This time last year, as we prepared for the Year of the Rabbit, there was a high amount of optimism that 2023 would be a positive year for Chinese risk assets in both in absolute and relative terms. This optimism turned out to be short-lived with investors caught like rabbits in the headlights as the mood changed. China and Hong Kong were among the worst-performing markets in 2023, with the post-COVID-19 economic recovery falling short of expectations.
This year, we enter the Year of the Dragon. According to Chinese tradition, the Dragon is a lucky creature, symbolising bravery and innovation. Indeed, there is a sense that you may need to be brave to currently invest in China. Chinese equities have now experienced a three-year bear market and, to borrow another popular Dragon inspired reference from the series Game of Thrones, ‘Winter has come’. Market investors have been trying to tackle three major concerns. We look at each of these to see if there are any signs of the ice melting.
My home is my castle
Concerns about the oversupply of Chinese property and the dramatic collapse in prices are front and centre when discussing China. Volumes of new residential properties are down 35% from peak sales. But there has been some loosening in property policies, which has seen some stabilisation of these rapid falls. From 2022 to now, there could be over 100 small loosening policies across different cities. More recently, we have seen bigger national policies – China is planning to roll out new rules to help property developers access commercial bank loans. The People’s Bank of China has also recently announced that the reserve ratio requirements for banks from the 5th February 2024, which will provide 1 trillion yuan (approx. £100bn) in long-term capital. This cut follows two previous cuts last year.
But a lot of the potential damage to gross domestic product (GDP) and sentiment has already taken place. The Chinese consumer seems very reluctant to spend, resulting in a deflation cycle. We are seeing evidence of falling prices, such as pork, which is a large component of China’s consumer price inflation. Deflation tends to be associated with an economic slowdown, and this is raising questions over the growth outlook for China – a country yet to see the recovery in growth from the lockdown lows. Recent data suggested that the world’s second-largest economy grew 5.2% in 2023, broadly in line with official projections. But it is concern over the economy’s direction that is further spooking investors. Data from the Bank of America Merrill Lynch Survey shows 0% of respondents now expect stronger GDP for China. If we go back a year ago, this number was 78%.
Figure 1: First time in 21 months investors expect weaker Chinese economy
Source: BofA Global Fund Manager Survey
Draconian laws
Another major concern with which investors are grappling is the changing rules in China. A crackdown on the education sector and internet firms has sparked worries about other sectors being targeted by the government. The government’s common prosperity agenda aims to narrow the wealth gap appearing in the country. First mentioned in the 1950s, the last few years have seen officials double down on the agenda. The result of this: companies such as Tencent Holdings adjusting earnings to be seen as doing a service. Tencent stated it will spend 100 billion yuan on common prosperity. But even bold actions like this do not result in a pass. Recently, Chinese technology shares fell after the country’s cyberspace regulator started to consult on rules limiting smartphone usage for children under 18. The rules would limit children to two hours a day (I think my 15-year-old daughter would leave home if I tried this), and it follows rules put in place four years ago, which limited online gaming for under 18s (my boys would have already left…). While the more recently pro-growth shift from the government does limit further rules, they cannot be ruled out. Some of the damage has already been done.
Playing with fire
Along with internal woes, the geopolitical scene with regards to China is hotting up. The number of elections happening in the world this year makes it an even more complex environment. The recent elections in Taiwan, a territory Beijing sees as its own, went to the Democratic Progressive Party and their leader, William Lai (who has been classed as a “troublemaker” by China), rather than the Chinese Nationalist Party, which promised better ties with China. This year will also see the US election and the potential return of President Trump, whose last term in office resulted in a trade war with China. Even with President Biden, the US policy towards China has been frosty at best. US efforts to block chip exports to China has resulted in Beijing enforcing controls around the exports of rare earth materials (gallium and germanium) used in making semiconductors.
Has winter passed?
Because of these multiple headwinds, investors within both global and emerging markets have fled to perceived lower-risk regions. The question for investors is: how much of this bad news is now in the price? Let’s consider the forward price to earnings multiples versus the US and Indian equities: Chinese equities are at a price-to-earnings ratio of around nine, compared to 19.5 for the US and 22 for India.
Figure 2: Price to Earnings Ratios
Source: Bloomberg
This discount shows that a lot of the concern may already be reflected in some prices. The extreme valuation differential outlined above implies much of investors concerns have been factored into market prices. So, will the Year of the Dragon lead to be prosperous for investors? Time will tell, but valuations are certainly in favour of those daring to be brave and innovative.
