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This is an excerpt from our 2023 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come. This is a chapter in the Equity Market Outlook section.
Amid a flurry of negative headlines this year, not all fair and balanced in my opinion, many global allocators have been grappling with the risks of investing in China equity. While there are indeed risks to be aware of (as with any investment), I believe there is also no shortage of potentially attractive opportunities for patient, discerning stock pickers.
When evaluating the opportunity set in China equity, it is important to bear in mind the potent incentives for both the US and China to maintain a collaborative ongoing relationship, given the substantial capital market, supply-chain, and trade interdependencies between the world’s two largest economies.
China remains one of the most critical trading partners for the US. It is the largest importer into the US and the third-largest recipient of US exports1. Additionally, US and global supply chains are deeply embedded in China. While there has been an increased trend toward nearshoring and “friendshoring” in recent years as companies look to build resiliency into supply chains, many companies are not able to quickly or completely extract their supply chains from China. For example, China is in many respects the global leader in supplying the renewable energy transition. It dominates the solar power supply chain, controlling 70% – 95% of that chain’s segments2. It also controls most of the processing of critical materials for the energy transition. The US and Europe would be challenged to replicate the supply chains needed for a successful energy transition without China. In addition to physical goods, China is also a critical supplier of capital as the world’s largest holder of foreign exchange and the third-largest holder of US Treasury debt3.
From China’s perspective, the relationship with the US also remains highly strategic. China reiterated its commitment to global integration and opening up during the recent Party Congress. The Chinese economy will need to navigate substantial demographic shifts in the years to come in the form of a shrinking working-age population and a growing retiree population. The country relies on US and other global end markets as buyers for its exports, which make up 20% of GDP4. The US is the largest importer (by country/region) of Chinese goods by dollar value by twofold over the second-largest importer (other than Hong Kong), Japan . Clearly, the economic linkages between the US and China remain strong and will likely remain so, in my view.
We expect China equity to enjoy cyclical support in the short to medium term. The market is pricing in meaningful risk; on a Shiller price-to-earnings (P/E) basis, Chinese H shares are cheaper than they’ve been in nearly two decades, while A shares are trading slightly below their 10-year average6. Locally, Chinese consumer sentiment has hit long-term lows (Figure 1). Meanwhile, many of the impediments to the Chinese economy over the last two years are issues that the government retains the power to ease or remove: tightened regulation in key industries, liquidity withdrawal from the real estate sector, and the no-COVID policy. The government has levers available to ease the economic pain, as we have begun to see with support for the real estate sector and loosening COVID restrictions. Unlike in many other major markets, the People’s Bank of China is also in a position to offer incremental support, having shrunk its balance sheet in recent years and with Chinese inflation still relatively muted.
We also see structural investment opportunities across the Chinese equity investment landscape. China has recently reiterated its focus on several long-term strategic goals, promising to extend structural tailwinds for certain sectors of its economy. For example, many Chinese companies look poised to benefit from strong domestic demand related to the global energy transition, including suppliers in the solar power supply chain and participants in the electric vehicle supply chain. There may also be opportunities in health care, where the government’s push to improve the quality of hospitals and medical care in lower-tier cities should benefit local medical device makers that serve the home market. Finally, in a lower-growth environment domestically, we expect industry consolidation and improving capital discipline to create opportunities. For example, the onshore package delivery industry has consolidated significantly, allowing the remaining players to meaningfully improve their profit margins.
The Chinese equity market remains dominated by retail money and professional investors with short-term incentives, but I believe patient stock pickers with extended time horizons can succeed in this market with the right approach. This has become even more true recently, in my judgment, as much of the longer-term global capital has incrementally pulled away from the market. When assessing this opportunity set against its risks, I would encourage allocators to position their China equity allocations accordingly to enable the necessary patience and a long-range investment perspective. Doing so may reap rewards down the road.
1Source: CIA World Factbook. | 2Source: Wellington Management. | 3Source: CIA World Factbook. | 4Source: World Bank. Data as of 2021. | 5Source: WITS (World Bank). Data as of 2020. | 6Source: Wellington Management, as of 30 September 2022.
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