No bulls in the China shop?

Among the key investment themes capturing the focus of multi-asset investors in 2024 is the outlook for Chinese equities. Faced with a confluence of geopolitical concerns and macroeconomic challenges, the MSCI China Index has delivered almost no return, annualised, over the last decade. In response to this lower return for higher risk relative to developed market equities and the unreliable diversification benefit, many asset allocators have chosen to underweight China in their portfolios. 

Looking beyond the current bearish narrative, there is little doubt that this complex and unloved asset class faces several structural challenges. On the other hand, the market is deep and full of opportunity, underpinned by an economy that, despite recent difficulties, is still resolutely moving up the value chain. 

Wellington’s no-CIO structure encourages a broad and diverse set of investment views. Unsurprisingly, one such example is our investment experts’ range of opinions about the prospects for China’s economic growth, policy, geopolitics and equity market fundamentals. 

Here, we bring the investment debate at Wellington alive by presenting both the bull and bear cases for Chinese equities as well as the aggregated views from our multi-asset team, to help inform our clients’ investment conclusions.

Breaking down the debate

What is the outlook for economic growth in China? 

• Bear case: China's reopening did not translate into the economic boom widely anticipated in 2023 given ongoing challenges within the real estate sector and a prevailing lack of domestic confidence. Without improving private sector confidence, any economic recovery will be slow. Leading property market indicators imply prolonged weakness, and demographics and deleveraging remain structural headwinds for growth as policymakers look to balance multiple competing priorities.
• Bull case: Investor sentiment does not price in much likelihood of improved economic growth despite Chinese households’ strong financial position. China’s economic cycle may be nearing its bottom and a likely end to US rate hikes could further support growth by reducing upward pressure on the renminbi and enabling further domestic monetary policy easing. The financial system is stronger now that Chinese authorities have addressed major pockets of systemic risk. Meanwhile, China is moving away from infrastructure- and real estate-driven growth towards more sustainable and productivity-enhancing activities, and its achievements in industries such as green energy and AI offer the potential for sustained, long-term economic dynamism. 

Multi-asset team view
On balance, our view leans slightly negative in the near term. Prolonged weakness in the property sector, demographics and deleveraging may overwhelm any positive cyclicality and cap the upside for Chinese economic growth in 2024. 

How will policy impact the outlook for Chinese equities? 

• Bear case: Chinese policymakers’ piecemeal and slow approach may persist until the economy has fully transitioned. For investors, the ideal regulatory environment is one where the private sector is appropriately rewarded for financial risks and governments are able to step in in the event of a systemic loss of confidence. Chinese regulators’ recent focus on making an example of private sector firms (including in the technology, education and health care sectors) to discourage moral hazard, while curbing excessive rent-seeking, has created a higher risk premium. 
• Bull case: Efforts from policymakers have picked up recently, supporting the balance of risks to the upside. The financial system has become more resilient, with the reduction of credit growth rates, stabilisation of overall leverage in the system, transformation of shadow banking credit into formal loans and the addressing of bad debt. There is scope to do more, including easing regulatory restrictions across industries, supporting domestic consumption and further loosening property sector policy. 

Multi-asset team view
Our read of the policy outlook for China is more positive. While it is difficult to predict the timing or scale of further policy support, we think the trajectory of policy should gradually improve from here. 

What influence will geopolitics have on the asset class?

• Bear case: Geopolitical tensions, specifically between the US and China, are unlikely to go away, and November’s US elections present further near-term risks. Intensified competition and a greater focus by the US and other developed economies on nearshoring amid great-power politics remains. It is difficult to quantify the geopolitical risk premia and, thus, how much is already priced at current valuations, presenting an unknowable source of future volatility for Chinese equities.
• Bull case: The sheer volume of China’s exports means that the Chinese economy is often perceived as reliant on export-driven manufacturing. However, few investors realise that China is an increasingly domestically orientated economy. This presents opportunities for active managers to lean into more domestically orientated sectors with less exposure to geopolitical risks or the global trade cycle. 

Multi-asset team view
Geopolitics will remain a source of volatility for Chinese equities. In our view, this necessitates both smaller position sizing and active management at both the asset allocation and stock selection level. 

What is the outlook for equity fundamentals? 

• Bear case: Significant earnings-pe-share (EPS) dilution effects are unlikely to moderate given higher net stock issuance than the MSCI World Index as well as one-off rebalancing/inclusions. In addition, IPOs entering the index at elevated multiples, and subsequently having multiples normalise, means that investors in the original IPO often end up being penalised. In the private equity market, many pre-COVID private investments are approaching expiry, and high exit demand could impact listed equity valuations. In addition, earnings revisions have been trending down in recent quarters. 
• Bull case: China remains a large and diverse opportunity set, with current market dislocations offering unique investment opportunities, underscored by its constantly evolving competitive landscape and aspirations for technological leadership. It is the least expensive major equity market, and low valuations typically have a strong relationship with higher future returns. Myriad oversold opportunities exist across various industries, including food, household goods, media & entertainment and health care, where prices have disconnected from fundamentals. Potential for long-term return can also be found in areas aligned with Chinese policymakers’ long-term strategic objectives, such as the AI, automotive and solar panel sectors, as well as in high-quality companies that increase their shareholder return through buybacks and dividends.

Multi-asset team view
While valuations are undoubtedly cheap and negative sentiment may create tactical opportunities, we anticipate a lower multiple given unquantifiable geopolitical risks and an unpredictable regulatory environment. Market structure remains a challenge for index-based investors, presenting a further hurdle for any significant reallocation.