The China edition

   Andrew McCaffery, Global Chief Investment Officer, Asset Management
   Victoria Mio, Head of Equity Research, Asia Pacific
   Vanessa Chan, Head of Asian Fixed Income Investment Directing
   Catherine Yeung, Investment Director, Asian Equities

   
Key points: 

  • With the West experiencing inflationary pressures, it has made investors cautious of a potential hard landing to quell inflation. Contrastingly, China’s more supportive central bank policy and its economic cycle shifting towards growth and stability, has made them more attractive to international investors looking to diversify their developed market exposures. 
  • The mortgage boycott in July created instability within the property sector of China and since then, we have seen targeted policies to tackle these issues, such as funds to complete unfinished projects and support to distressed issuers. In the situation where they are unable to stabilise the sector, it would have relatively insignificant impact on the solvency of the overall banking system, given roughly only 0.4 per cent of the mortgage balance is at risk due to the recent mortgage boycott. 
  • Shortening of quarantine times and the adoption of a standardised approach across the nation, have contributed to industrial activity, consumption, and mobility, gradually building China’s social stability post-pandemic. 
  • Despite the dollar strengthening, the People’s Bank of China’s (PBoC) actions are providing more certainty in terms of the exchange rates. Unlike some countries it is not importing inflation, and the renminbi is showing relative stability and diversification. 
  • With the end of the mandatory hotel quarantine policy in Hong Kong, this may be a testing ground for China. As the Covid policy is seen as a very distinct hurdle for investors, if gradually removed this will boost investor confidence.
  • China’s corporate earnings season recently concluded, indicating significant divergence between sectors. Earnings growth showed ongoing recovery from Covid, while some sectors will benefit from policy support and are therefore providing attractive opportunities, such as autos, renewable energy, and infrastructure.
  • In line with the expectations of the Party Congress, there is potential for sentiment to improve if we see policy move towards opening China’s capital markets internationally. 
  • Despite being the biggest coal producer, China has been actively developing renewable energy and is the largest producer of solar power, in line with their commitment to become carbon neutral by 2060. 
  • From an asset allocation perspective, property, Investment Grade, High Yield bonds, and technology are looking attractive. 

 

Andrew, could you summarise the market and economic situation, and how you are positioned?

Andrew McCaffery: In the developed world, the key question is still how to contain inflation and it is still the focus for central bank policy. At the same time, fiscal policy is very interventionist, with the electorates of many countries, including the US, UK, and those in Europe, wanting more economic support. Managing these situations will be a real challenge for the advanced nations. To get inflation in check, there will need to be some form of recessionary activity and rates will have to go up and stay up for some time. More recently we have seen some challenges with fiscal policy intervention; in the UK, it is creating concerns over the country’s debt profile at a time when it is already suffering an intense cost-of-living crisis. Meanwhile, winter is approaching and is this is expected to exacerbate the adverse effects of energy shortages.

As a result, investors are cautious. There is an uncertainty over whether economies will be able to achieve economic soft landings, or if they will have to have go through hard landings to quell inflation. 

China is in a very different position. It is emerging from a challenging period of economic tightening and regulatory developments. Now, economic tightening has shifted towards stimulus, both in monetary and fiscal terms, and regulatory headwinds are also showing signs of easing. Some of the biggest challenges are those associated with its property market, but these are starting to be addressed. The upcoming Party Congress will be important in setting policy expectations for the coming year. 

We are somewhat encouraged by recent developments in China. It has not experienced the same inflationary pressures as the West and this is allowing it to provide stimulus. The challenge is to get that stimulus to have the desired economic effect, given the ongoing disruption the country is suffering because of Covid. Once these problems are overcome, we should see more optimism reflected in China’s asset markets. International investors are looking to diversify their developed market exposures and with China’s central bank policy now supportive and its economic cycle shifting towards growth and stability, it looks attractive relative to other parts of the world. 

Vanessa, how are you viewing the property sector in China?

Vanessa Chan: We believe that it is the intention of the regulator to ensure that the physical property market remains stable. The mortgage boycott in July created instability within the system and since then, we have seen targeted policy to tackle these issues, such as funds to complete unfinished projects and support to distressed issuers.

On the developer side, we believe that companies are still in ‘self-help’ mode and need to continue to seek collaboration with the state. Ultimately, the state's influence over the sector will increase, so that there is more balance between privately-owned and state-owned enterprises. We are watching the implementation of policy support and how it will reflect in economic indicators. 

Victoria, assuming the Chinese authorities are not able to stabilise the property sector, how will it impact the banking sector?

Victoria Mio: Mortgages account for 20 per cent of banks’ loan balances, while developer loans are around 6 per cent. If the property market continues to weaken, it could cause more defaults on the developer loans. Based on our estimates, only 0.4 per cent of the mortgage balance is at risk due to the recent mortgage boycott. Even a worst-case scenario would therefore have relatively insignificant impact on the solvency of the overall banking system. It does not represent systematic risk. 

The second-degree impact on the developer loans can become serious, however. Fortunately, banks have built up strong balance sheets and high capital ratios, so we are confident that there will not be financial dislocation. However, we may see some spill over impacts on property sector supply chains, affecting things like materials businesses.

The property sector may face further pressure in the near-term but will gradually recover in the coming months. The government is aiming to implement a series of actions to ringfence the damage and restore confidence.


Victoria, what about social stability in relation to Covid lockdowns?

Victoria Mio: Covid control policy is now the biggest uncertainty surrounding China’s economy and we are monitoring it closely. Since June, there have been two notable improvements - a shortening of quarantine times and the adoption of a standardised approach across the nation. We are now seeing green shoots in industrial activity, consumption and mobility. We are also hopeful that positive policy changes may also be announced at the forthcoming Party Congress. 

Andrew, how would you describe the direction of monetary policy in China versus that of the world’s other major central banks?

Andrew McCaffery: We are seeing high levels of uncertainty around policy setting across the developed markets. For the Federal Reserve (Fed), there is now the perception that to address inflation concerns, not only will rates have to go higher but they will also be higher for longer. Comments from the Fed also suggest some concern around the strength of the dollar, but their challenge is that the dollar is the global reserve currency and that higher rates are attracting capital flows to the US.

In China, the PBoC’s actions are providing more certainty in terms of the exchange rates. Unlike some countries it is not importing inflation, which is creating confidence and stability. If China is seen as being stable and generating consistent levels of growth, it will paint a very different picture to backdrop seen across many developed countries. 

Vanessa, what is your view of China in a broad Asia context?

Vanessa Chan: As we have discussed, inflation is under control in China and that is helping to provide stability, but we are observing different situations across Asia. 

India is likely experience 6 per cent-7 per cent growth this year, it is suffering from inflation pressures, but the Bank of India has already hiked rates three times. In the middle of the pack is Indonesia, which is likely to grow at 4 per cent-5 per cent GDP this year, with around the same level of inflation (it has also started to hike rates). At the other end of the spectrum is Thailand, given its tourism-reliant economy has not quite recovered from the impact of Covid yet (it is only just starting to hike rates). 

Victoria, what is your outlook for Hong Kong?

Victoria Mio: Hong Kong just announced that it is ending the mandatory hotel quarantine policy, allowing new arrivals to stay in a hotel of their own choice. The quarantine measures between Hong Kong and China remain the same, but the re-opening of Hong Kong is going to increase travel between and via the two countries. Hong Kong’s Covid policy may be a testing ground for China, so if successful we can be hopeful that China will seriously consider optimising its Covid policy soon.

Victoria, China’s corporate earnings season has just concluded. What did this tell us?

Victoria Mio: We noticed significant divergence between sectors. Energy, consumer staples and financials delivered positive earnings, but we are still seeing headwinds in real estate, industrials and consumer discretionary, which are traditionally more cyclical. Broadly speaking, earnings growth showed ongoing recovery from Covid and margin recovery, while some sectors will benefit from policy support and are therefore providing attractive opportunities, such as autos, renewable energy and infrastructure.

Andrew, do you think the shift in Covid policy will be a potential catalyst for China and, therefore, the rest of Asia?

Andrew McCaffery: I think it will. Freedom is put to work and this will drive consumption. As broader economic activity increases, the effects of stimulus will start to come through. Covid policy is seen as a very distinct hurdle for investors and if gradually removed this will boost investor confidence. In the second quarter, investors were looking for ways to exit the Chinese market, whereas in the third they have been looking for ways to re-enter. The difference between this outlook and that of much of the developed world will become even more visible in data and sentiment, and that is when I think markets start to exhibit a more distinct positive response than the holding pattern we have been in for some time.

Some people are calling the Party Congress as a potential catalyst to re-enter the Chinese market. What is your view?

Andrew McCaffery: There is difference between expectations in China / Asia and those in the US / Europe. There is the potential for sentiment to improve if we see policy move towards opening up China’s capital markets internationally. 

Vanessa Chan: There will be talk of policy support. However, for property, any support will need time to work through the system. We are also likely to see some more support for domestic consumption. Overall, we are constructive that policy stimulus will come through eventually.

Victoria Mio: The Congress will not just affect short-term sentiment but will also have an impact over the next five years. It normally focuses on personnel and there are not normally major policy announcements, but policy can be indirectly affected by the top leadership. Afterwards, we can expect improved policy coordination and implementation due to the settling of personnel issues. I expect a readjustment of Covid policy, which may lead to clearer market expectations on re-opening. 

Victoria, we have previously seen droughts and power shortages in China. Is energy crisis a risk?

Victoria Mio: 65 per cent of China’s energy consumption comes from coal and it is the biggest coal producer, so it has better control over its energy supply. It has also been actively developing renewable energy and is the largest producer of solar power, boasting the complete value chain. However, it still faces higher energy costs when the oil price is increasing. 

Does the use of coal mean that China is moving away from its aim of being carbon neutral?

Victoria Mio: We see the use of coal as a temporary solution, as China has very strong commitments on reaching carbon neutrality by 2060. There are stringent regulatory requirements restricting polluting sectors such as coal. As we have seen a drought and related electricity shortages, the government has decided to temporarily use more coal in preparation for the winter, but the direction of change has not changed. 

What are your views from an asset allocation perspective, given the issues we have been discussing?

Vanessa Chan: From a fixed income perspective, I think property is looking very attractive in terms of valuation. Investment grade is presenting some high-quality opportunities, if you have a long-term horizon and holding power it could be very interesting. There are also some opportunities in China and Asia High Yield. Technology is also an area to watch, as we see ongoing regulatory relaxation benefit cash-rich companies that have been under pressure. China onshore bonds could also provide stability, particularly in foreign-exchange terms.

Andrew, what do you think of the renminbi compared to other major currencies?

Andrew McCaffery: Broadly speaking, the key driver of foreign exchange markets is the dollar and expectations of Fed policy. However, the renminbi is showing relative stability and diversification against the key factors that have been driving the dollar higher. 

Andrew, would you agree with Vanessa about High Yield?

Andrew McCaffery: There are distressed opportunities that may see restructuring and repricing. However, in Investment Grade you can still get diversification in terms of company quality and many high-quality Chinese businesses are experiencing more tailwinds than their international counterparts.

Technology has been beaten down in valuation, but it could do relatively well if there is a sense that the headwinds facing the sector are declining. The potential for re-pricing is quite high. Cyclical consumption ideas will also start to come back to the fore and we are seeing some signs of support for these businesses come through.

We will hear a lot of noise about the renminbi weakening against the dollar, but that isn’t going to be a key component as to how policy is going to be managed. 

Victoria, how do you view the outlook for value and growth?

Victoria Mio: In the first half of the year, there was a clear preference for value sectors like commodities, energy, and banks. However, over the last few months, we have seen both growth and value performing in a similar way, driven mainly by fundamentals. Investors are now making more rational decisions.