China Outlook 2024: Bear with it

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.

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.

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. 

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.

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.

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.

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.

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 24^th 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 22^nd 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 5^th 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 23^rd 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.

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.