China: Opportunities at an Inflection Point
China is accelerating efforts to achieve Common Prosperity and implementing other policy initiatives aimed at sustainable growth. What will this reshuffling of policy priorities mean for investors in 2022 across China’s equity and bond markets?
How do you view the performance of the Chinese economy in 2021? What is your outlook for 2022?
Vivian: China’s economy was still quite strong in 2021, with consensus for real gross domestic product (GDP) growth at around 8.5%; this follows 2020’s growth of 2.3%, the strongest among major economies. However, we have seen a broad-based slowdown in recent months as a result of COVID-19 Delta and Omicron variants, government environmental controls, and regulation impact.
We expect 2022 to be a year of rebalancing in the Chinese economy as the government looks to find a balance between supporting economic growth and accelerating structural reforms and sustainability initiatives, namely Common Prosperity and carbon neutrality. This may lead to decelerating growth around 5.5% in 2022.
Overall, we expect macro policies to turn more accommodating in 2022 to support the growth target.
Overall, we expect macro policies to turn more accommodating in 2022 to support the growth target. President Xi’s stated goal is to double the size of China’s GDP by 2035, which equates to average annual real growth of about 4.7% for the next 15 years. It would start higher and decline, probably toward 3% as we approach 2035—but that is still healthy growth for a $14.5 trillion economy.
Clifford: Economic performance has been on track, but there are many conflicting forces behind the scenes. The political agenda is gaining influence relative to technocratic economic policies as top-down policies such as decarbonization and Common Prosperity take precedence. Growth will be sustained into 2022, but export numbers might pull back somewhat as other major economies open up further.
How will the Common Prosperity agenda affect economic growth?
Vivian: Growth remains a key part of China’s story, but the government is now more focused on fostering sustainable, broad-based growth.
Income and wealth inequality have increased substantially in China in the past several decades, and one of the focuses of Common Prosperity is to change income distribution from a traditional pyramid shape to an oval. Broadening the base of economic productivity is necessary to offset some of the structural growth challenges, such as an aging population.
Against this backdrop, we are likely to see a shift in the growth mix of the Chinese economy. Previous growth drivers like the digital economy may contribute less. Others, such as high-end manufacturing, semiconductors, and green energy industries, will likely accelerate.
Clifford: There has been skepticism about Common Prosperity, but the government is intent on finding a balance between social stability and wealth generation for the broader Chinese population.
Another way of implementing Common Prosperity could be through patient inaction and holding back from conventional policy responses. For example, most people expected “pivotal” government actions to address the recent sell-off in the Chinese property market. So far, there has been none. However, “no policy” is itself a policy. The government may be trying to address a sector where high prices favor the rich and hurt the general population.
What is the inflationary outlook in China? Why is consumer inflation lower than other countries?
Vivian: China’s producer price index (PPI) year-over-year change was 13.5% in October 2021, the highest level in the last 20 years. This sharp increase was driven by rising global commodities prices, structurally reduced supply of manufacturing capacity as a result of supply-side reforms, infrastructure stimulus, and export growth.
But China’s consumer price index (CPI) year-over-year increase in October 2021 was only 1.5%. There are structural reasons for this huge divergence. China has a strong and growing e-commerce business, which tends to lead to price deflation.
Also, Chinese manufacturers have been able to largely absorb PPI pressure despite some margin compression in the near term given the compensation from strong unit volume growth and improved cost structure.
Clifford: Pork prices, a key inflation driver in China, have decreased in 2021 as pig herds expanded and slaughter rates increased. The big disruptor, however, so far this year has been vegetable prices, as heavy rainfalls in September and October are affecting crop productions.
Meanwhile, there is a risk of surging raw materials prices and other elements of today’s high PPI passing through to CPI in the second half of 2021. China has had several nationwide and regional lockdowns as a result of COVID-19, which curbed consumer spending and kept demand pressure off CPI.
But a big question going forward is how the government will approach COVID-19 in 2022. Will China continue with zero tolerance, or start to learn to live with COVID-19? If there is more opening up, we could see more pressure on consumer prices.
Vivian, how favorable do valuations appear in the Chinese equity markets heading into 2022?
Vivian: Valuation risk is lower overall than a year ago, which should be supportive for Chinese equities in 2022, everything else equal. Earnings growth was mixed in 2021, with divergence between consumer-driven and manufacturing-driven industries; this divergence was exacerbated by policy and regulatory developments.
For example, China’s internet industries experienced both fundamental and policy headwinds in 2021. As a result, the broader Chinese equity index, MSCI China All Shares Index, depreciated 13% in U.S. dollar terms in 2021. The domestic China A-Shares index, CSI 300, depreciated 3.5% in renminbi in the same period.
We expect overall Chinese equities to fare better in 2022, predicated on earnings recovery and less demanding valuations. The MSCI China All Shares Index was trading at a 13.5x forward P/E ratio, comparing favorably to the S&P 500 Index, which is around 20x.
But at the sector level, we have seen valuations rise for certain segments, such as high-end manufacturing and green energy.
Clifford, what’s your outlook for the Chinese bond market in 2022?
Clifford: We expect more balanced, two-way flows to drive the market in 2022. Foreign inflows should continue to be strong because China is still one of the few major economies running positive real interest rates. Meanwhile, investors and index providers continue to increasingly recognize Chinese government bonds as a mainstream asset class, through either higher investment allocations or broader index inclusions.
Rising interest rates have the potential to make Chinese government bonds less attractive versus U.S. Treasuries and European bonds.
On the other hand, interest rates are rising globally amid pent-up inflationary pressures globally. This has the potential to make Chinese government bonds less attractive versus U.S. Treasuries and European bonds from a valuation standpoint. Of course, there is still a long way to go in closing the valuation gap, but investors may need to seriously reevaluate the arbitrage trade of going decidedly long Chinese government bonds if inflationary risk in China increases like it has in other countries.
Given these countervailing pressures, local inflation could determine the fate of the Chinese bond market in 2022. Chinese CPI remains low, and I don’t expect inflation to increase much, at least in the first half of 2022. So I am cautiously optimistic about Chinese government bonds, and I think that current valuations are attractive from both an outright and relative perspective.
The renminbi (RMB) is an important risk factor to watch for currency-adjusted bond returns. It is strong now—the CFETS RMB Index was over 102 at the end of 2021, driven by offshore investor inflows, FX (resilience thanks to the government’s stable currency policy), and healthy current account positioning (which occurred as travel restrictions prevented leakage from tourism outflows). But a view of continued RMB strengthening will start to be challenged against a backdrop of a strengthening U.S. dollar and an eventual slowdown in China’s export growth.
Vivian, given the large-scale social and economic rebalancing in China right now, where do you see opportunities in the equity markets?
Vivian: Traditionally, core investment opportunities in China have been in structurally growing sectors, such as consumer, healthcare, and technology. In our view, that has not changed, although the near-term growth outlook of these sectors such as consumer and healthcare may be impacted by the resurgence of COVID variants and the related lockdowns. Some segments have faced material policy headwinds in recent times, but these have largely stabilized.
The internet and e-commerce industry remains an important opportunity because the business model is so favorable; plus, recent policy-related concerns have made valuations more attractive.
We also continue to see opportunities in healthcare, especially in areas such as contract research/manufacturing organizations, innovative drugs, specialty hospitals, non-generic Chinese traditional medicine, and others. These are secular growth areas because they are underpenetrated, and/or there is a big domestic substitution story taking place. For example, certain highly innovative Chinese medical products and devices are much cheaper than global peers for the same technological efficacy.
We also like technology. Digital technology used to be dominant, and is still important, but hardware-driven technology is a bigger growth story now. This includes high-end manufacturing, automation, semiconductors, green energy, electric vehicle batteries, and the like. We think it will be even more attractive in the future, both from the perspective of industry growth and government support.
Vivian Lin Thurston, CFA, partner, is a portfolio manager and research analyst on William Blair’s Global Equity team.
Clifford Lau, CFA, is a portfolio manager on William Blair’s Emerging Markets Debt Team.
Emerging Markets 2022 Outlook Series
Part 1: Slowflation to Expansion
Part 2: Headwinds Abate for Emerging Markets Equities
Part 3: A Brighter Outlook for Emerging Markets Debt
Part 4: China: Opportunities at an Inflection Point