Author: Asia Investment Strategy Team
As we enter the year of the dragon after a challenging period, China’s post-reopening optimism of a year ago feels like a distant memory. The picture for 2024, however, is not all gloom. Policymakers have been more vocal – with headline after headline of potential market support measures coming off the press in the first month of the year. Despite the stock market’s slipping sentiment and persistent problems with the property market, certain segments of the Chinese economy have also proved their resilience. Nonetheless, a lack of confidence is pervasive and policy will likely need to be more forcefully supportive to stem a deflationary spiral. To help you navigate China’s winding path forward, we take a close look at the key areas of interest for the Chinese economy and equity markets.
Why did 2023 not play out as expected?
2023 was a difficult year for the Chinese economy. As the country emerged from COVID lockdowns, many businesses, particularly in the services sector, saw an immediate boom. But soon the reopening bounce faded and the property market turmoil worsened. Over the summer, one of China’s largest private sector developers, Country Garden, fell into distress – and this in turn shook business and investor confidence. The worsening property market spilled over into consumer sentiment and strained local government finances. From there it was a race to ring-fence local government debt risks and reform the financial system. Along the way, policymakers delivered some modest easing, such as policy rate cuts and fiscal support, which helped to cushion the economy but did not drive economic activity higher.
China’s change in growth expectations diverged significantly from the U.S. in 2023
Change in consensus 2023 GDP growth expectations from October 2022, %
The line chart compares the changes in consensuses 2023 GDP growth expectations for China and the United states in percentage terms, represented by the orange and blue lines respectively. The timeline of the of the chart shows the expectations starting in October 2022 until December 2023. The chart initially illustrates negative GDP growth for China and the United States in 4Q 2022, due to COVID Restrictions and recessions expectations for the two nations. For the US, however, expectations turned positive after consensus view changed to a soft-landing following resilient growth in the US in 2023. Expectations for China also turned positive after the country re-opened in early 2023. However, China GDP growth expectations fell after weak sentiment in the second half of 2023.
Heading into 2024, there are well-flagged headwinds, but questions still remain about what comes next. While policy goals and details are becoming clearer, there are significant uncertainties regarding implementation and effectiveness. In our view there are three key elements that could hold the balance of risks for growth in 2024. We will present both the bull and bear cases and our view around them.
Property
First is the housing market. This is arguably still a key barometer of confidence, both for the economy as well as the markets. Although the housing slowdown is going into its third year, organic demand looks some way away from bottoming, while price expectations have turned more bearish. In the first two weeks of the year housing sales were at roughly half of last year’s level, which is a poor start. Households are still not confident that developers, given their financial difficulties, could deliver completed housing units. The cumulative difference between properties sold and properties finished highlights the extent of the issue.
China property sales have far exceeded completions
Sales vs completions, million square meters
This line chart compares Chinese real estate cumulative sales against cumulative housing completions from 2005 to 2023 in million square meters. The dark blue line represents cumulative completions, and the aqua line represents cumulative sales. In the near 20-year time frame, cumulative completions has dragged cumulative sales by an ever-increasing spread. The flattening of the curve for cumulative sales starting in 2021, during the ongoing Chinese property crisis, reflects the slowdown in cumulative sales and decrease in consumer confidence around Chinese real estate.
This is causing sales to further weaken and weaker sales to further exacerbate developer pressures, creating a downward spiral. This is evidenced in the collapse of presales, while sales of existing units have remained stable.
There are several programs being rolled out to support the property sector. In late 2023, the government proposed to expand some major urbanization projects, including the redevelopment of so-called ‘urban villages’, which are clusters of self-built residential constructs in mega cities. Details are light and implementation is still at a very early stage given complex land rights and local differences, which means there is considerable uncertainty as to what the impact could truly look like.
Bull case: The proposal appears that it will go ahead, given the high priority of stemming the property downturn. For example, the People’s Bank of China (PBOC) has already identified a major policy tool that may be used for financing. Once it is more fully rolled out, the urban renewal project could translate into up to 10% of annual sales, assuming a 10-year implementation timeline. That means a full roll out could help to bring about a stabilization in housing sales in 2024.
Bear case: While growing public sector construction through expanding social housing and renovating rundown urban areas could help offset some of the downturn in property investment, such programs do not directly address the reasons for the loss of confidence in developer presales. It is positive on a macro level, but not one that necessarily resolves the current micro issue, which is a lack of confidence that developers can complete purchased homes and that house prices will not continue to fall. In the event this program is underwhelming and/or purchasers confidence remains weak, property prices and sales could continue to contract, weighing on household sentiment and the broader sector.
Our view: Without further measures, this announced policy is probably not enough to address unfinished units and developers’ financial health.
Housing slowdown continues into its third year
Housing sales, 12-month moving average (12mma)
This line chart features both the housing sales value and housing sales volume on a 12-month moving average basis for the Chinese real estate market. The dark blue lines shows housing sale volume in million square meters while the aqua line shows housing sale value in billion yuan. The diagram’s inception date is 2004 and shows both lines trending upwards with notable declines in 2008, 2012, 2014, and 2020. The trend lines reversed directions sharply in 2021 after the onset of the Chinese property crisis. At the end of 2023, average housing sales is approximately at 800 million yuan while average housing sakes volume is estimated to be at 80 million square meters.
Exports
The second element is exports. The cyclical challenge is well-understood given consensus expectations for slower growth in developed markets, and particularly the U.S. Global supply chain diversification is a more structural concern. Both have resulted in falling export prices in 2H 2023 amid concerns about over-capacity.
Bull case: Export prices have since stabilized, suggesting businesses have already adjusted and the export outlook could improve. Emerging sectors like electric vehicles (EVs) have expanded quickly and is becoming a driver of overseas exports. China’s dominant role in many high-tech supply chains makes supply chain diversification and “de-risking” more of a buzzword than reality.
Bear case: The rapid growth of EV exports and overall dramatic expansion in manufacturing capacity provided support to the economy during the housing downturn, but the surge in exports and growing attention to issues of overcapacity is beginning to spark pushbacks in global capitals. Trade tensions could result, leading to renewed pressures on China’s export and manufacturing industries.
China has quickly become one of the biggest car exporters globally
Passenger car exports, million units, rolling 12-month sum
This line chat shows units of passenger car exports on a 12-month rolling basis of Japan, China, South Korea, Germany and the US. The dark blue line represents Japan. The light red line represents China. The dark purple line represents South Korea. The aqua line represents Germany. The light purple line represents the US. The time series of the graph starts in 2012 and ends in 2023. This graph shows that Chinese passenger car export remained mostly constant in the past decade and remained at 1 unit. Chinese export rapidly accelerated in the second half of 2020 and has maintained its accelerated growth. Chinese passenger car exports have grown since 1 unit in 2020 to 4 units at the end of 2023, outpacing South Korea, Germany and the US.
Our view: China’s crucial role as a global manufacturer is unlikely to abate, and cyclical demand for exports could remain healthy. Deglobalization and de-risking are often pointed to as risks, but the data shows that supply chains are simply lengthening with China’s role still intact, and much of the discussed investments flowing into Indonesia and Vietnam are in fact Chinese manufacturers extending their own supply chains. Autos is a highly politically sensitive industry so there is a chance of trade frictions, but it is unlikely to happen quickly, and it will likely be limited to just a few countries, as most of the emerging world lacks an auto sector and are happy to import attractively priced Chinese EVs.
Sentiment
The last element is business sentiment. Given the increase in regulations over the last few years, private sector investment has slowed dramatically. While there is a cyclical element to it, government policies also matter for confidence in the corporate sector.
Business investment has slowed significantly
Fixed asset investment growth and investment by private enterprises, YoY %
This line graph shows fixed asset investment growth and investment by private enterprise’s YoY growth from 2012 and 2023. Fixed asset investment growth is represented by the dark blue line while investment by private enterprise is shown as the orange line. Observing the trend lines, both fixed asset investment and investment by private enterprise’s growth rates have on average slowed from 2012 to 2019. Investment growth felly sharply in 2019 to approximately -25% YoY. Due to the low basis in 2019, 2020 saw strong YoY growth in investments. After the sharp decrease and increase in 2019 and 2020, both fixed asset investment growth and private enterprise investment growth resumed to their slowing paces. By December 2023, fixed asset investment growth is approximately 5% YoY while private enterprise investment is approximately -5% YoY.
Bull case: In recent weeks we saw some mixed signals, but a more clear and predictable regulatory environment will be a key factor towards stabilizing business investment.
In 2023, policymakers delivered a modest amount of monetary and fiscal easing. We expect that monetary policy easing could continue in 2024, and could quicken if the U.S. eases monetary policy, as currently expected by the markets. Fiscal policies could do more heavy lifting – particularly in coordination with other government agencies – towards stabilizing the housing market. A less turbulent housing market combined with more regulatory clarity could hold the key to a more lasting positive economic outlook.
Bear Case: Piecemeal stimulus and policy support for the housing market risks entrenching deflation and exacerbating the downward confidence spiral. Policy could keep growth from cyclically worsening, but in the absence of more forceful stimulus and a plan to restore health to the property sector, growth could remain muted. Amid all the attention to property and stimulus policies, overall government priorities have focused on security and self-reliance at the expense of growth and economic reforms, risking a continued sluggish outlook.
China is experiencing some of the worst deflation since the Global Financial Crisis
GDP deflator, YoY%
This line graph shows fixed asset investment growth and investment by private enterprise’s YoY growth from 2012 and 2023. Fixed asset investment growth is represented by the dark blue line while investment by private enterprise is shown as the orange line. Observing the trend lines, both fixed asset investment and investment by private enterprise’s growth rates have on average slowed from 2012 to 2019. Investment growth felly sharply in 2019 to approximately -25% YoY. Due to the low basis in 2019, 2020 saw strong YoY growth in investments. After the sharp decrease and increase in 2019 and 2020, both fixed asset investment growth and private enterprise investment growth resumed to their slowing paces. By December 2023, fixed asset investment growth is approximately 5% YoY while private enterprise investment is approximately -5% YoY.
Our view: This argument is challenging to have a view on. In the near term it appears policymakers have a newfound urgency to restore confidence. On the other hand it is not clear policies will be effective since confidence is a tricky thing to estimate. We think the risks are evenly balanced in both directions.
Overall, 2024 looks to be another broadly challenging year for China’s economy with noticeable variation in outlooks across various sectors. A key overarching theme is the hope for more substantial stimulus to revive animal spirits and restore confidence, but the scope and effectiveness of those measures remain uncertain. So what does this outlook mean for investors?
FX: hedge weakness and use in carry trades
Starting with the currency, we maintain the view to hedge long exposure to the Chinese Yuan (CNH), or use it as a funding currency, for a few reasons. Firstly, CNH currently has a lower interest rate than many major currencies – and rate differentials can potentially further widen given the PBOC is firmly in an easing cycle in contrast with the rest of the world. Investors can thus enjoy lower borrowing costs or hedging with a positive carry.
You are paid to long almost all majors against CNH
1-year carry vs CNH
This line graph exhibits China’s GDP deflator data on a YoY basis from 2005 to 2023. GDP deflator data has fluctuated annually in China since 2005 but it has mostly been in positive territory except a few occasions. The first incident was in 2009 during the Global Financial Crisis, when GDP deflator approach -2% The second occasion was in 2015, when GDP deflator fell year-over-year to negative territory. The third occasion was in 2020, when the GDP deflator fell slightly beneath 0. The most recent time was 2023, when the GDP deflator fell to the lowest level since the Global Financial crisis and approached -2% again.
Secondly, balance of payment pressures remain as export growth could slow and/or outbound tourism flows could pick up. Last but not the least, geopolitical risks are lingering given the busy global elections calendar in 2024, which could continue to weigh on the currency. On seasonality, CNH usually trades strongly into Chinese New Year, benefiting from exporter conversion flows that could be a good window for investors to establish positions.
Equities
Policy action is becoming more assertive
With Chinese equity markets hitting new lows, authorities have turned more aggressive with support measures. Some examples:
- On 24th January the PBOC lowered the reserve requirement ratio (RRR) by a surprise 50bps, estimated to release RMB1tn of liquidity into the market.
- The National Press and Publication Administration’s (NPPA) draft rules that were announced on 22nd December – with potential negative implications for mobile games in China – were removed from their website after market backlash. It is relatively rare for draft rules to be removed, increasing speculation that a less restrictive set of rules could be released.
However, the market is still hoping to see more macro stimulus, like expanded fiscal spending and coordinated efforts to resolve the property downturn. The “Two Sessions” set of government meetings, scheduled to begin on 5th March, is a key event to monitor on that front.
There are also some earnings risks ahead. Currently, consensus is still looking for 13% / 16% EPS growth for MSCI China in 2024E / 25E , which is optimistic (vs. our 10-11% for both years). Given consensus expectations have not fallen in the past few months, we think there could be some misses in the upcoming March reporting season, capping near-term market upside. Margin and sales growth will likely continue the recovery trend, but the pace could also be slower than expected.
Is the rumored market rescue package a game changer?
On 23rd January, Bloomberg reported that Chinese authorities are considering a USD319bn package of measures to stabilize the slumping A-share markets. The funds would supposedly come from offshore accounts of China State-Owned Enterprises (SOEs) amounting to RMB2tn (~USD278bn). So-called ‘National Team’ corporations like China Securities Finance Corp or Central Huijin Investment would reportedly provide an additional RMB300bn (~USD41bn) of funding from the onshore market.
We believe that the package itself is not a game changer, but it could mark the bottom of market sentiment.
Firstly, we are unsure if offshore Chinese SOEs have RMB2tn of free cash flow to invest into the A-share market. RMB2tn is a significant amount, representing 3.3% of total A-share market cap, or 7.7% of free float A-share market cap. It also represents 2.3x of the onshore market’s 1-year average daily turnover.
Based on our rough estimates, the largest 50 HK-listed Chinese SOEs have ~RMB13tn of cash on hand as of end-June 2023. About 80% of this balance is held by Chinese banks, which are reluctant to hold equity investments as they are punitive to their capital. For the remaining RMB2.4tn held by non-bank SOEs, the are in onshore RMB deposits. In other words, in order to fulfill this package they could use the onshore deposits but it would drain their cash and these companies would have to set aside their capex/dividend plans for this rescue package. It makes the plan look unlikely.
If this package is confirmed, its scale is significant (bigger than a similar 2015 rescue package equivalent to ~8% of free float market cap) and it could provide sentiment support to both onshore and offshore equity markets.
A tactical trading opportunity
We expect offshore and onshore equity markets to stabilize around current levels (Hang Seng Index ~15,000, CSI300 ~3,200), but it is probably too early to call a turnaround. Investors have been hurt many times in the past year, and would tend to take profit first whenever there are rebounds. Foreign investors also have a significant overhang of underwater positions in China given the large inflows in the past few years.
Cumulative foreign equity flows since Q1 2020
USD billions
The bar chart shows the cumulative foreign equity flows since Q1 2020 for Japan, China and India in USD billions. China experienced the highest cumulative foreign equity flows of USD 136bn compared to Japan and India which only has USD 57bn and USD 11bn respectively. This shows that foreign investors continue to have a significant overhang of underwater positions in China given the large inflows in the past few years since Q1 2020.
We could see a tactical bounce driven by short covering and closing of underweight positions, while distressed valuations (P/E and P/B ratios below 1 standard deviation and close to 10-year lows) could limit downside risk. Until a more comprehensive stimulus plan that rejuvenates broad demand and confidence and/or a comprehensive plan to deal with the challenges in the property market is implemented, China remains a trading market.
MSCI China historical price-to-earnings ratio
Next twelve months (NTM) P/E Ratio
The line chart shows the consensus next twelve months price-to-earnings (NTM P/E) ratio for the MSCI China Index over a 10-year period from 2014 to 2024. The 10-year average for MSCI China Index’s NTM P/E ratio is at 11.3x with a +1 standard deviation of 13.3x and -1 standard deviation of 9.6x. The shaded area represents the price movements of MSCI China Index over the same period, which moves closely in line with its’ NTM P/E ratio. Both NTM P/E ratio and share price of MSCI China was on an upward trend, albeit with some volatilities in between from 2014 to 2021. NTM P/E and price level starting values in Jan 2014 were 8.4x and 61.1 which saw a general increase before they hit a peak in Feb 2021 with NTM P/E at 18.8x and 122.9 for price level. This was followed by a sharp decline for both indicators where they fell from their peaks in Feb 2021 to 8.2x and 48.3 for NTM P/E ratio and price level in Oct 2022 due to China’s zero-Covid policy. NTM P/E ratio and price level of MSCI China then rebounded and increased to 11.8x and 69.4 respectively amid optimism on China’s reopening. However, that did not last for long as NTM P/E ratio and price level of MSCI China fell and was on a downward trend since Jan-23 due to harsh regulatory crackdowns and disappointing macroeconomic performance. Both price and NTM P/E has fell to their current levels of 53.3 and 8.6x, with NTM P/E ratio below is -1 standard deviation of 9.2x.
CSI 300 historical price-to-earnings ratio
Next twelve months (NTM) P/E Ratio
The line chart shows the consensus next twelve months price-to-earnings (NTM P/E) ratio for the CSI 300 Index over a 10-year period from 2014 to 2024. The 10-year average for CSI 300 Index’s NTM P/E ratio is at 12.2x with a +1 standard deviation of 14.0x and -1 standard deviation of 10.3x. The shaded area represents the price movements of CSI 300 Index over the same period, which moves closely in line with its’ NTM P/E ratio. The starting values of CSI 300 Index’s NTM P/E ratio and share price level was at 8.4x and 2178 respectively in Jan 2014. There was a sharp spike from Jan 2014 to June 2015 where consensus NTM P/E ratio hit a 10-year high of 18.1x and CSI 300 price level reached 5335. However, the trend quickly reversed with both NTM P/E and price level falling to 11.2x and 3340 in Oct 2015. CSI 300 NTM P/E ratio and price level were range-bound from Oct 2015 to May 2020, with NTM P/E ratio hovering around its’ 10-year historical average of 12.2x. This was followed by a sharp increase from May 2020 to February 2021 when both NTM P/E ratio and price level hit their peak values of 17.1x and 5807. However, after this episode, the consensus NTM P/E ratio and price level has been on a downtrend trend with the NTM P/E ratio and price level at 9.9x and 3300 as of January 2024. Consensus NTM P/E ratio of 9.9x is trading below its -1 standard deviation of 10.3x as of January 2024.
For a short-term tactical trade, we expect offshore to outperform onshore, given its higher beta nature and more oversold conditions. Depending on existing positions and risk tolerances, we propose the following strategies:
- Tactical upside: For investors hoping to enter tactical trades or add beta, we are constructive on high-quality blue chips that are beaten down, but could recover strongly when the market turns.
- Defensive positioning: For investors who prefer to stay on the sidelines to wait for more clarity, consider solid companies with strong balance sheets and stable dividend payouts. SOEs could also be a safe haven that can structurally benefit from reform policies in the long-run.
From a broad portfolio perspective we advocate a neutral positioning to China, or around 4-5% of an equity allocation. We continue to advocate for global diversification for investors with a significant overweight or home bias. Structured products could also be an attractive way to create more predictable exposure to this market.
All market and economic data as of February 05, 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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Index Definitions
Hang Seng Index: is a free float-adjusted market-capitalization-weighted stock-market index in Hong Kong. It is used to record and monitor daily changes of the largest companies of the Hong Kong stock market and is the main indicator of the overall market performance in Hong Kong.
CSI 300 Index: A capitalization-weighted stock market index designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange.
MSCI China Index: Captures large and mid-cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 712 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.
