse to reach new heights over the long term.

Glossary

*Market Stabilisation Fund: A Market Stabilisation Fund is a financial mechanism typically employed by governments or central banks to mitigate excessive volatility in financial markets. The primary purpose of such a fund is to stabilize prices and prevent abrupt and drastic movements in the market.

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‍Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.

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