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This year started with strong expectations for Chinese equities, with global allocators reconsidering the asset class following the lifting of the remaining COVID restrictions. As these expectations collided with the reality of a slower-paced recovery, we have seen investors increasingly turn bearish. Looking ahead to 2024, we take a more constructive view and here are the reasons why.
China’s GDP growth for the first quarter of 2023 reached 4.5%, suggesting that the economy may emulate the growth rate seen in 2021 when the country reopened domestically. Yet, during the many trips I made this year across China, visiting first-, second-, and third-tier cities, I witnessed a more modest recovery. While there are pockets of strength, I believe the economic rebound is slower than the headline numbers imply.
One area that holds back growth is the property market. We saw a meaningful drop in residential property prices in 2022, and we still appear some way off from a recovery. While new-home sales picked up in the first quarter of this year, demand has leveled off since, as buyers remain wary, with lower-tier cities the most affected.
The job market is another area of concern. Companies’ capital expenditure — particularly in the manufacturing sector — remains muted, which limits the demand for staff. Salary growth and signs of a more sustainable consumption boom are key areas to watch in this context as recent strong consumption data may be more linked to pent-up demand rather than structural recovery. For instance, travel outside of China is still far below pre-COVID levels and we observe a reduced willingness to spend lavishly.
It is not all bad news, however. A more modest recovery is likely to encourage greater policy support, and we have experienced a lot more regulatory loosening at the sector level.
In the past two years, the Chinese technology sector has faced significant pressures as regulators sought to address issues such as anticompetitive behavior by large monopolistic conglomerates, weak data security, and excessive capital-driven expansion. These regulatory interventions impacted key sectors such as e-commerce, mobile payment, ride-hailing, and online education, and caused the suspension of initial public offerings and the delisting of Chinese internet companies.
Officials have now announced an end to this regulatory campaign and promised support to help drive innovation, boost employment, and bolster the technology sector’s international competitiveness. In March, Chinese business magnate Jack Ma’s return to China was a clear signal of this shift as was the resumption of granting licenses for video games after being halted for several months. I think that companies in the mobile gaming and internet space that are market leaders or gaining market share stand to benefit from this more business-friendly climate.
In the semiconductor and hardware space, China is targeting independence given the impact of political frictions on supply chains, with even regional suppliers such as Taiwan reconsidering exports to mainland China. In response, I expect China to invest heavily in its domestic hardware and semiconductor industry to catch up with global leading chipmakers. With that in mind, I focus on large players that have a distinctive edge and are less reliant on the global supply chain.
Over the past two years, Chinese health care stocks have experienced a significant contraction in value (Figure 1) from the heights seen in 2021, when COVID pushed up share prices. This decline reflects not only the impact of COVID-related lockdowns but also foreign fund outflows and policy headwinds, notably the volume-based procurement policy that led to price reductions for medicines. Looking forward, however, we note several positive factors that could boost the long-term growth potential of the sector.
From a policy perspective, I believe the worst is behind us and note the positive signals coming from central government in support of innovation. A key inflection point was the relatively modest reduction in pricing of the National Reimbursement Drug List last December. While cutting the price of medicine reduces the cost burden for the public purse, the associated uncertainty can disincentivize long-term research and development efforts. The limited price cuts suggest the Chinese government is aiming to strike a better balance between incentivizing innovation and controlling prices, a move that may benefit producers of drugs and medical consumables.
Another area we are exploring within the health care sector is Chinese medical device manufacturers, given the authorities’ push to expand hospital capacity and improve the quality of medical care. In our recent trips to China, most health care companies we met are sticking with their strategy to work on “innovation and globalization.” Innovation is not only critical for private enterprises but also for state-owned health care companies as China’s state-owned enterprises are undergoing reform.
While I do not think a complete US/China decoupling scenario is likely or imminent, I seek to avoid areas most vulnerable to future US regulation, such as biotech, aerospace, and defense, while targeting opportunities that geopolitical friction could bring for Chinese players. For example, local champions operating within strategic industries such as the electric vehicle supply chain, clean energy, or advanced manufacturing could enjoy stronger domestic demand and policy support.
I continue to believe that the Chinese equity market is a place where patient stock pickers with the right approach and access to deep research will reap rewards. An approach equipped with an in-depth understanding of policy directionality as well as industry and company dynamics should, in my view, capture the sustainable long-term growth potential that high-quality Chinese companies offer.
Equity Market Outlook
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By
Andrew Heiskell
Nicolas Wylenzek