Market Flash Update – China in Focus: Challenges, Pessimism, Potential
China in Focus: Challenges, Pessimism, Potential
If You Only Have a Minute:
Investor sentiment in China, the world’s second-largest economy, has deteriorated in the past few weeks.
The ‘market pendulum’ has swung from optimism to pessimism since the start of 2023.
Despite the negative sentiment, ‘there is still hope’ for China:
Chinese policymakers have clearly turned more supportive
While major economies are heading into recession, China is in early recovery
Valuations are in the historical ‘buy-zone’ for long-term investors
While we remain cautiously optimistic, we are still disciplined to our FVT process:
Expect adjustments if current challenges and sentiment lead to weaker fundamentals
Using volatile markets to our advantage: We are actively on the lookout for opportunities to further diversify our risks while maintaining a strong upside for our investors.
“I definitely think there’s too much pessimism priced in, but I also think that the bar for [China] markets to turn pessimism around is higher….”
NatWest Markets Strategist
“Bottoming out of earnings growth and clearer structural outlook, in combination with continuous stabilization of geopolitical conditions, would offer a better upgrade opportunity and attract back long-term money.” Morgan Stanley
“Valuations are reasonable, earnings are poised to grow at a mid-teens pace, and policymakers have moved in the direction of more market-friendly practices.”
JP Morgan Private Bank Mid-Year Outlook
“Zhongrong’s missed trust payments won’t lead to a financial tsunami in China.” Bloomberg Intelligence on China’s Trust missed payments
China in Focus: Challenges, Pessimism, Potential
The Pendulum Swings: Extreme Optimism to…
A recent news headline read ‘China: Time to Worry?’. Indeed, seemingly bad news about the Chinese economy and market seems to be rolling out non-stop, with investor sentiment taking a hit.
At the start of 2023, there was widespread anticipation that the end of China’s zero-covid policy would trigger the next stage of growth for the world’s second-largest economy. After a period of lackluster performance, China equities rallied strongly from their lows in October 2022. The mood then was overwhelmingly positive – prominent asset managers such as UBS, Deutsche Bank, and Morgan Stanley all came out with positive outlooks.
CNA, 9 Jan 2023
Such news or reports reflect the positive mood at the start of the year. China had gone through a stretch of painful and challenging period for its economy, and the tides were turning in its favour. With a potentially strong economic rebound on the back of more attractive valuations; there was a good case for a strong market recovery. Of course, a lot was based on high hopes and expectations that the economy could stage a fierce rebound. This eventually came in below the high expectations, as we know now.
The Pendulum Continues to Swing: …Extreme Pessimism
After a blistering rally of more than 20% from the bottom in October 2022, performance and sentiment took a quick turn. While the economic recovery (coming out from strict COVID-19 restrictions) has been happening, it has failed to maintain the initial strong momentum after a brief spurt.
In particular, the property sector slump has continued in what is increasingly likely to turn out to be an ‘L-shaped’ recovery – a potentially slow and prolonged period of recovery. The result is that the ‘market pendulum’ has swung from extreme optimism to pessimism today.
Bloomberg, 17 Aug 2023
Chinese Trust firm missed payments: Contagion?
The pessimism was exacerbated by recent news that a leading Chinese trust firm, Zhongrong International Trust Co., skipped payments on dozens of their investment products (which are commonly backed by real estate projects). This led to concerns that the property slump could lead to a broader contagion to other parts of the economy.
While the latest development has hit broader sentiment, initial analysis indicates that this is unlikely to lead to a larger crisis of confidence. Bloomberg Intelligence believes that ‘Zhongrong’s missed trust payments won’t lead to a financial tsunami in China’. They found that nine of the top 10 trusts are backed by strong state-owned enterprises, and with total trust assets a minor part of China’s overall financial system.
Additionally, the Chinese authorities have acted quickly to set up a task force to study and get ahead of a potentially bad situation. We will continue to monitor developments here.
China: Is There Still Hope?
One can think of China as a stalled engine that is restarting; multiple efforts are needed, with some false starts, until it really takes off.
China’s challenging situation today is also potentially its biggest advantage. As major economies in the world face headwinds in the form of tight conditions (the effects of high-interest rates are still working their way through the system!) and likely greater slowing ahead, China’s economy has gone through a recession and is now in early recovery. One such “false start” was the blistering 20% post-covid reopening rally from last October.
Source: Fidelity Q3 2023 Business Cycle Update
There has also been a marked and clear shift in tone from policymakers in China. From the tough regulatory crackdown and restrictive monetary policy from before, the government has turned more market-friendly. While it has not led yet to a meaningful revival in credit and economic growth, this will undoubtedly be supportive for the economy and corporate earnings sooner than later. This was evidenced as recently as July when China equities rallied 7% on the heels of positive announcements from the top-level politburo meeting.
Valuations are in the buy zone for patient long-term investors. As an indication, Price-to-sales for China ‘A’ is 1.1x compared to 2.3x for US equities – a large discount. Even if you are pessimistic about the current challenging situation in China, the attractive valuation continues to point towards higher returns for those who can take today’s uncertainties. When China ‘A’ markets hit such valuations before, they rallied strongly over the subsequent years.
As Howard Marks once said ‘There is no asset so good that it can’t become overpriced and thus risky, and few so bad that there’s no price at which they’re a buy (and safe).’
Outlook & Strategy
Our investment strategy is not just a passive ‘buy-and-hold’ approach. Over the past 5 years, we have made three decisive moves in China; buying when fundamentals and valuations were in our favour, and reducing when they were not:
We added to China ‘A’ equities at the start of 2020, when low valuations coupled with accommodative policies set the stage for good future performance. Back then, our investors did not have to wait long for value to be realized; China outperformed strongly that year. This paved the way for us to reduce our allocations when China’s economy started to slow.
Fast forward to April 2023, we once again increased our China ‘A’ allocations as the fundamental picture improved. Despite sufficient ‘hope’ as highlighted in the previous section, it is disappointing that prevailing sentiment has grown more negative since then. We continue to be cautiously optimistic but aware that near-term prospects remain uncertain and dynamic – we will stick to our process and adjust if current challenges and negative sentiment translate into weaker fundamentals. In the current volatile market, we are also actively on the lookout for other opportunities to further diversify our risks while maintaining a strong upside for our investors.
While we cannot rule out the possibility that this time is different, some things also do not change. Until there are better opportunities, today’s undemanding valuations and low expectations give good potential for China’s compressed coil to spring back in the coming weeks or months.
Market Flash Update – China in Focus: Challenges, Pessimism, Potential
China in Focus: Challenges, Pessimism, Potential
If You Only Have a Minute:
“I definitely think there’s too much pessimism priced in, but I also think that the bar for [China] markets to turn pessimism around is higher….”
NatWest Markets Strategist
“Bottoming out of earnings growth and clearer structural outlook, in combination with continuous stabilization of geopolitical conditions, would offer a better upgrade opportunity and attract back long-term money.” Morgan Stanley
“Valuations are reasonable, earnings are poised to grow at a mid-teens pace, and policymakers have moved in the direction of more market-friendly practices.”
JP Morgan Private Bank Mid-Year Outlook
“Zhongrong’s missed trust payments won’t lead to a financial tsunami in China.”
Bloomberg Intelligence on China’s Trust missed payments
China in Focus: Challenges, Pessimism, Potential
The Pendulum Swings: Extreme Optimism to…
A recent news headline read ‘China: Time to Worry?’. Indeed, seemingly bad news about the Chinese economy and market seems to be rolling out non-stop, with investor sentiment taking a hit.
At the start of 2023, there was widespread anticipation that the end of China’s zero-covid policy would trigger the next stage of growth for the world’s second-largest economy. After a period of lackluster performance, China equities rallied strongly from their lows in October 2022. The mood then was overwhelmingly positive – prominent asset managers such as UBS, Deutsche Bank, and Morgan Stanley all came out with positive outlooks.
CNA, 9 Jan 2023
Such news or reports reflect the positive mood at the start of the year. China had gone through a stretch of painful and challenging period for its economy, and the tides were turning in its favour. With a potentially strong economic rebound on the back of more attractive valuations; there was a good case for a strong market recovery. Of course, a lot was based on high hopes and expectations that the economy could stage a fierce rebound. This eventually came in below the high expectations, as we know now.
The Pendulum Continues to Swing: …Extreme Pessimism
After a blistering rally of more than 20% from the bottom in October 2022, performance and sentiment took a quick turn. While the economic recovery (coming out from strict COVID-19 restrictions) has been happening, it has failed to maintain the initial strong momentum after a brief spurt.
In particular, the property sector slump has continued in what is increasingly likely to turn out to be an ‘L-shaped’ recovery – a potentially slow and prolonged period of recovery. The result is that the ‘market pendulum’ has swung from extreme optimism to pessimism today.
Bloomberg, 17 Aug 2023
Chinese Trust firm missed payments: Contagion?
The pessimism was exacerbated by recent news that a leading Chinese trust firm, Zhongrong International Trust Co., skipped payments on dozens of their investment products (which are commonly backed by real estate projects). This led to concerns that the property slump could lead to a broader contagion to other parts of the economy.
While the latest development has hit broader sentiment, initial analysis indicates that this is unlikely to lead to a larger crisis of confidence. Bloomberg Intelligence believes that ‘Zhongrong’s missed trust payments won’t lead to a financial tsunami in China’. They found that nine of the top 10 trusts are backed by strong state-owned enterprises, and with total trust assets a minor part of China’s overall financial system.
Additionally, the Chinese authorities have acted quickly to set up a task force to study and get ahead of a potentially bad situation. We will continue to monitor developments here.
China: Is There Still Hope?
One can think of China as a stalled engine that is restarting; multiple efforts are needed, with some false starts, until it really takes off.
China’s challenging situation today is also potentially its biggest advantage. As major economies in the world face headwinds in the form of tight conditions (the effects of high-interest rates are still working their way through the system!) and likely greater slowing ahead, China’s economy has gone through a recession and is now in early recovery. One such “false start” was the blistering 20% post-covid reopening rally from last October.
Source: Fidelity Q3 2023 Business Cycle Update
There has also been a marked and clear shift in tone from policymakers in China. From the tough regulatory crackdown and restrictive monetary policy from before, the government has turned more market-friendly. While it has not led yet to a meaningful revival in credit and economic growth, this will undoubtedly be supportive for the economy and corporate earnings sooner than later. This was evidenced as recently as July when China equities rallied 7% on the heels of positive announcements from the top-level politburo meeting.
Valuations are in the buy zone for patient long-term investors. As an indication, Price-to-sales for China ‘A’ is 1.1x compared to 2.3x for US equities – a large discount. Even if you are pessimistic about the current challenging situation in China, the attractive valuation continues to point towards higher returns for those who can take today’s uncertainties. When China ‘A’ markets hit such valuations before, they rallied strongly over the subsequent years.
As Howard Marks once said ‘There is no asset so good that it can’t become overpriced and thus risky, and few so bad that there’s no price at which they’re a buy (and safe).’
Outlook & Strategy
Our investment strategy is not just a passive ‘buy-and-hold’ approach. Over the past 5 years, we have made three decisive moves in China; buying when fundamentals and valuations were in our favour, and reducing when they were not:
We added to China ‘A’ equities at the start of 2020, when low valuations coupled with accommodative policies set the stage for good future performance. Back then, our investors did not have to wait long for value to be realized; China outperformed strongly that year. This paved the way for us to reduce our allocations when China’s economy started to slow.
Fast forward to April 2023, we once again increased our China ‘A’ allocations as the fundamental picture improved. Despite sufficient ‘hope’ as highlighted in the previous section, it is disappointing that prevailing sentiment has grown more negative since then. We continue to be cautiously optimistic but aware that near-term prospects remain uncertain and dynamic – we will stick to our process and adjust if current challenges and negative sentiment translate into weaker fundamentals. In the current volatile market, we are also actively on the lookout for other opportunities to further diversify our risks while maintaining a strong upside for our investors.
While we cannot rule out the possibility that this time is different, some things also do not change. Until there are better opportunities, today’s undemanding valuations and low expectations give good potential for China’s compressed coil to spring back in the coming weeks or months.