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China: the growth question

2024 Outlook

Insight
5 December 2023 |
Active ESG
The world’s second largest economy has underwhelmed. Is it time for a turnaround?
The Federated Hermes 2024 Outlook

There are four large components of our Asia ex Japan benchmark: China, Korea, Taiwan and India. Of these, China and Korea’s performance over the last at least decade and a half has been particularly poor. China trades at a record low valuation relative to the rest of the world. Korea trades on an average price-to-book multiple of below one. Many individual stocks in both countries trade on single digit price-to-earnings multiples and unusually high dividend yields. 

China’s poor performance and cheap valuation results from a relationship with the West that has deteriorated and slowing growth, caused in turn, by a property sector that became too large relative to the rest of the economy. Korea’s cheap valuation can be attributed to a high weighting of cyclical companies, many of which are anticipated to have (for now) declining earnings, and poor corporate governance that results in the mistreatment of minority shareholders.

Upcoming webinar: Federated Hermes Asia ex-Japan Equity

31 January 2024 | 09:00-10:00GMT

Join us for the next Federated Hermes Meeting Room: Virtual portfoIio briefings on Asia ex-Japan Equity on Wednesday 31 January 2024, with Jonathan Pines, CFA, Lead Portfolio Manager, Sandy Pei, CFA, Deputy Portfolio Manager and James Cook, Investment Director.

When stocks are this cheap, it only takes news to be less bad than feared for stocks to rise.

Still, given the extreme absolute and relative valuations on offer, we are betting on both Korea’s and China’s stock markets to outperform. When stocks are this cheap, it only takes news to be less bad than feared for stocks to rise. In China the impetus might be provided with a softening of tensions with the US and continuing stimulatory policy support (followed by fear of missing out by underweight fund managers). In Korea, a rise in stock prices may result from an anticipation of the beginning of upcycles in key industries and a slow improvement in governance (from a low base) as a more muscular Korean activist investor class continues to emerge.     

The tigers that didn’t roar

China is the world’s second-largest economy, accounting for a third of the emerging market universe and half of emerging market GDP. China is a significant player in the global supply chain and a leader in critical areas such as renewable energy technologies, electric vehicle batteries and mature chip production. It is also fast catching up in several other high-end areas such as biotech, automation, robotics and artificial intelligence (AI). Hence, it is not possible to ignore the market entirely. We do not share the view many hold in the market that « China is largely uninvestable, » and we see a favourable risk-reward situation in China.

China is at a crucial junction with multiple challenges, including a geopolitical rivalry with the U.S., the fallout from the pandemic, and stresses in its property sector, to name a few. These are immensely challenging issues that will test the resolve of the Chinese leadership. 

While the challenges are significant, we are hopeful that the leadership has not succumbed to the market demand for a significant fiscal stimulus, as this will amount to « kicking the can down the road » over resolving the structural issues within the economy. China firmly believes in deleveraging, which we think is the correct strategy. Hence, our focus has shifted beyond the reopening of the economy to the economic transition to a higher value-added economy.

A credible policy to stabilise the economy will help China outperform global indices in the short term.

While deleveraging is painful in the near term, it will help the economy grow sustainably over a more extended period without worrying much about debt/asset bubbles. A credible policy to stabilise the economy will help China outperform global indices in the short term. However, its long-term performance will depend on how successfully the leadership in China manages the economy’s transition. 

The economic transition involves shifting away from a reliance on property and heavy resource orientation (a reliance on an ever-increasing supply of commodities and energy to fuel economic activity) towards other more sustainable growth drivers, such as rising middle-class consumption, improving people’s quality of life, and increasing focus on higher value-added activities – which, will help the economy develop with better and more effective and productive capital allocation. 

China is fast becoming a dominant theme in risk markets and if the situation worsens it could weigh on sentiment in Emerging Markets (EM) in 2024.

A solution to the real estate recession would be welcome and could prove to be significant.

Many hoped that the opening of the economy following the end of zero-Covid curbs would fuel an economic surge, as when China rebounded from the 2008-09 global financial crisis, lifting the rest of the world. This view failed to account for the fact that China’s myriad issues pre-date Covid, and its heavy-handed handling of the Covid-19 pandemic only made things worse, psychologically scarring the population. While some of the high frequency economic data has turned slightly more positive (perhaps indicating a cyclical bounce), the medium-to-long term issues remain. In 2024, policymakers will have to address the real estate market and its associated debt in the form of developers’ borrowing and mortgages for growth to meaningfully recover. Directly and indirectly contributing to around 25% of GDP¹, a solution to the real estate recession would be welcome and could prove to be significant.

The 2024 U.S. Presidential Election also has the capacity to affect EM risk in a profound manner, as any change in bilateral relations between the U.S. and individual EM countries or blocs can impact spreads. One of the most significant geopolitical risks in this context, is an escalation in trade tensions with China. A Biden win could see a continued softening in relations, as witnessed in their most recent talks in California. A Trump win could see the return of a transactional foreign policy where sanctions are used to achieve key policy objectives, but is also realistic to anticipate that any change in the White House could once again spark an escalation.

In our opinion the Chinese fixed income space in 2024 remains challenged and unattractive on a valuations basis. Therefore, the importance of looking beyond China cannot be understated, as recently highlighted by the outperformance in countries such as Mexico, Brazil, Peru, and Turkey, can offer attractive alternatives.

The Federated Hermes 2024 Outlook

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