Chinese shares have fallen just over 40% from their peak in 2021. This is their longest-ever drawdown – and the second deepest. What’s going on and where do we go from here?
Chinese equities have suffered a roller-coaster few years. Following a brief sell-off in response to the outbreak of COVID-19, Chinese equities rose just under 60% in less than a year, led by technology companies as the pandemic resulted in an acceleration of digital adoption. However, since early 2021, a combination of factors has meant that the market has been in a sustained decline. What has led to such a protracted fall and when might the recovery begin?
MSCI China All Shares (USD) with key recent events
Whilst most countries have now seen a relaxation of Covid restrictions, China remains resolute in their approach to dealing with the virus.
Shanghai, home to 25 million people, was in lockdown between March and early August. It was the first major city in China to feel the full force of the “zero Covid” policy since the initial outbreak in Wuhan in 2020. Stock markets fell 20% in a matter of days as China saw a huge rise in reported cases, eventually resulting in more than 340 million people in lockdown – more than the entire population of the US.
The Chinese Communist Party (“CCP”) has persisted with the policy, at a time when global demand for China’s exports is falling as well. More recently, we have seen the city of Chengdu, with over 20 million inhabitants, along with four cities near Beijing, in full lockdown, sending consumer confidence to its lowest ever reading.
China’s response to COVID-19 remains one of the most significant risks to our outlook on China’s economy and markets.
Clearly, as long as this policy persists, it will be a drag on economic growth. We have seen some signs of policy easing, such as the reduction in quarantine time. Higher vaccine rates are another positive development. However, much more needs to be done to vaccinate the elderly if vaccinations are to provide a path to an easing of restrictions.
China’s property market is another major economic headwind. This became apparent late in 2021, when Evergrande, a major property developer, failed to meet two bond coupon payments. The housing market is of particular importance to China, representing around 20% of its GDP, far higher than in western economies.
The Chinese market has also evolved in a very distinctive way, with off-plan, new-build residential properties representing 90% of housing transactions2. Until the recent market stress, developers would buy land from the local government and borrow money to start construction. They would then sell unfinished property to consumers, using their deposits as collateral to borrow more to finish the project and expand operations further.
This left homebuilders highly indebted and highly leveraged, which worried the CCP. They introduced the “Three Red Lines” policy, which essentially forced homebuilders to reduce their debt. Only 6% were able to meet the conditions of the new rules. To rebuild liquidity and capital to the required new levels, many developers have had to pause construction. Subsequently, some buyers have stopped making payments on mortgages for homes that have not been completed and are calling on the government to resolve the situation. As of September, the boycotts have widened, representing around 4-5% of total mortgages. This caused stock markets to fall to fresh lows.
As China was starting to see better news on Covid, geopolitical tensions flared up and created a new source of uncertainty for the economy. In August, Nancy Pelosi, speaker of the US House of Representatives, flew to Taiwan. The move angered the CCP, which responded by ordering a show of military force in the seas around the island.
As well as its historical significance for China, Taiwan’s role in the semiconductor industry means it is also of great strategic importance. The island is home to the world’s largest semiconductor foundry, TSMC. At the moment, China has to import the latest versions of these computer chips, used in everything from smartphones to spaceships – and missiles. The CCP’s response prompted the US to further restrict exports to China by US chip manufacturers, in a bid to prevent Beijing from gaining access to the latest technology.
Whilst tensions in the region are likely to persist – as they have for decades – further escalation has for now been avoided. As long as this remains the case, geopolitical tensions should not prove too much of a headwind for stock markets.
The idea of “common prosperity” has emerged as one of the most important ideologies guiding China’s policymaking over the past couple of years. The goal is to reduce inequality through wealth redistribution. It has resulted in a period of regulatory pressure across industries, targeting companies and sectors that are perceived to be generating excess profits. The most notable victim has been the education sector: regulation introduced in June 2021 resulted in a number of tutoring companies being forced to effectively become non-profit organisations. We have also seen increasing antitrust scrutiny on technology companies, with the suspension of the Ant Financial IPO (which at the time would have been the largest IPO ever) and Alibaba fined a record $2.5 billion.
Investors have been more focused on other issues over the past year, but the concept of “common prosperity” and regulatory intervention are likely to remain an important consideration for Chinese equity markets.
Stimulus, policy shift, longer-term themes
We are beginning to see some responses from the government to the issues outlined above.
There has been some easing of Covid restrictions. We have seen the strict quarantine rules eased from 14 days in a centralised facility, to 7 days followed by a further 3 at home. This is the first change to the Zero Covid policy since its introduction.
In an attempt to improve the housing situation, we have seen $148 billion loaned to developers to complete open projects (although it is estimated that $444 billion is required1.) The People’s Bank of China, has also cut the 5-year interest rate by 0.15%, making mortgages slightly cheaper, with the aim of boosting demand. And policymakers have issued a slew of special project bonds this year to boost investment in infrastructure, using up an initial quota by June. Since then a total of $300bn in extra infrastructure investment spending has been approved2. So far, this is not enough to resolve the issues but they are signs that the government is willing to support key industries.
Elsewhere we are seeing other positives, with bank lending growth once again turning positive earlier this year – historically a good indicator of better equity performance. Given the sell-off, Chinese equities are valued below their long-term average. However, it should be noted that there is still a wide disparity between sectors, with technology and other “new economy” companies still looking comparably expensive to more traditional businesses.
At this stage, we are happy to maintain exposure to China as part of our broader allocation to emerging market equity. While volatility may persist in the near term, further clarity around Covid policies and support for the housing market could help investor sentiment. We believe that valuations are also supportive at these levels.
Over the long term, China will likely end up playing a key role in other investment themes that we favour, including technological disruption and energy transition. China owns the vast majority of the world’s solar panel supply chain, controlling at least 75% of every key stage of solar photovoltaic panel manufacturing and processing3. China also continues to lead in terms of investment, making up almost two-thirds of global large-scale solar investment. In the first half of 2022 alone, the country invested $41 billion, a 173% increase from the year before.
1 Capital Economics
2 Gavekal Draganomics
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