Economic Commentary

Why have investors soured on China?

At the turn of the year, investors were optimistic that a relaxation of covid restrictions would power a strong reopening recovery in China, which in turn would fuel a sustained rise in Chinese equity markets. Things have not exactly turned out that way. Sure enough, the initial rally in Chinese equities was impressive: for example, the iShares MSCI China Exchange Traded Fund (ETF) started the year strongly, and by the end of January was up around 50% from the October 2022 lows. However, it has since fallen back, and is now down around 17% from the January highs and has dropped 5% since the start of the year1.

What has gone wrong?

Technical analysts might argue that after such exuberance over the winter, a subsequent pull-back was inevitable. However, there have also been more fundamental factors behind the souring of sentiment.

US-China tensions

There is little doubt that the deterioration in relations between Washington and Beijing has made investors wary of investing in China. It is perhaps no coincidence that Chinese equity markets peaked around about the time that an alleged Chinese spy balloon was spotted over North American airspace and subsequently shot down by the U.S. Air Force. In addition, disagreements over issues ranging from the war in Ukraine, the disputed island of Taiwan and the export of high-tech goods have continued to strain relations between the two governments.

With Washington wary that Chinese access to cutting-edge technologies might raise a potential threat to national security, the US-China tech war has escalated and broadened. In the most recent broadside, Beijing announced curbs on the export of germanium and gallium, two materials used in the production of silicon chips. The US-China tech war is the latest headwind to face Chinese tech companies, with Beijing having waged a crackdown on the tech sector (as well as others, such as consulting businesses) for much of the last three years. Perhaps unsurprisingly, Chinese tech companies have not seen their shares attract the same degree of interest as their counterparts in the US, where euphoria over artificial intelligence (or AI) has fueled sharp gains in recent months.

Disappointing growth

Disappointing economic activity has also been a factor weighing on Chinese equities, as foreign demand for Chinese goods has ebbed and the reopening resurgence in consumer spending following the lifting of covid restrictions has fallen short of expectations. GDP bounced back sharply during the first quarter, rising 2.2% q/q, but growth has subsequently lost momentum, expanding by a relatively lackluster 0.8% q/q during the second quarter2.

Part of the problem has been depressed consumer confidence. Chinese household incomes were hit harder during the pandemic than in many developed economies, and lingering concerns about the economic outlook have made consumers wary of running down any excess savings balances that were built up during lockdown. A recent survey from the People’s Bank of China (PBOC) showed that the proportion of households that preferred to save their money rather than spend it rose to 58.3% - the highest in the survey’s 21-year history3.

As a result, although measures of mobility and domestic tourist activity have rebounded following the easing of covid restrictions, consumers are spending less on each trip. For example, the number of trips during this year’s 5-day bank holiday in May was up 19% from 2019 (i.e. pre-covid) levels, but spending was up only 0.7% over the same period4.

The precarious jobs situation, particularly for young people, is one reason consumers are being cautious about splashing out. Reflecting a structural mismatch in the labour market (notably not enough graduate jobs for the swelling numbers of university leavers), the unemployment rate among 16 to 24 year olds rose to a record 21.3% in June.

For older, wealthier households, the ongoing malaise in the real estate sector is weighing on sentiment. Although government support measures have served to stabilize activity in some regions, the fall in home prices from their 2021 highs have exerted a negative wealth effect (whereby declines in household wealth depress spending) on homeowners. With some estimates suggesting that property makes up around 70% of Chinese households’ wealth, house prices can exert an outsized influence on consumer confidence5.

In marked contrast to trends in most Western economies, lackluster demand in China is contributing to below-target inflation and raising fears about deflation. Chinese consumer prices were unchanged during the year to June, while the producer price index (PPI) was down 5.4% y/y, as prices for energy, chemicals and metals declined6. In turn, soft demand and falling prices have depressed margins, squeezing the profits of Chinese industrial companies. During the first five months of the year, industrial profits fell 18.8% y/y, and in May were down 12.6% y/y7.

Piecemeal policy response

Faced with such sub-par economic data, investors have been disappointed by the policy response from Beijing. To be sure, there has been a series of targeted stimulus measures put in place in recent months, including VAT exemptions for small businesses, credit support for property developers, tax breaks for electric vehicle purchases and some easing of monetary policy.

However, there is growing concern in some quarters that the authorities are not doing enough to avoid a potentially damaging period of deflation. For example, despite the disappointing real economy data and the plunge in inflation, key policy interest rates were cut by just 10 basis points in June; the People’s Bank of China (PBOC) cut the loan prime rate to 3.55% last month, the first reduction since August 20228.

Concerns about high debt levels and the potential for aggressive monetary easing to put downward pressure on the Renminbi (China’s currency) suggest Beijing will continue to be wary of introducing a large, broad-based stimulus package. However, pressure for greater support is growing, and the expectation is that some new initiatives will be announced at the politburo meeting scheduled to take place later in July.

Rather than resort to the traditional playbook of ramping up investment in infrastructure, investors would like to see measures that encourage consumer spending, which in turn would help rebalance the economy. Interest rate cuts and looser fiscal policy could help in the short term. But ultimately, such rebalancing would require deeper reforms, such as an improvement in social security provision (unemployment benefit, pensions etc.) which could incentivise households to reduce precautionary savings balances and feel more confident about spending.

Amidst indications that Beijing is prioritising national security issues over economic growth, the general expectation is that any forthcoming policy initiatives will be modest. The same can probably be said regarding the political/geopolitical environment. Relations between Beijing and Washington are likely to remain strained, but following recent visits to China from US Secretary of State Antony Blinken and Treasury Secretary Janet Yellen, high-level communication channels between the two superpowers have at least been re-established. On the domestic front, signs that Beijing’s crackdown on the tech sector is coming to an end following a declaration of support from Premier Li Qiang to senior industry executives has also helped lift Chinese markets in recent days9.

Whether such piecemeal improvements in the economic/political backdrop will be enough to lure investors back to Chinese equities remains to be seen. However, after the recent period of underperformance, the negativity towards the Chinese market is now reflected in comparatively low valuations. For example, the trailing price/earnings (P/E) ratio (which measures the share price divided by the latest fiscal year’s earnings per share) of the iShares MSCI China ETF, stands at 1310, considerably lower than the P/E ratio on the equivalent US ETF of 22.511. Given this gap in valuations, any improvement at the margin might be sufficient to usher in a better relative performance from the Chinese market going forward.

18 July 2023