China’s situation in 2022 was eerily similar to that of 2021, with its markets on track to become one of the worst-performers among the major economies for the second year running.
Much of the world has gone on to fully re-open but China has vehemently stuck to its zero-Covid policy (ZCP) and it is in its third year of lockdowns and extensive testing.
The government has changed its tone and shifted to a ‘dynamic’ ZCP. But despite the ‘dynamic’ buzzword, not much has changed for the Chinese people. In fact China recently implemented its most significant lockdowns since the 2020 Wuhan outbreak. Shanghai, a metropolis of more than 25 million people, was locked down for more than a month.
Economic activity was disrupted significantly as Shanghai is China’s largest economic zone accounting for more than 4% of economic output. The ramifications were far-reaching as other economic zones in China lost access to crucial value-added parts from Shanghai.
The situation highlighted the fragility of the ecosystem involving industries such as technology, healthcare, automation and automotives.
Although the lockdowns were subsequently lifted in June 2022, the damage had been done as China’s GDP contracted for the first time since the beginning of the pandemic.
As a result, China is unlikely to meet the official GDP growth target of 5%, which in recent months has been greatly de-emphasised in the country. Lockdowns across different provinces and cities were common in 2022, pressuring all aspects of the economy like consumption and manufacturing.
Perhaps the only bright spot was the export sector, but its growth is quickly losing momentum due to a slowing global economy.
The property sector also provided a moment of déjà vu in 2022. In 2021, the sector faced a triple challenge of slowing pre-sales, bond defaults and a downturn in share prices. A similar story was repeated in 2022, although the decline in pre-sales did slow thanks to a low base effect.
There were some key changes this year as the government, which had seemingly refrained from rescuing the market, has finally shown a change in stance. In the last quarter of 2022, the government announced a series of financing measures and support for the property sector.
Although these measures were generally narrower in focus (e.g., targeting only developers which had not defaulted) relative to the past, they were still seen as important steps with the government seemingly recognising the importance of the property sector within the economy.
The latest measures were also considered much more resolute compared to actions undertaken in 2021.
Focus on consolidated sectors, investments with ‘Chinese characteristics’
Much of the world’s recent experience with innovative technology has been a bumpy one. In 2020, investors were seemingly willing to forgive companies with no earnings, but in 2022 they appear to have reversed their approach.
The situation is no different in China. We view companies with high valuations and sporadic earnings with caution. Technology companies in China are generally profitable and do not have significant cashflow issues that some US start-ups face. But the valuations of Chinese technology companies can be high, and they face more regulatory uncertainties.
The software internet sector faces domestic regulatory issues while the hardware sector grapples with geopolitical uncertainties. However, we see significant upside opportunities in many sub-sectors after two years of significant corrections, and an earnings recovery could be on the horizon.
The rationale supporting these sectors – namely domestic substitution trends and the difficulty in replacing China as a main manufacturing base globally for technology hardware – has remained unchanged for the past three years.
Many consolidated industrial sub-sectors also exist which present very interesting opportunities for investors if the macroeconomic environment improves. We like the logistics, transportation, automation, light industries and materials components sectors.
Environmental, social and governance: Is decarbonisation taking a back seat?
Sectors that were popular in 2021 and early 2022 – such as renewables, electric vehicles (EVs) and those linked to environmental plays – have suffered a setback due to factors such as oversupply and geopolitical sanctions (solar panels manufactured in Xinjiang have come under scrutiny).
In addition, these sectors have also suffered as the pursuit of renewables by overzealous local governments resulted in power shortages. However, decarbonisation still remains a strong investment theme.
Decarbonisation could mount a strong comeback in 2023, albeit in a different form. Decarbonisation sectors enjoyed a broad rally in 2021-2022 regardless of their fundamentals but investors in 2023 could be more discriminating, assessing which subsectors will likely be beneficiaries.
We believe that investors could favour subsectors such as upstream materials and energy storage. Selective sectors, such as solar, will likely benefit from global trends, especially from Europe. Wind, on the other hand, is expected to benefit from stronger offshore demand in China.
Geopolitical risk
Geopolitical risk is likely a top concern for every investor focused on China with Taiwan, Xinjiang, Sino-US diplomatic tensions and the semiconductors/technology race heating up between the two global powers being the main themes.
In 2022 tensions heightened in the Taiwan Strait following Russia’s invasion of Ukraine and investors grappled with the possibility of war breaking out between Beijing and Taipei.
Reaching out across the globe, president Biden strengthened Washington’s relations with its allies such as Australia and Japan while reinforcing its presence in the Asia Pacific.
Furthermore, Washington’s relationship with its European allies is viewed to be stronger than it was during the Trump era. However, Taiwan’s opposition party Kuomintang (seen to traditionally favour warmer ties with Beijing) did surprisingly well in the November 2022 Taipei mayoral election. As such, tensions over Taiwan may go on a slightly lower boil until the 2024 presidential election.
Sino-US relations are stuck at a low ebb, but recent events suggest that European countries, especially Germany, in addition to Japan and South Korea, want to chart their own course regarding semiconductor sanctions. Political tensions may have peaked in 2022 but we believe risks will persist.
Covid
Although the Chinese government appears to be putting aside its ideological beliefs in an attempt to get the economy back on track, it may not all go according to plan. Covid controls have proven to be tricky, with the virus surprising even the most sophisticated scientists.
Given China’s geographic and demographic size, bringing Covid under control might take longer than expected, triggering significant volatility and generating uncertainty.
What if coronavirus-related death rates rise? What if the virus continues mutating? What if the healthcare system cannot cope? There are many ‘what ifs’ with Covid and it could be a case of one step forward, two steps back for the government.
There is much uncertainty ahead for China’s economy and its property sectors with the global economy slowing down. Inflation may also grip China as it has in many countries which have lifted Covid restrictions.
Summary
We believe that the rewards will outweigh the risks related to China amid an existence of enough cyclical, thematic and structural trends that could enable the country to outperform in 2023.
Valuations have also become very attractive, with the MSCI China Index having declined by roughly 50% over the past two years and even a moderately positive factor or development could help the market outperform.
Eng Teck Tan is senior portfolio manager in the Asian equity team at Nikko Asset Management. The views expressed above should not be taken as investment advice.