Touching Off: The Opportunities in Chinese Equities

The Chinese economy has faced possibly its toughest two years since economic reform under Deng Xiaoping.

An Unprecedented Two Years

The Chinese economy has faced possibly its toughest two years since economic reform under Deng Xiaoping.

The first and most obvious stress has been the impact of Covid-19. While China’s zero-Covid policy was initially very successful, the Omicron variant has proven much more difficult to contain. Lockdowns have been reimposed across the country, and although Shanghai is slowly removing restrictions, the highly infectious nature of the Omicron variant means there can be no guarantee the worst has passed. Indeed, Shanghai reimposed some restrictions in the wake of 11 new infections discovered on 9 June.¹ While some progress is being made, lagging vaccination/booster rates, particularly among the elderly, suggest lockdowns could persist well into the second half of the year. Additionally, there remain questions about the efficacy of China’s homegrown Covid vaccines which may have impeded efforts to return the country to normal (Figure 1).

Indeed, of all the deteriorating trends, rising unemployment is the one policymakers are unlikely to tolerate for long, suggesting more forceful intervention is not far away.

These lockdowns have had profound effects on the Chinese economy. GDP growth in the first quarter came in at 4.8%. While this surpassed analyst expectations of 4.4% growth, it is still below the 5.5% target the country has set for 2022. About a fifth of China’s GDP is driven by exports (Figure 2). In April, China’s export growth slowed to 3.9%, the weakest in almost two years, as the Covid-19 curbs halted factory production. Indeed, supply chains have come under particular stress, with many overseas companies unable to access Chinese-made products and components. Loading times at the port of Shanghai, the world’s busiest port, have increased significantly since the start of the year, and now hover around 70 hours, compared with between 20 to 30 hours pre-pandemic². The scale of the slowdown can be seen from the number of riders of Chinese subway systems of the ten largest cities, with seven out of the ten well below February levels (Figure 3). This dampened economic outlook is also being reflected in the country’s unemployment numbers: the urban unemployment rate rose from around 4.9% in September 2021 to 6.1% in April³, the highest level since March 2020 (Figure 4). It was also the second-highest reading since 2018, when China first started publishing the data. Indeed, of all the deteriorating trends, rising unemployment is the one policymakers are unlikely to tolerate for long, suggesting more forceful intervention is not far away.

Construction and real estate account for around 14% of the Chinese economy, giving this slowdown profound consequences for overall growth.

The third challenge for investors to grapple with has been regulatory uncertainty in various sectors – including property, education and the internet – which has weighed on Chinese equities, both onshore and offshore. In the wake of the collapse of Evergrande, the property sector has undergone a prolonged bout of stress, with curbs introduced to reduce speculative purchasing and developer leverage. As a consequence, home sales have been trending down consistently throughout late 2021 and 2022, and are down more than 40% year on year in April 2022 (Figure 5). Likewise, around 70% of Chinese offshore real estate bonds trade at yield-to-maturity of above 15% (Figure 6), reflecting the nervousness of many investors towards the Chinese property market. Construction and real estate account for around 14% of the Chinese economy, giving this slowdown profound consequences for overall growth.

The peak of infections may have passed, although the highly infectious nature of the omicron variant means that we are only cautiously optimistic in this regard.

Finding the Bottom?

However, we may now be closer to the nadir of the Chinese downturn, in our view.

Although the zero-Covid policy appears set to remain in place, the initial easing of conditions in Shanghai is encouraging in the near term, while gradually rising vaccination and booster rates (Figure 7) among the elderly suggest China will be better prepared for reopening in the second half of the year. Furthermore, a Chinese developed mRNA vaccine – similar to those used successfully in Western nations – is currently under trial in the United Arab Emirates and may well be ready for use later this year⁴. While 10 cities are in full lockdown, the peak of infections may have passed, although the highly infectious nature of the omicron variant means that we are only cautiously optimistic in this regard (Figure 8).

Irrespective of the overall direction of the Chinese economy, we believe investors should focus on the one metric that matters: earning revisions. Over the long term, we believe that the direction of earnings revisions is the most important driver of future stock prices.

There is no doubt that the last two years have been profoundly challenging for the Chinese economy. However, we believe we may have touched off the bottom and could now be entering period of relatively stability: lockdowns will hopefully begin to ease, credit conditions are improving and the regulatory uncertainty may be subsiding. While it may be difficult to imagine 5.5% economic growth over the next year, it is more than likely that renewed policy efforts to promote growth will have a beneficial effect on the Chinese economy, and on Chinese equities as a consequence.

The Metric That Matters: Positive Earnings Revisions

Irrespective of the overall direction of the Chinese economy, we believe investors should focus on the one metric that matters: earning revisions. Over the long term, we believe that the direction of earnings revisions is the most important driver of future stock prices. While the market may fluctuate in the short term, if a company grows its earnings, its price will eventually rise to match – and vice versa. Earnings momentum in China is currently negative (Figure 10) and the country has had the worst relative earnings revisions of any major region (Figure 11). The relative position is moving in China’s favour: China is reaching the end of its tightening phase, whereas the rest of the world is just beginning to apply the monetary policy brakes. If we are indeed reaching a period of relative stability in China, loosening policy may begin to reverse earnings revisions momentum, benefitting Chinese equities overall and in relative terms.

However, even if earnings revisions remain negative at index level, we still see a great deal of opportunity in Chinese equities.

However, even if earnings revisions remain negative at index level, we still see a great deal of opportunity in Chinese equities.

This is amply demonstrated by earnings dynamics in the Chinese financial sector. Figure 12 shows earnings revisions versus the company’s share price over four years for two listed Chinese banks. Chinese banks have not had the easiest few years, as turbulence in the property sector and the wider disruption of the economy have threatened the profitability of existing loans. However, it is clear that some banks simply have a superior operating model compared to their competitors. Within the same timeframe and confronted with the same challenges, Bank A has consistently outperformed Bank B, with only 2% of positive earnings revisions driving 15% share price appreciation. Indeed, the relative performance demonstrates the magnifying effect of revisions on stock prices. Although the relative differential in revisions was 14%, the relative performance gap was 17%.

Irrespective of the wider economic backdrop, companies with positive earnings revisions will be the ones that outperform.

In all of these areas – whether or not the market continues to trend down, we are comforted by the knowledge that if a company grows its earnings, positive sentiment and price rises will eventually follow.

Conclusion

The past two years have arguably been the most economically challenging in China’s recent history. However, there are signs that stability is slowly returning.

For discretionary equity investors, we believe the focus should be on the metrics that matter; in particular, earnings revisions. Irrespective of the wider economic backdrop, companies with positive earnings revisions will be the ones that outperform.