The gathering clouds over China’s economy are weighing on investor sentiment.
The MSCI China Index has fallen 5.3% year-to-date (in US dollar terms) and the Hang Seng Index has fallen by 7.3%. In contrast, the US blue chip S&P 500 has risen 15.9%, boosted by its leading tech stocks and speculation around generative artificial intelligence (AI), which has also propelled the Nasdaq up 37.7%1.
Figure 1: China-focused indices lag the market
China’s economy has struggled this year, on the back of tepid export demand, sinking property prices and weak consumer confidence. Country Garden, the country’s largest private property developer, missed bond payments this month, and one of China’s biggest shadow banks, Zhongrong Trust, skipped payments on several investment products, adding to concerns that the property slump is spreading to the financial sector.
The People’s Bank of China unexpectedly cut key policy rates for the second time in three months on 15 August in a bid to boost the country’s sputtering post-Covid economic recovery.
China positioning
The Federated Hermes Global Emerging Markets (GEMs) Fund has 33.45% invested in China (including Hong Kong) versus the benchmark MSCI EM Index weight of 30.67%, a Fund relative overweight position of 278bps2.
The GEMs Fund has no direct exposure to Real Estate developers, to Country Garden, or Zhongzhi Enterprises Group, the holding company for Zhongrong Trust.
The Fund does have a position in a largely retail-focused bank that we deem to be of higher quality than its peers. We have stress tested its property developer book for potential non-performing loans (NPLs) and also looked at its local government financing vehicle exposure. Our conclusion is that the possibility of impairment to tangible book value is low and there will not be any need to do a dilutive capital raise.
The Fund also has a position in a leading property management services company, which is a diversified business with a resilient parent and a good track record of delivering earnings-per-share growth. It has the lowest credit risk of any property service company in the industry and we expect it to benefit from some of the structural changes the sector is experiencing.
Undue pessimism
We remain excited about our holdings in China. We believe the market is unduly pessimistic on China’s economy and its equity markets. While there are issues around the property sector, geopolitics and muted consumer sentiment, the market is trading at valuation levels last seen in the 1990s. This is abnormal in our view, and we believe as consumer sentiment in China improves and geopolitical tensions stabilise, there should be enough impetus for markets to re-rate companies that benefit from earnings support and earnings-per-share (EPS) upgrades.
We are focused on how China will likely evolve beyond the post-Covid recovery. We believe the economy is unlikely to grow at more than 5% in real GDP terms in 2023 considering the constraints under which China is operating. Our preference is to invest in attractive themes with the potential to outgrow the economy, such as digitisation, renewables, electric vehicles (EV) and biotechnology.
We believe the market is unduly pessimistic on China’s economy and its equity markets.
Overall, we view China as being investable in select parts but not everywhere. Investors need to avoid the pitfalls, some of which are unique to the market. It is crucial to avoid any sectors related to geopolitical issues, for example, such as the US entity list. In addition, we are avoiding old economy state-owned enterprises (SOE), and low-quality companies in cyclical industries, especially those with excessive leverage and those generating returns below the cost of capital. We believe the world looks increasingly resource-constrained and that such companies will remain vulnerable to input cost inflation.
An economic reset
Longer term, our view is that China is going through a major economic reset after years of excessive build up in the property sector resulting in unsustainable local government finances. Policymakers in Beijing are trying to find a solution which ensures a smooth unwinding of such excesses. However, the market is hoping for some form of ‘big-bang’ stimulus which would perhaps take China back to where it all started – more debt thrown at areas that need less not more.
We believe that Chinese policy makers will have to come up with innovative solutions that might include restructuring property sector finances to help complete projects which have been started, restoring confidence in the consolidated property market, changing the mechanisms by which local governments fund themselves, and finding alternative ways to boost consumer sentiment and wealth.
It is likely to turn attention towards the private sector and capital markets as a means of boosting confidence in the economy, job creation and eventually income and wealth generation. We are also likely to see lower monetary policy rates for a considerable time as the financial system digests high leverage levels related to the property sector.
In conclusion, we believe economic normalisation in China is necessary to help the economy form a solid foundation on which it can build on its structural advantages: world-class manufacturing and infrastructure; and leadership in renewable energy and advanced technologies such as robotics, automation, biotechnology, microchips, and AI.
With a shrinking property sector, resources will ultimately be better allocated to areas that will help China move up the value chain.
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1 Bloomberg as at 16 August
2 Federated Hermes
