By Jasmine Duan
Since June, China’s economic recovery has been fading amid a COVID-19 resurgence, a continued housing market downturn, and elevated geopolitical tensions regarding Taiwan. Furthermore, a drought has constrained hydroelectric output and industrial production in Sichuan Province, a major industrial center.
Both the path and the pace of the country’s economic growth are garnering more attention from investors in developed countries given China’s outsized contribution to the global economy. With the UK and Europe likely facing a recession and the U.S. economy on shaky ground, China’s trajectory becomes even more important than usual. We assess the main issues that are contributing to China’s economic uncertainty, and discuss implications for equity positioning.
Sticking to zero-COVID
We think the consensus view among market participants is that China’s COVID-19 containment measures are not likely to be loosened before the 20th National Congress of the Chinese Communist Party later this year. This important event, held every five years, approves the country’s roster of top decision makers.
However, we see some evidence that despite the strict policies, China is actively exploring options for reopening and re-engaging with the world.
For example, Hong Kong recently shortened its quarantine period for inbound travelers to three days from seven days. The city will host two major international events in early November: a two-day financial summit intended to help the city re-establish itself as a major financial center, and the World Rugby Sevens tournament. Hong Kong’s arrangements for the two events are important, as they may serve as examples for the future reopening of the city, and even for China as a whole.
Media outlets outside China have reported that President Xi Jinping may visit Saudi Arabia soon, and is considering attending the Shanghai Cooperation Organization regional summit in mid-September in Uzbekistan. Bloomberg has also reported that Xi will attend the G-20 Summit in Indonesia in November. These would be the Chinese leader’s first international trips in nearly three years. In our view, attending international events would demonstrate that senior leaders are willing to balance COVID-19 health risks with the benefits of reconnecting with the world, which could pave the way for a broader reopening.
The zero-COVID policy remains a risk factor for the economy, but we think lockdowns such as we saw in Shanghai earlier this year are unlikely to happen again. Any future COVID-19 resurgence should be less disruptive to the supply chains of major production centers and the economy as a whole because newly updated pandemic protocols have eased quarantine rules for close contacts and inbound travelers, and the government has announced measures to reduce overly strict containment measures at the local level.
Property market still vulnerable
Since late June, a spreading mortgage boycott in China has dominated news headlines. Homebuyers across the country are refusing to repay mortgages on yet-to-be completed projects that are suffering construction halts. This has shaken confidence in the housing market by highlighting the risk of buying presold apartments from struggling developers.
The situation is still evolving, but we think the damage to the Chinese banking sector is likely to be limited. Commercial banks impacted so far have reported that at-risk mortgages amount to about 0.01 percent of their loan books. Furthermore, rather than walking away from their liabilities, Chinese homebuyers are demanding delivery of their apartments.
However, the possibility that the situation could encourage banks and local governments to tighten their criteria for mortgage approvals and impose stricter rules on developers’ use of presale funds is cause for concern, in our view, because this would exacerbate the financing squeeze facing the property sector.
Currently, local governments are taking the lead to ensure the completion of residential projects by setting up local rescue funds, and by providing financial support to some projects. We see these moves as incremental support at the project level, not as evidence of a full-scale rescue plan led by the central government. Even if the central government were to intervene, significant time would be needed to develop a nationwide plan.
The bottom line is there is no quick fix for the property market problem. We think local-level rescue funds alone will prove insufficient to restore homebuyers’ confidence at the national level. The weakness in China’s housing market could last longer than we previously expected.
China’s property sales have been slowing
Sales of residential buildings in China (y/y change)
Line chart showing China’s sales of residential buildings has dropped sharply since July 2021 when the year-over-year change was -7.19% and at the end of July 2022 it was -28.64%.
Source - RBC Wealth Management, Bloomberg; monthly data through 7/31/22
More forceful economic stimulus
China’s government has been reluctant to announce large-scale monetary policy loosening because the problems facing its economy are rooted in a lack of loan demand due to the uncertain growth outlook and COVID-19 restrictions. The disappointing July credit data show that loan demand remains relatively soft.
After taking a short break from policy easing in July, the People’s Bank of China (PBoC) has resumed its easing cycle. On Aug. 15, China’s central bank responded to the recent weak data with a surprise policy rate cut of 10 basis points (bps). Subsequently on Aug. 22, it further cut its key lending rates, the 1-year and 5-year loan prime rates, by 5 bps and 15 bps, respectively. Although these moves may not be enough to meaningfully mitigate the growth pressure, we think the PBoC wants to reassure market participants that it is taking action to stabilise the economy. And on Aug. 24, the central government announced additional fiscal spending mechanisms, mostly aimed at infrastructure projects.
We think policymakers may ultimately announce more aggressive easing to limit downside risks, and there could be one more benchmark rate cut this year.
In our view, the 5.5 percent GDP growth target set by the government at the beginning of the year will be almost impossible to achieve. Beijing recently downplayed the importance of meeting growth targets, stating it intends to “keep economic growth within a reasonable range,” which we believe indicates a focus on ensuring employment and maintaining inflation targets.
Tension over Taiwan
Taiwan has become the latest geopolitical flashpoint of the ongoing conflict between the U.S. and China.
However, despite recent forceful rhetoric, we don’t expect China to further escalate tensions over the island. As RBC Global Asset Management Inc. Chief Economist Eric Lascelles recently wrote, “… it still seems unlikely that China will actually invade Taiwan in the near term, or that China and the U.S. will come to blows. The main reason is that such a conflict would be disastrous for all parties, from both a military and an economic perspective.”
The restrictions China recently imposed on food imports from Taiwan are largely symbolic and should have only a modest impact on the island’s economy, in our view. We think China will avoid placing more sweeping trade sanctions on Taiwan because doing so could hurt China’s manufacturing sector. More than 70 percent of Taiwan’s exports to China are tech products, such as electronics and advanced semiconductors, which are heavily intertwined with regional tech supplies and China’s own exports to the rest of the world.
Taiwan’s food exports to China/Hong Kong are less than 1% of total exports
Taiwan’s 2021 exports to China/Hong Kong
Doughnut chart showing Taiwan’s 2021 exports to China/Hong Kong and that its food export is less than 1% of total exports so China’s current trade restrictions on food will have limited impact on Taiwan’s economy. More than 70% of Taiwan’s exports are tech products (i.e. electronics and high-tech chips), which are heavily intertwined with regional tech supplies and China’s own exports to the rest of the world.
Tech products, 72.3%
Plastic and rubber, 5.8%
Base metals, 4.0%
Mineral products, 1.2%
Source - RBC Wealth Management, Taiwan Ministry of Finance
That being said, we expect tensions surrounding Taiwan to persist over the medium term, as both U.S. political parties seem to be interested in using the issue for domestic political gains, and some congressional leaders are focusing on the issue in an attempt to achieve their foreign policy objectives. This could, at the very least, raise headline risks for markets from time to time.
Equity strategy implications
There are many uncertainties surrounding China’s economy and equity market at the moment. We believe China’s market needs time to digest recent headlines, and could be volatile in the near term.
However, the current pessimism seems at least somewhat reflected in the market’s valuation. The MSCI China Index is trading at a price-to-earnings ratio of 10.5x the 12-month forward consensus estimate, far below its five-year average of 14.9x.
We believe additional accommodative monetary and fiscal policies will be forthcoming, and should provide downside support to Chinese stocks – particularly given that other major developed markets are still going through rate hike cycles.
Going forward, we think further relaxation of the zero-COVID policy will be key to restoring corporate and consumer confidence in the Chinese economy. Policy direction toward the property market will also be a focus for investors.
Within the Chinese equity universe, we favor structural themes such as the energy transition, and prefer investments in the renewable energy value chain. We also think themes connected to the country’s plans to achieve self-sufficiency in the technology sphere will benefit from government policy support amid geopolitical tensions. High-end manufacturing, such as the electric vehicle value chain, should benefit in the medium to long term. The valuations of some stocks in this area appear attractive, in our view, following the recent correction.
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