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While wearing masks and keeping a distance from relatives has been a major inconvenience for most of us while waiting for vaccines to roll out, this is nothing compared to the intensely draconian regulations China has adopted to keep its goal of “zero covid” intact. . Being forcibly sealed in your block of flats, sent to a mandatory isolation centre, or subjected to tests in order to walk into a supermarket and buy a packet of noodles, puts the haphazardly imposed regime in the UK into perspective.
Regardless of the merits of China’s approach to public health—many of which are also debatable—zero Covid has had a major effect on China’s economy, as the disruption continued long after other countries had normalized their daily lives. China’s policymakers are left with uncomfortable choices: open up now and risk waves of Covid patients overwhelming the health system, or maintain the status quo in the face of growing anger and economic damage. Events in early December suggest the leadership has moved decisively in favor of the former, as it began easing restrictions soon after the wave of protests seen last month. We will soon know the final answer to this conundrum, but investors in China’s stock market are already starting to bet that China’s leadership will have no choice but to open society further next year.
Even before that, it’s certainly true that the decline in China’s stock indexes, both in Shanghai and Hong Kong, has left investors wondering whether China’s decline is a smart move now, given that the price-to-earnings ratio of the Shanghai Composite (SSE) is at an all-time low of just 12 – at least one standard deviation below the long-term average. After Goldman Sachs and JPMorgan recently pointed to the value of Chinese stocks, the Shanghai Composite Index performed well, rising 11 percent in just over a month and recovering from its lowest value of the year. However, the fact remains that, aside from the difficulties surrounding zero Covid, a lot needs to happen next year for the market’s faith to be rewarded.
Economic turnovereye?
There is some evidence that China is beginning to deal with the fallout from the property sector collapse. Infrastructure spending looks set to remain on the rise through 2022, which should give the economy some headroom as the real estate sector’s credit windfall resolves. This is mainly the reason why analysts evaluate forecasts of China’s economic growth. For example, analysts at Schroders, which has a specialist team for Asia and emerging markets, raised previous forecasts for GDP growth from 3 to 5 percent, although 5 percent in Chinese terms still represents a poor economy. Even Schroders qualifies his analysis by saying that while the economy should begin a cyclical recovery next year, the driving force behind the country’s performance will be political, not just economic.
But there will be external factors that can help both China and its stock market. First, if US interest rates peak next year, the weakening dollar will begin to help liquidity in emerging markets. Chinese stocks, along with all other non-dollar-denominated indices, have suffered from outflows of funds held in dollar accounts as interest rates have risen. Therefore, a reversal will bring an immediate technical boost to Chinese stocks.
Another thing to consider is whether China can effectively export its way back to respectability as its covid controls are relaxed and workers return to factories. This is likely to be more difficult than 20 years ago because of a fundamental change in the way people view unfettered trade, or more specifically the length and resilience of supply chains. That point has been brought into focus by the pandemic, and the war in Ukraine now has many countries reevaluating whether their reliance on certain companies and countries for key components like microprocessors is necessarily a good thing. The US is proactively pursuing a policy of returning to key manufacturing for microchips while investing in research and development.
At the same time, the US has also restricted access to sensitive technology, such as developments in artificial intelligence, that China could transfer or use. While not formalized into anything as official as a boycott, the possibility that China will struggle to export goods in the quantities it wants next year due to a shift in attitude towards its political ambitions remains one possible outcome. The reality is that the principle of unfettered free trade is under constant pressure.
Where to look for cAlue
Investors have the option of simply buying a tracker fund and tracking an index such as the MSCI China, effectively waiting to see if they can benefit from the profits that the cyclical economic recovery should bring. If stock pickers want to try their luck with active funds or even individual Chinese companies, then Schroders has some useful guidance for 2023.
In short, sectors that will benefit from China’s entry include IT and green energy, while Schroders believes that construction machinery and materials will benefit from heavy infrastructure spending. In addition, lower valuations of health care companies have also put the sector on the value radar. The asset manager even thinks the notoriously frothy e-commerce sector has fallen to levels that have eliminated its premium. Next year, the asset manager predicts the sector will trade more like a consumer cyclical – ie. in line with its potential for earnings growth, not anything more.
For a number of reasons, 2023 will be a pivotal year for China, likely to determine a range of key economic, geopolitical and investment issues. If anything, the times are sure to be interesting, which may or may not be the Chinese curse.
Back to: Where to invest in 2023
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