Schroders '23 China. Will zero-Covid loosening create spark?

As unrest in China over Covid restrictions grows, our experts look at what could be in store for the Chinese economy, equity and debt markets in 2023.

• We expect Chinese GDP growth to increase to 5 per cent in 2023 from 3 per cent in 2022, helped by infrastructure spending, a recovery in the housing sector and loosening Covid-19 restrictions.

• China equity markets look attractive in the short-term but could face headwinds from policy uncertainty over the medium term.

• A reversal in dollar strength should be supportive of China debt in 2023.

China’s economy

David Rees, Senior Emerging Markets Economist

We still expect China’s economy to stage a recovery in 2023.

Admittedly, the outlook for exports, which have been the key driver of growth over the past couple of years, is challenging. Indeed, we think exports are likely to contract in 2023. This is because we expect many developed market economies to fall into recession as high inflation and interest rates choke off demand.

The expected slump in exports puts the onus on domestic demand to drive any recovery and there are clearly still vulnerabilities here. A combination of the government’s zero-Covid policy and collapse in activity in the real estate sector have weighed on domestic output and hit consumer confidence hard.

However, there are reasons to think there will be some improvement. Infrastructure spending has been buoyant in 2022 and should underpin growth for a while longer as policy remains supportive. Meanwhile, housing indicators may have started to find a floor and could stage some recovery in 2023 from a very low base. And the service sector would clearly benefit from any loosening of Covid restrictions that may emerge during the course of the year. This would help to unleash the cyclical recovery that leading indicators have been suggesting for a while will get underway in earnest as we head into 2023.

Chart 1: Recovery in China GDP expected in 2023

Source: Schroders, Refinitiv Datastream,606579

The upshot is that our base case remains for GDP growth to pick up, from an expected 3% in 2022 to around 5% in 2023. This would be a bit better than is generally expected given how downtrodden expectations have become. The problem for markets is that, following the National Congress in October, politics rather than economics have been in the driving seat for sentiment. And even though we expect the economy to stage a cyclical recovery in the near term, the long-term outlook is challenging.

China equity markets

Louisa Lo, Deputy Head Asia ex Japan Equities

China equity markets will likely continue to be influenced by the global macroeconomic backdrop. Particularly the extent of future rate hikes and whether the US and EU experience soft or hard landings in terms of their economic slowdowns. A peak in the US interest rate cycle could take the heat out of the US dollar, which should help liquidity in emerging market economies.

Growth and equity markets to remain volatile

Domestically, we may have already seen the worst in terms of China’s zero-Covid policy, with recent developments suggesting a gradual move away from the policy. While a full re-opening is unlikely, we expect to see more pragmatic implementation of Covid policies next year. That said, a Covid exit wave remains a risk and as a result, economic growth momentum could remain somewhat volatile.

The government has recently become more supportive of the property sector, rolling out a set of measures to boost developer financing in November 2022. These should go some way to helping stem the negative sentiment-spiral currently being experienced and may signal that the worst of the property tightening cycle is over. However, it will likely still take some time for the sector to more fully recover given the softer economic backdrop and perhaps, more importantly, for investors to become comfortable that systemic risks are declining. We remain selective in terms of our investments in this space.

US-China tensions and geopolitics will likely continue to drive volatility in Chinese equity markets. Recent announcements like the US CHIPS and Science Act – which will see major investment in research and development of semiconductors in the US - highlight the real impact that geopolitics can have on industries in China. 

Supply chain safety and self-sufficiency will remain a key priority for the government going forward in our view. As such, we expect to see an acceleration in investments into areas of strategic importance like technology, military, and supply chain independence. We also anticipate that de-globalisation trends will continue.

With Chinese equity markets trading at more than one standard deviation below long-term valuation levels, the market’s risk-reward profile looks reasonably attractive in the short term.

The chart below shows valuations on a forward price-earnings (PE) basis for both the offshore and onshore Chinese equity markets. A forward PE is a company’s price divided by the earnings per share for the next 12 months.

Chart 2: China market valuations

Source: Factset, as at 31 October 2022. 606580

Indeed, markets could rebound sharply if we continue to see signs of an economic re-opening and/or a gradual move away from zero-Covid, or further efforts to support the property market. 

That said, increased investor uncertainty around policy execution and the government’s stance on private business and shareholder returns may present a stronger headwind for Chinese equity markets over the medium term.

We favour sectors that run alongside policy priorities

We hold a fairly balanced investment positioning, favouring sectors that run alongside policy priorities.

IT and industrial names should benefit from supply chain localisation and industrial automation upgrading. Meanwhile, renewable energy companies (solar and wind) can capture increasing investment into the environment and the focus on a greener China. We also favour construction machinery, in anticipation of a pick-up in infrastructure spend, and consumer names and companies that may benefit from a re-opening of the economy. The healthcare sector is also becoming more attractive after significant corrections over the past year.

On the internet/e-commerce sector, we have become less negative given low valuations and improving earnings. Top-line (revenue) growth should start to recover in 2023 as economic growth improves, but in contrast to the past where the sector traded at a significant valuation premium to the market, we would expect these companies to trade like consumer cyclical names. That means they should be valued more or less in line with their earnings growth potential.

We continue to take a bottom-up approach to investing, with allocation between the offshore and onshore markets reflecting the opportunities we see at a company level. While valuations in the offshore market currently look more attractive, onshore markets may be better supported over the medium to long term given the greater number of stocks that provide alpha opportunities. 

China debt

Julia Ho, Head of Asian Macro and Asian Bonds

The outperformance of Chinese onshore bonds so far this year, as well as during the pandemic in March 2020 and in 2021, demonstrates the asset class’s resilience and diversification benefits. Indeed, international investors increasingly perceive it as something of a “safe haven”.

Chart 3: China bonds outperformance

Source: Schroders. Bloomberg

Going into 2023, the outlook for Chinese onshore bonds looks positive, especially if US dollar strength reverses.

The longer-term case remains compelling too. The monetary policy backdrop is supportive. China’s capital markets are becoming increasingly accessible. Meanwhile, Chinese bonds are increasingly being included in major global bond indices - bringing China into the investment universe for more international investors. The internationalisation of the renminbi (as it increasingly becomes more of a global currency for trade, investment and foreign exchange reserves) is also supportive. The low volatility and diversification benefits of the asset class also remain appealing.

We have recently upgraded our growth outlook for China following the recent spate of measures that have been implemented to support the property sector. The authorities also appear to be gearing up a gradual re-opening of the economy in 2023 given recent moves to ease the country’s zero-Covid policy.

The relaxation of Covid curbs will likely focus primarily on reviving domestic demand, but the ensuing improved mobility within China should help consumer and business confidence to recover from current depressed levels. That said, we caution that border re-opening is likely to be slow and calibrated, and things might get worse before they get better, considering the potential rise in Covid cases and the onset of winter.

On a positive note, a slow normalisation of outbound tourism should help constrain the deterioration of China’s balance of payments position and stabilise the trade-weighted renminbi.

In terms of interest rates, our view is that Chinese government bond yields will likely be range-bound (that is, trading in a narrow range) and stable going into 2023. This is because muted inflationary pressures with a modest pace of economic recovery means that the People’s Bank of China should tend towards keeping monetary policy accommodative and liquidity ample. Moreover, with the yield curve still positively sloped (that is, short-term bonds have a lower yield than longer-term bonds), exposure to Chinese bonds could be a good place to be for carry (or income), in our view.

Over the longer-term, we believe common prosperity, regulatory reform, ongoing deleveraging and the country’s ageing population are themes that are supportive of bond investments.

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