China's economic recovery rests on a solid foundation

Investment Director Catherine Yeung sat down with Fidelity’s Global Chief Investment Officer Andrew McCaffrey, Head of Asian Fixed Income & Hong Kong Investments Marty Dropkin, and Portfolio Manager Hyomi Jie to discuss China’s economic and social backdrop, assessing the impact of COVID lockdowns, currency developments, the property sector and the health of the bond market.

As we enter the third quarter of 2022, the backdrop for China shows  signs of policy stimulus and an easing of regulatory activity. Challenges remain as the country is committed to a ‘dynamic-COVID’ program aimed at swiftly identifying and suppressing clusters as they arise. Still, there are signs that the controls are working with the cautious reopening of Shanghai and Beijing. “We also see signs which point to the possibility of a nascent up-cycle in China, which will take time to develop but is nonetheless positive,” says McCaffery.

Underlying currency stability

The past few months have seen the renminbi weaken against the US dollar, but that is only part of the story because we also need to assess it against a trade-weighted basket of currencies called the China Foreign Exchange Trade System (CFETS). The renminbi has also declined against CFETS, but its performance has been reasonably stable and may remain so given China’s integration with other markets. “I think people should look at the currency from both perspectives – against the dollar and CFETS – because that’s what the government does,” notes Dropkin.

The pandemic’s effect on growth and investor sentiment

Returning to the pandemic, China has been experiencing sporadic COVID lockdowns since the second half of last year, not only the well-publicised restrictions in Shanghai and Beijing but also across the Northeastern provinces and farther south in Guangzhou, so it’s a broad-based and ongoing process. “This is hurting supply chains and mobility, which translates into headwinds for overall economic growth,” says Jie. “Not surprisingly, the Shanghai closures are having a bigger impact given it's one of the most important economic hubs in the country, accounting for almost half of China’s GDP,” she adds. Looking ahead, the dynamic-COVID strategy could potentially be relaxed once China’s internally developed mRNA vaccine is rolled out.

There has been caution among foreign investors regarding this COVID policy. Yet, McCaffery points out that the recent easing of restrictions in Shanghai elicited a positive market reaction and demonstrated that people believe there will be a sustainable recovery, especially given the policy stimulus that’s coming through. “Arguably, we may have already reached the bottom of the cycle, which is when you try to capture opportunities.”

Cautious optimism toward the real estate market

Turning to the property sector and Dropkin observes that conditions are improving, but expectations need to be kept in check. For instance, some High Yield companies are experiencing significant changes in the market value of their bonds, and these dynamics will take time to work through. However, there has been a shift in the regulatory dimensions of the real estate segment, with a relaxation of home-purchase restrictions and reductions in down-payment requirements. Also, sentiment toward state-owned property companies is now healthier, with decent valuation metrics and strong support for many of these names.

Long-term consumer trends remain intact

In terms of consumption developments, Jie separates these into two groups: the cyclical perspective and a structural viewpoint. Starting with the cyclical side, she agrees that issues in the property sector have been a significant headwind to overall consumption, given the negative wealth effect and sentiment. But, again, we also need to consider how COVID measures have affected spending patterns. “No one is completely upbeat on the state of China’s consumers. More positively, much of this pessimism is already reflected in earnings estimates and valuations,” says Jie. As such, the market is now trying to ascertain the pace of the recovery, which will be guided by mass-testing regulations that require a negative result every 48 to 72 hours to access shopping malls, public transport, or offices. “This is hampering progress with consumption at around 80–90 per cent of pre-pandemic levels.”

From a structural perspective, Jie thinks the consumption mega-trend remains in place. Income levels are still increasing, as is urbanisation. Also, geopolitical tensions may lead China to rely more on domestic activity. And once the current COVID policies become the ‘new norm’, we believe that the government’s focus will gradually shift towards economic growth, and in that process, domestic consumption will be a core theme. “It is worth noting that the rise of local brands and the premiumisation trend, which have been the critical drivers of value creation in the consumer space, remain intact,” says Jie.

Sustainability is still top of mind

Despite the recent uncertainty, China’s government has not lost focus on pursuing its environmental, social and governance (ESG) goals. At the market level, Dropkin says he is witnessing a remarkable change in private and state-owned companies' willingness to engage with investors, which is evidence that policymakers have introduced an ethical mindset that is permeating every section of society. “This is a critical issue and one which we believe China will address at a much faster pace than the rest of the world.”

Uninvestable? Not necessarily

Lastly, the conversation turns to a premise that China has, somehow, become “uninvestable”. Dropkin strongly disagrees, citing the dynamics mentioned above and the fact that the country’s structural growth story remains intact. He also points out it may have already seen some of the most demanding regulatory changes. Jie and McCaffery agree by specifying China’s lack of correlation with global stock markets, which may provide attractive investment opportunities, especially from a bottom-up stock-picking perspective.