Investment Strategy

How do the lockdowns impact our view on China?

Apr 28, 2022

Cross Asset Strategy 

As the rates move year-to-date has been driven by a hawkish Fed and elevated inflation (rather than better growth), it might increasingly weigh on the equity market, which could in turn remain volatile in the short-term. But multi-asset investors can still find opportunities: the equity market is trading at an average price-to-earnings multiple for the first time since before the pandemic, and while the yield gap might appear low, higher inflation can actually create a stronger incentive to own equities. Long-term investors can feel comfortable about buying equities at an average multiple when we have a constructive view of corporate earnings. Critically, bonds have offered protection, in contrast to the last three weeks when U.S. equities and Treasuries sold off side-by-side. The risk-off tone has seen a significant rally back in sovereign bonds, not least since markets are now assuming that central banks won’t move quite as aggressively as they were expecting to at the end of last week. As we move into late cycle we have been stressing the opportunity of adding core fixed income, given the current levels of yields and credit spreads. Within equities we remain selective and focused on defensive parts of the market including healthcare and high-dividend payers.  

Strategy Question: How do the lockdowns impact our view on China?

A lot has happened in China over recent weeks. Omicron swept across the country and multiple regions re-imposed mobility restrictions, including the strict lockdown in Shanghai that has resulted in significant supply chain disruptions. In addition, authorities released a flurry of new support measures, though the market appears to have deemed them insufficient – equities have continued to sell off and the RMB weakened sharply. In today’s note we will unpack these developments and discuss our take on Chinese assets.

Gauging the lockdown impact

Now into the third year of the pandemic, this wave is shaping up to be the most significant to China since the initial outbreak in 2020.  Disruption is being seen not only in consumption and services, but also in production.

On the consumption side, March monthly retail sales contracted for the first time since 2020, with broad-based weakness across discretionary spending and services. Unemployment has continued to tick up, but so far the impact on incomes is minimal. Nonetheless, if the trend continues it will likely generate a second leg impact on consumption.  The March data reflected the impact of early lockdowns in Guangdong and Jilin, and we expect further weakness in Q2 when the full extent of expanded lockdowns in April are reflected in the new figures.

On the production side (where more high frequency data is available) disruptions started to surface in March and sharply escalated when Shanghai entered a full lockdown. As shown in the chart below, after a full bounce-back from the Lunar New Year break and the week-long lockdown in Shenzhen/Guangzhou, nationwide truck freight volume tumbled 30% at the end of March, and volume in Shanghai dropped 80%. This implies that logistics on a national level are taking a significant hit given Shanghai’s crucial role in the supply chain. Industries with complex supplier networks in the region are seeing disruption or suspension of production, predominantly in electronics and automobiles. Shanghai itself accounts for 40% of China’s chip production and 11% of auto production. The gross impact could be even larger when taking into account factory shutdowns in neighboring cities including Kunshan, which is a key production hub. The China Passenger Car Association (CPCA) projected a 30% year on year drop in auto production in April. The disruptions in factory output and logistics could also have significant ramifications for exports, adding to existing challenges including a slowdown in external demand.

We think the cumulative lockdowns could lead to a 0.5ppt drag on full-year GDP, based on the assumption of a four-week lockdown in Shanghai. Our GDP forecast of 4.5%* accounted for downsides from China’s Zero COVID policy (assuming rolling lockdowns), so we maintain this forecast for the time being. However, as Shanghai enters its fourth week of lockdown with no clear indication of a reopening date – and with the possibility of more restrictions in other major cities such as Beijing – risks are skewed to the downside.

Are the announced stimulus measures enough?

In response to the rapidly deteriorating economic backdrop, authorities announced a flurry of new support measures. The PBOC delivered a 25bps cut to the Required Reserve Ratio (RRR) with an extra 25bps for a small number of rural banks, and urged small and medium-sized banks to lower the deposit rate ceiling by 10 bps. The central bank also announced a policy basket with 23 new relief measures, including a step-up in the use of re-lending programs, which are expected to drive RMB1 trillion ($157bn) of new bank loans to targeted sectors. On the fiscal front, local government bond issuance has been accelerating, paving the way for an increase in infrastructure investment. In the housing sector, city-level restrictions have been easing and mortgage rates are declining. Nonetheless, substantial weakness persists in property, and it’s unlikely these measures will be enough to turn around flagging confidence in the sector.

We recognize that policies are turning more supportive and that there will likely be more to come on the horizon. But it is not immediately clear how much “boost” the policies can bring to the real economy given the difficulty of translating policy into improved sentiment (i.e. the extent bank liquidity can translate into business capex and household consumption). The more proactive fiscal policies may end up doing more of the heavy lifting. Infrastructure investment has indeed rebounded in the first three months of the year. We will continue to watch this space to gauge the policy impact. We will likely continue to see some downward pressures on growth in the near term given 1) the restrictive policies in place to deal with COVID, and 2) a continually slowing housing sector.

Investment implications

For investors, we are still selective towards risk assets in China despite the amount of weakness already in the price. With the Hang Seng Index/CSI300 trading at 9x/ 11.7x forward P/E, valuations are close to distressed levels and clearly the equity markets (both onshore and offshore) have priced in a lot of pessimism. This is not unreasonable given the uncertainty around China’s Zero COVID policy and the virus’ further spread to other Chinese cities. Supply chain disruptions, lockdown-induced consumption slowdowns, and imported inflation from higher commodity prices and RMB depreciation, could add margin pressure to Chinese corporates. That is why we see further downside risks to corporate earnings in Q2, before rebounding in Q3 2022. This explains why we maintain a relatively cautious near-term view on China equities.

As a key tool to revive growth, the infrastructure sector is expected to receive even stronger policy support in the RMB2.3trn stimulus package. President Xi, for example, just made a commitment that “all-out efforts must be made to spur infrastructure spending”. Instead of traditional infrastructure like roads or high-speed railways, a stronger focus is expected on “New Infrastructure”, including high-speed internet, new energy vehicles (NEVs), and artificial intelligence. We may also see commitments to facilities which can help to upgrade China’s industrial automation, such as industrial parks for new startups, R&D centers and vocational schools. We favor onshore A-shares over offshore given their higher sensitivity to policy support.

Past weeks also saw the RMB sharply depreciate against the dollar. Looking ahead, the drivers behind RMB strength over the past two years are fading. Export growth will likely slow, and strong portfolio inflows are turning into outflows as U.S. Treasury yields crossed over those of Chinese Government Bonds. This trend of weakness could continue. Despite a strong current account surplus, similar to 2015-2016, depreciation could be driven by capital outflows. A slowing growth outlook, reduced yield buffer, slowing property market, and less global confidence in China as an investment destination, point to continued outflow pressures. Policymakers will likely want to smooth out this process, but tolerance for gradual depreciation may remain part of the policy toolkit to support growth in coming months, especially given that the RMB still sits at strong levels versus the CFETS basket. We have been recommending that clients with RMB hedging needs to do so. As we see risks of further depreciation we have been recommending switching out of CNH-denominated bonds and direct long FX exposure.

 *Note: PB outlook figures shown are the midpoint of our view with a range of +/-10 basis points.

All market and economic data as of April 28, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

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Index definition:

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

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The CFETS RMB Index mainly refers to CFETS (China Foreign Exchange Trade System) currency basket, including CNY versus FX currency pair listed on CFETS. The sample currency weight is calculated by international trade weight with adjustments of re-export trade factors.

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