Do investors see a revival in China’s fortunes?

Two Kepler analysts debate the outlook for the country in 2023, and share investment trust suggestions.

A record-breaking cane toad has just been found in Australia. ‘Toadzilla’ weighed 2.7kg when found by a startled park ranger, six times more than the average toad. Coming just days before the Chinese New Year, this could perhaps be thought an auspicious event, given that the toad symbolises prosperity and wealth in Chinese culture?

China had a dreadful 2022, with repeated lockdowns wreaking havoc with an economy that was also struggling with a debt crisis in the real estate sector and the weakening of Western investment in the country. Will the new year, which began on Sunday, bring a revival in its fortunes?

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The market has rallied strongly over the past three months - could this be the beginning of a sustained recovery? Or will the recovery be swiftly ‘euthanised’ by the global slowdown, just as poor ‘Toadzilla’ has been by the Aussie conservationists? Two of our analysts debate the outlook.

Bull - Ryan Lightfoot-Aminoff

In the past couple of months, there have been significant and important changes that I believe will be very supportive to China’s outlook in 2023. The most notable was the reversal of the zero-Covid policy in November. Following startling widespread protests, the Chinese government abruptly abandoned its strict Covid rules that had been in place since 2020 and had acted as a handbrake on economic growth.

As a result, the Chinese economy is finally having its delayed reopening. The restrictions on the Chinese population have been lifted and this has unleashed considerable pent-up demand from the Chinese consumer. They are now allowed to travel, purchase and experience again, which will provide a big boost to domestic demand, something the Chinese government wants to develop.

The zero-Covid policy had been a large drag on global demand and markets. As this policy has been reversed, it should provide a boost to demand, just as concerns over an economic slowdown in developed markets is building. There may still be short-term issues with sick days causing temporary setbacks to supply chains, but the outlook for China in the first quarter of 2023 is looking considerably better than it was just six weeks ago.

As a result of this, the Chinese leadership can now turn its attention to growth after a number of difficult years, much of which has been, arguably, self-inflicted. There are signs that the leadership is willing to be much more pragmatic too. A recent in-person meeting between Presidents Biden and Xi is a strong sign of a thawing in US-Sino relations, which have been a headwind to the country and a big reason for investors staying away.

Central bank policy is also a big tailwind. Contrary to almost all leading economies, China is cutting its interest rates to stimulate economic growth. The impacts of increased rates have been felt very acutely in the Western world, and China, being the only major economy cutting them, should see the benefits in their economy. In cutting rates, I believe this demonstrates China is in a different cycle to the rest of the world. They are now going into an expansionary phase, which should provide immediate support to the domestic economy.

Looking further out, Western economies are clearly at a tough point right now, but after recessions come recoveries. Should developed economies bottom out later in 2023, it could cause a recovery in their demand that will be supportive to China, too, due to its role as the ‘factory of the world’.

It has been easy to paint a negative picture about China of late but, as a result, valuations are cheap. JPMorgan China Growth & Income (LSE:JCGI)pointed to their expected return framework signalling strong upside and they have taken their gearing to the maximum permitted level to take advantage of this, although they acknowledge there are hard to quantify near-term risks.

Similarly, the managers of abrdn China (LSE:ACIC) recently pointed out to us that the MSCI China All Share Index is trading at 10.4x versus the MSCI World Index’s 14x. On top of this, both trusts are trading at discounts; JCGI at a modest 3.0%, while ACIC at a considerable 14.3% discount, the widest in the peer group, as at 19 January 2023. Asia Dragon (LSE:DGN)is a broader Asia trust that is increasing its weight to China to take advantage of what managers Adrian Lim and Pruksa Iamthongthong believe are low valuations in the country. They have increased their allocations to the Chinese internet names, which they believe will see a pick-up in retail demand, as well as adding to the likes of AIA, which are set to benefit from increased activity in the insurance market, particularly travel insurance.

With the economy reopening, monetary conditions easing and companies potentially entering a positive earnings’ cycle, I believe there are plenty of reasons the Chinese market can be supported in a range of time periods. The headlines have focussed on the negatives and this has affected investor sentiment. However, for those investors willing to look beyond this, I think it could be seen as a cheap market with plenty of opportunity for recovery.

Bear – Thomas McMahon

I think there are a few reasons to continue to be wary of a Chinese recovery this year. While the reopening post-Covid is a positive, the Chinese property market remains weak, with commercial operators heavily indebted and residential demand very low. Housing sales have fallen by 20% each quarter for six quarters. The government is changing tack and extending liquidity, abandoning its ‘three red lines’ policy which was aimed at strangling leverage. However, it is an open question whether their measures will stimulate the sector, rather than simply backstop it. Developers remain highly leveraged, with few having achieved what the ‘three red lines’ demanded of them, and the credit lines that have been opened are targeted at ’high-quality’ lenders and seem aimed at ensuring solvency, rather than rapidly boosting expansion. Some analysts say that the point of the original policies was to reduce reliance on the sector, in which case it has, arguably, been achieved and we should not expect a significant rebound to drive growth in 2023.

If property won’t drive the economy as before, could industry and manufacturing? The problem is that global demand for Chinese products will be weak this year due to weakness in consumer countries. The developed world is teetering on the brink of a recession, with inflation the key driver. And China’s reopening will boost commodity prices, including gas prices, which will in turn hit profit margins and consumers’ disposable income in the West.

Additionally, we have to consider the political dimensions. Biden and Trump’s foreign policies are more similar than the Twitterati would like to believe and the Orwellian-named Inflation Reduction Act, which provided for massive fiscal stimulus, has significant protectionist provisions which favour the domestic green industries – industries to which China is devoting more and more attention. The US, under Biden, has also severely constricted the ability of US entities to use or contribute to the development of Chinese semiconductors, a critical driving force behind technological growth. The ban also applies to third country products using US technology, severely restricting the ability of European companies to sell to China. Domestic demand will have to play a larger role in any 2023 Chinese recovery.

I think investors will also be much warier of investing in Chinese companies than they were between 2017 and 2020. The radical intervention by the Chinese government in the education and e-commerce sectors reminded Western investors that China is an autocratic communist state, where private property is tolerated as long as it suits the Party. I expect this has created an additional risk premium which will be applied by overseas investors to Chinese assets, most obviously in the technology and e-commerce assets, which were so highly prized in the past. This should weigh on the rebound potential, in my view.

China has had a good bounce from its Q4 2022 lows, up around 27%. I am not predicting doom from here, but I am sceptical that it will rocket away and be the best emerging market to invest in for the year. I think Latin America looks more interesting. Brazil looks likely to be able to embark on a rate-cutting cycle soon. It has significant commodity exposure, which will benefit from a Chinese re-opening, while politically it sits astride the new fault line between China, Russia and the West, able to take investment from both sets of parties. We discuss this in more detail in our recent note on BlackRock Latin American (LSE:BRLA). Another option for investors is the smaller abrdn Latin American Income (LSE:ALAI). We will be publishing an initiation note on ALAI in the coming weeks. Both are high-yielding trusts trading at double-digit discounts.