V-shaped recovery

Bringing Covid-19 under control has paid dividends for China. For one, it is the only major economy expected to post positive GDP growth this year, according to projections by the International Monetary Fund.

As it is, China’s economy has bounced back strongly. Over the span of just two quarters, it has already recovered lost ground in the first quarter and exceeded pre-pandemic levels of output, embodying the literal definition of a V-shaped recovery. The economics of this pandemic-stricken time is relatively straight-forward: Contain the virus and self-sustaining economic recovery will likely follow.

Firing on all cylinders

Recent data show that China’s economic recovery is increasingly becoming more broad-based. The initial stage of its economic rebound was led by the supply side or by a recovery in industrial production. It’s little surprise that after weeks of shutting down factories and production lines, just turning on the lights would trigger a jump in output. Growth in industrial production jumped sharply after China reopened for business in the second quarter as central authorities pushed state-owned enterprises to re-start supply side activities quickly.

Private consumption as proxied by the growth in retail sales lagged. So did growth in domestic fixed asset investments. Both economic gauges are key measures of demand-side health. These metrics were improving for sure, but not with the vigour and robustness observed in industrial production, leading to a two-speed recovery where the supply side led the rebound, while domestic demand lagged. Sector-wise, manufacturing saw a sharp recovery while services trailed. This was to be expected as services typically depend on face-to-face interaction and therefore suffered the most as public health measures forced consumers to be homebound.

Nevertheless, the economic rebound broadened steadily. October’s monthly activity data appear particularly promising, with retail sales and fixed asset investments growing a firm 4.3% and 1.8% from a year ago, setting up the economy for a strong fourth quarter. Clearly, the demand side of the economy is catching up with supply. A more even balance of growth between China’s demand and supply side will create a stronger and more solid foundation for a sustainable recovery.

However, there is still room for improvement. Retail sales have not recovered to pre-crisis average growth rates of about 8.0% year-on-year, while fixed asset investment growth has not fully normalised. The good news is with fears of the virus receding, coupled with the sooner-than-expected distribution of vaccines, China’s consumers will start spending again while businesses will resume investments.

Room for more policy accommodation

In terms of policy, the Chinese government has restrained from enacting massive debt-fuelled spending packages that characterised their earlier response to the Global Financial Crisis some twelve years ago. Instead, the government has focussed on containing the spread of the virus while implementing other moderately sized targeted fiscal support measures. This is in sharp contrast to developed countries that scaled up fiscal spending dramatically to buoy their respective economies during the unprecedented lockdowns in the second quarter.

The same restrained approach applied to monetary policy. The People’s Bank of China (PBOC) avoided the race to zero interest rates much unlike their developed market peers and therefore enjoys plenty of room to ease monetary policy if necessary. The upshot is higher real interest rates as compared to the US, which confers a yield advantage to Chinese assets which would invariably attract foreign funds into the country’s financial markets.

The benign inflation picture in China also allows the PBOC to let the economic recovery run unencumbered without having to raise interest rates. If anything, the PBOC might be sitting closer towards the hawkish-end of the monetary policy spectrum as opposed to other developed market central banks that remain on an easing bias due to near-term economic pressures arising from subsequent waves of Covid-19 infections.

In essence, this will sustain the yield differential between Chinese and developed market assets, hence sustaining inflows into the China’s financial markets. We’ve already seen evidence of this as fund inflows into China from foreign markets surged over the past two quarters, exceeding even pre-pandemic levels. Brighter growth prospects and the persistent yield advantage may continue to feed this trend.

“Dual circulation”

China’s leaders remain resolutely reform minded. The term “dual circulation” has become a veritable buzzword in Chinese media and trade papers. At a Politburo meeting in May, the nation was urged to "fully bring out the advantage of China's super-large market scale and the potential of domestic demand to establish a new development pattern featuring domestic and international dual circulations that complement each other." Again, in July, President Xi Jinping reiterated that China will accelerate its "dual circulation" development strategy, with a focus on expanding domestic output while stepping up the pace of opening its voluminous capital markets to draw in foreign investment and stabilise trade.

Increasing China’s economic resilience against external pressures seems to be the primary objective of this new growth model. The shift in growth focus from external drivers (exports) to internal drivers (domestic consumption) is also likely a strategic response to the broadening tensions with the US and the increasing hostility of foreign countries towards Chinese tech companies.

Shoring up domestic consumption

Focussing on domestic consumption as a key driver of growth is sensible, given the 1.4-billion strong consumer market and a burgeoning middle class of more than 400 million people. At 38.8%, the share of private consumption as a proportion of China’s overall nominal GDP in 2019 is extraordinarily low, especially when compared to the US where private consumption accounts for close to 70% of GDP. Of course, China is still in the early or middle stages of economic development versus the US which is already an advanced economy. This suggests that there is ample room for growth in domestic consumption. Over time, it will increasingly account for a larger proportion of overall output and become a major growth driver.

In addition, with China’s pool of high-earning individuals set to surge in the next 15 years, the demand for wealth management services and products is expected to grow as well. This might be among the reasons for the government’s recent efforts in accelerating the pace of opening up its capital markets.

Decreasing dependence on imports of essentials

Increasing self-reliance would also encompass shifting selected supply chains and production lines within Chinese territories to ensure the country has ready access to essential goods, as opposed to relying on imports. A good example is foreign produced microchips that Chinese tech companies largely depend on for their own products. To wean itself off foreign produced chips, China is accelerating the development of the domestic semiconductor industry so that the sector will be able to cover about 70% of all domestic demand in the next five years. This process of substituting imports for domestically produced goods will hold long-term structural implications for manufacturing in China.

Greening the recovery

Industrial restructuring is expected in the energy sector as well, given the clear policy targets and long-term development plans for clean and renewable energy and new energy vehicles (NEV). With a target of achieving carbon neutrality by 2060 and carbon emissions to peak by 2030, this would be a long-term negative for traditional fossil fuel energy sectors like coal but an unambiguous positive for the renewable energy sector such as solar and wind.

Meanwhile, in the automobile and NEV space, the government has set a 20% NEV penetration target by 2025, in addition to other long-term development plans expected by 2035.

The future is digital

The Chinese government continues to prioritise investments in the local e-commerce sector as well. Their unwavering focus on building and improving internet infrastructure, both in terms of connectivity and speed, throughout the country has been instrumental in creating the solid foundations that led to the founding of the much celebrated Chinese tech giants that investors lust for today, including Alibaba, JD.com, Tencent, Byte Dance, Meituan-Dianping and so on. The combination of supportive government policies and entrepreneurial tenacity and ingenuity has led to a vibrant and rapidly growing e-commerce sector. In fact, eMarketer valued China’s retail e-commerce market at $2.3 trillion, which accounts for 57% of global online sales.

All these years later, the government’s support for e-commerce has not waned. Recently, it launched a strategic development plan to invest in “new infrastructure” that is expected to accelerate the growth, advancement and development of the e-commerce sector. The plan includes projects focussed on building the infrastructure necessary to support digital services and intelligent ecosystems including 5G networks, the Internet of Things and data centres. This should aid in improving connectivity across various regions in the country and allow tech companies to leverage China’s huge internal market to grow the sector.

A multi-year growth story

These structural reforms are by no means exhaustive nor are they quick fixes. Realigning supply chains and restructuring the manufacturing and industrial sectors may have knock-on impacts on the labour market and consumer confidence. There are also stark geographical disparities to contend with, as each region has differing levels of income and differing levels of development and infrastructure. Realising the massive potential in private consumption arising from developmental trends including rising affluence, expanding middle class and urbanisation is admittedly alluring, but will not be a cake walk by any means. Government support is instrumental in ensuring a smooth, orderly and balanced transition. Efforts in this space bears close monitoring.

But let’s not miss the forest for the trees. 2020 has been a banner year for China. The year started off in turbulent fashion with the spread of Covid-19, but the country has overtaken all others when it comes to containing the virus and engineering a robust recovery. All in, China’s cyclical growth prospects remain bright. Meanwhile, secular growth trends provide a wide breadth of investment opportunities for investors to consider.

Watch out for the potholes ahead

With the exception of Hong Kong, North Asian stocks – namely China and Taiwan – have outperformed international stock markets year-to-date. Much of this can be attributed to their success in containing the virus and quickly normalising economic activity.

In view of the outperformance, valuations are not categorically cheap, and the market may be susceptible to bouts of volatility. At this juncture, the valuation of the onshore A-share market (the CSI 300) appears less demanding relative to the offshore market (MSCI China). The CSI 300 index is trading at 14.8 times Price-to-Earnings (P/E) based on next year’s expected earnings (2021e), which is about 2 standard deviations above its 10-year historical average versus the MSCI China, which at 15.2 times P/E, is hovering near peak valuations of the past 10 years. In view of the relatively rich valuations, a bottom-up stock picking strategy alongside active management might be necessary to generate returns and maximise investment gains in the Chinese market.

In addition, US-China tensions are never far away, even with a different administration. Recently. President-elect Joe Biden told the New York Times that tariffs on Chinese goods will remain while his administration conducts a full review of the existing Phase One trade deal and consults with US allies. Mr Biden said his trade policies will focus on “China’s abusive practices”, including “stealing intellectual property, dumping products, illegal subsidies to corporations” and forced technology transfers. This should remind us that while a Biden administration will likely conduct trade policy strategically and with less unpredictability, underlying tensions with China will remain. Furthermore, we recognise that Chinese stocks may face a fair degree of volatility in the near term, given President Trump’s executive order banning US persons from investing in selected Chinese companies deemed to have ties with the Chinese military and the recent passage of the China delisting bill in the House of Representatives.

Within China itself, its marquee tech names found themselves in the firing line of potential anti-trust regulatory overhauls. The draft anti-trust guidelines are meant to guard against anti-competitive or monopolistic behaviour within the internet industry and curb the consolidation of market power. This is important to ensure a vibrant tech space in the long run and to even out the playing field for potential competitors. The draft regulations are indeed comprehensive, but the key unknown is the strictness and degree of regulatory enforcement. While a strict implementation of the rules would naturally limit market leaders’ operational flexibility, history leaves questions over how severe enforcement can get.

All considered, the operational and financial impact on major internet players are likely to be limited for now as regulators are still in the midst of finalising what the rules will be.

Indeed, the recent drama surrounding the abrupt cancellation of the Ant Financial IPO and the unexpected release of draft anti-trust regulations underscore the types of idiosyncratic regulatory risks that one might encounter in this region of the world. As a result, investors should be prepared to deal with waves of volatility when such unexpected events unnerve the markets.

Mine for opportunities mindfully

Nevertheless, we are sanguine on China’s long-term growth outlook and would seek to gain meaningful exposure to stocks in the region. From an asset allocation perspective, we remain overweight on equities, particularly Asia ex-Japan stocks. Within this space, we are positive on the Chinese, Hong Kong and Singapore markets.

In terms of fixed income, we remain positive on Emerging Market High Yield bonds with a preference for Asian High Yield, which would invariably include Chinese assets. The recent onshore Chinese defaults merit monitoring, but we do not view them as systemic threats to the offshore market. Still, investors should exercise caution in the High Yield space, perform their due diligence and seek selective exposure mindfully and prudently amid the volatile environment.

We continue to advocate a long-term approach when investing in China. Taking concentrated exposure to a few stock names as a directional play on a short-term theme – like Ant Financials IPO – might be ill-advised. Instead, we would prefer to invest in key entrenched secular growth trends that may play out over a multi-year horizon in a diversified manner.

These themes include:

• The long-term growth story in the Asian tech sector,
• The growth in domestic consumption as the middle class in China continues to expand,
• Continued advancement of the e-commerce sector in China,
• The beneficiaries of China’s “dual circulation” growth strategy and
• The beneficiaries of capital market liberalisation policies as well as rising demand for wealth management services and products amid the rise in general affluence.

Investors may consider allocations into China equity funds, or High Yield bond funds with good performance track records to engage opportunities in the region in a diversified manner. This will help mitigate downside risks and ride out the volatile market environment.