Location, location, location or credit, credit, credit

Please find below our latest thoughts on China:

• Given everything that has happened this year, it is notable how similar the year-to-date performance of China equities has been compared to other major indices, in local currency terms at least.
• MSCI China A Onshore and the S&P 500 have both returned around -21% and MSCI Europe -17% (as at 28 September).¹
• However, this YTD figure masks a topsy-turvy year for China A-shares with a Q2 bounce giving way to a weak Q3.
• As usual, the key driver of China A-shares has been domestic economic conditions – which, after all, have the greatest influence on domestic retail investors who dominate market turnover.

Chart 1: YTD performance of China A shares and global equity markets (local currency)

Source: Bloomberg, as at September 28, 2022.

• And the recent weak period for the market coincides with disappointing macro performance.
• The two biggest factors weighing on economic activity are the housing market and Covid policies. What happens next with both of these will likely shape the near-term performance of the equity market.
• So far, there has been more policy action on the property side.
• While the usual mantra in housing is “location, location, location”, it’s more like “credit, credit, credit” in China at the moment. The way the system works is that homebuyers put in their money upfront and move into their new home after it has been built. In short, they run significant credit risk.
• It’s no surprise, therefore, that buyers are turning increasingly to large, state-owned developers that can survive the downturn. Likewise, banks are set to favour these developers when extending mortgages to buyers.
• Government policy in property is designed to do “just enough” and avoid repeating mistakes of the past, when “big bang” stimulus resulted in high debt levels and overbuilding. We expect further policies to ensure a stabilisation in the market, most likely coming after the Party Congress to be held in mid-October.
• More broadly, property is a sector that looks to be in a period of gradual but sustained long-term decline, mainly due to demographic trends. And therefore, the main focus of policies to stimulate the economy is more likely to be in new growth sectors – semiconductor equipment, renewable energy, higher-tech manufacturing and food security, for example.
• In our view, it is the tight Covid controls that are playing the bigger role in dampening investor spirits, depressing consumer spending and therefore also contributing to the property downturn.
• The much-awaited “China reopening” is only a matter of time. The ongoing ad-hoc lockdowns and frequent testing are unsustainable for growth, social stability and global connectivity.
• So far there have been only glimpses of opening up. Hong Kong’s decision to end mandatory hotel quarantine has been well received locally. But the three-day ban on going to restaurants, bars and other facilities is unlikely to tempt many tourists, even with the return of the renowned rugby Sevens (4- 6 November).
• Still, the fact that a sporting event with capacity for more than 30,000 spectators is taking place for the first time since 2019, combined with the resumption of package tours from mainland China to Macau, are small steps in the right direction.
• And it’s interesting that related stocks such as online travel portals and Macau casino operators have perked up recently, despite the lack of concrete news on changes to Covid policy in mainland China.

• Finally this week, a comment on currencies. The renminbi has depreciated by around 7% vs. the US dollar since the beginning of August.²
• The PBOC has been taking action to slow the pace of the depreciation and limiting the extent of the volatility but has not attempted to defend a specific exchange rate level.
• The central bank sets a daily fixing for the currency, and daily trading is confined to a band of 2% above and below the fixing. For some weeks now, the PBOC has consistently set the fixing at a stronger level than implied by the previous day’s trading.
• There have been other technical measures as well, which have marginally shifted incentives to short the renminbi. For example, a 20% risk reserve ratio has been reimposed on forward contracts. In reality though, this is mainly a signalling effect.
• Indeed, the current decline is more a function of US dollar strength against all currencies than a market judgement on China. YTD the renminbi has, in fact, appreciated against sterling, the euro and the yen.³
• Nonetheless, the fall in the renminbi vs. the US dollar and the growing interest rate differential between China and the US (China government 10-year bond 2.7%, US 10-year Treasury 3.7%4) has contributed to a reversal in portfolio capital flows.
• Foreign investors have been net sellers of China onshore bonds every month since February.5 The impact on equities has been more muted – foreigners have continued to be net buyers YTD, although to a lesser extent than previously.

¹ Source: Bloomberg, as at 28 Sept
² Source: Bloomberg, as at 28 Sept
³ Source: Bloomberg, as at 28 Sept
⁴ Source: Bloomberg, as at 28 Sept
⁵ Source: Gavekal, as at 27 Sept