2022 has been a challenging year for Chinese equities, with multiple headwinds. Looking into 2023, we are expecting meaningful improvement. Growth is likely to accelerate with China’s decisive move to reopen, the expected improvement of the property market, and a benign inflation outlook. Chinese equities could be a bright spot amid a global deceleration in 2023.
Since the Party Congress in October, Beijing has worked towards addressing the two key issues that have dragged China’s economy and market lower over the past 18 months. Firstly, there has been a clear pivot in Covid-19 policy. Secondly, the launch of 16 measures to support the property sector is expected to help the sector recover. China’s leaders have also planned a full agenda to meet with foreign leaders to address and stabilise the geopolitical situation.
The spike in cases brought by the reopening will lead to shortterm pain in the economy, as indicated by the weak PMI in December. However, we think the pace of recovery may also be faster than the market expects. We think economic activities could return to normal after the Lunar New Year. The reopening will likely significantly boost domestic consumption and private investment.
Economic cycle at a unique stage
China is currently at a very different stage of its economic cycle compared with other major economies. While other major economies are tightening to fight decade-high inflation, China has room to ease as inflation remains moderate. This divergence in inflation is a result of different responses to the pandemic. During the initial Covid-19 outbreak, China prioritised protecting supply, while consumer demand and employment remained weak.
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China’s stable inflation outlook provides a favourable backdrop for liquidity. If we take the credit impulse as an indicator of China’s monetary cycle, the People’s Bank of China started to tighten in mid-2020 as the economy recovered strongly from the initial Covid-19 lockdown, contributing to the slowdown over the past 18 months. The credit cycle turned at the beginning of 2022 when China loosened the margin. However, monetary policy has not flowed through to the real economy because of the extended Covid-19 lockdowns and property market issues. As these issues are expected to improve in 2023, the credit multiplier will likely strengthen.
With the lowest institutional holdings over five years and cyclically-adjusted valuations far below average, the risk and reward ratio is favourable. China’s corporate profits were suppressed in 2022 due to Covid-19 and the property decline. However, the consensus expected China’s 2023 earnings per share (EPS) growth to accelerate to 10% from 2% in 2022. On the other hand, global EPS growth (The MSCI All Country World Index, ACWI) is expected to decelerate from 7.5% in 2022 to 3.7% in 2023. We think China is in a unique economic cycle and expect corporate earnings to accelerate meaningfully in 2023.
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An essential part of the global supply chain
China’s supply chain strength is robust despite all the concerns about decoupling. Foreign direct investment into China has increased by about 20% year-to-date in 2022. China’s manufacturing capex in 2021 accounted for over 60% of the global total, and manufacturing output accounted for 30% of the global total, record-high percentage shares in both cases.
China has lost its share in labour-intensive industries such as apparel, furniture, and electronics assembly. On the other hand, the country has been quickly gaining a share in technology-intensive areas like auto parts, electronic components and other equipment (such as those related to the electric vehicle battery, smart grid and fracking). China’s demographics have turned from tailwind to headwind, but its education and engineering dividend is just starting. Annual new STEM (science, technology, engineering and mathematics) graduates in China are higher than for OECD (Organization for Economic Cooperation and Development) countries combined.
Selective decoupling has been seen in strategic high-tech industries, such as leading-edge semiconductors, biotech, and potentially electric vehicles. This may slow down China’s development in certain areas, such as high-performance computing and artificial intelligence. On the other hand, the concerns about supply chain security have helped to accelerate local substitution in power, semiconductors, analogue technology and medical devices.
Market leadership to broaden
To active investors, China remains a fertile hunting ground for investment opportunities. We expect market leadership to broaden, and investors should look beyond well-discovered mega-caps to identify potential future winners. The themes we are following closely include the best growth assets in China that will emerge stronger from the economic downturn. Examples include online recruitment, shopping mall operators and hotel chains.
We also find ample opportunities in businesses with idiosyncratic drivers that are doing well despite the weak macro environment, such as auto parts and industrial companies levered to the energy transition, shipbuilding and oil field services. Another theme to look out for is defensive businesses with a historically attractive total return and improving outlook in 2023, including “growth at a reasonable price and yield” and value names in consolidating industries.
With better visibility on Covid-19 and property market outlook in 2023, we expect various domestic-related sectors — including consumer discretionary, business service, and advertising — to accelerate toward the second part of 2023. These are areas where we tend to find companies with very strong business models, and we expect to find more attractive opportunities in these areas as the economy improves.
Wenli Zheng is portfolio manager of the China Evolution Equity Strategy at T. Rowe Price
