China is accelerating its efforts to achieve common prosperity and implementing other policy initiatives aimed at sustainable growth. What will this shift in policy priorities mean for investors in 2022 in China’s stock and bond markets?
How do you see the performance of the Chinese economy in 2021? What are your prospects for 2022?
Vivian: The Chinese economy was still quite strong in 2021, with consensus for real gross domestic product (GDP) growth of around 8.5%; this follows growth of 2.3% in 2020, the strongest among major economies. However, we have seen a general slowdown in recent months due to COVID-19 Delta and Omicron variants, government environmental controls, and regulatory impact.
We expect 2022 to be a year of rebalancing the Chinese economy as the government seeks to strike a balance between supporting economic growth and accelerating structural reforms and sustainability initiatives, namely common prosperity and carbon neutrality. This could cause growth to decelerate to around 5.5% in 2022.
Overall, we expect macroeconomic policies to become more accommodative in 2022 to support the growth objective. President Xi’s stated goal is to double the size of China’s GDP by 2035, which equates to an average annual real growth of around 4.7% for the next 15 years. It would start higher and decline, probably around 3% as we approach 2035, but this is still healthy growth for a $14.5 trillion economy.
Clifford: Economic performance is on track, but there are many contradictory forces behind the scenes. The political agenda is gaining influence over technocratic economic policies as top-down policies such as decarbonization and shared prosperity take precedence. Growth will be sustained through 2022, but export figures could decline somewhat as other major economies open up further.
How will the Common Prosperity Agenda affect economic growth?
Vivian: Growth remains a key part of China’s story, but the government is now focusing more on promoting sustainable and broad-based growth.
Income and wealth inequality have increased dramatically in China over the past few decades, and one of Common Prosperity’s goals is to change income distribution from a traditional pyramid shape to an oval. Broadening the base of economic productivity is necessary to offset some of the structural challenges to growth, such as population ageing.
Against this backdrop, we will likely see a shift in the growth mix of the Chinese economy. Previous engines of growth, such as the digital economy, may contribute less. Others, like high-end manufacturing, semiconductors and green energy industries, are likely to pick up speed.
Clifford: There has been skepticism about common prosperity, but the government is determined to strike a balance between social stability and wealth generation for all Chinese people.
Another way to implement shared prosperity might be through patient inaction and refraining from conventional policy responses. For example, most people expected “pivotal” government actions to deal with the recent sell-off in China’s property market. So far there has been none. However, “no policy” is itself a policy. The government may be trying to attack a sector where high prices favor the rich and harm the general population.
What is the outlook for inflation in China? Why is consumer inflation lower than in other countries?
Vivian: The year-on-year change in China’s producer price index (PPI) was 13.5% in October 2021, the highest level in 20 years. This sharp increase was driven by rising global commodity prices, structural reduction in the supply of manufacturing capacity following supply-side reforms, infrastructure revival and export growth.
But the year-on-year increase in China’s consumer price index (CPI) in October 2021 was only 1.5%. There are structural reasons for this huge divergence. China has a strong and growing e-commerce business, which tends to lead to price deflation.
Additionally, Chinese manufacturers were able to absorb much of the PPI pressure despite some near-term margin compression, given the offset from strong unit volume growth and a cost structure. improved.
Clifford: Pig prices, a key driver of inflation in China, have declined in 2021 as pig herds have expanded and slaughter rates have increased. However, so far this year, the big disruptor has been vegetable prices, as heavy rains in September and October have affected crop production.
Meanwhile, there is a risk of a spike in commodity prices and other elements from today’s high PPI spilling over into the CPI in the second half of 2021. China has experienced several national and regional lockdowns following COVID-19, which dampened consumer spending and kept demand pressure on the CPI.
But a big question going forward is how the government will tackle COVID-19 in 2022. Will China continue with zero tolerance or start learning to live with COVID-19? If there is more openness, we could see more pressure on consumer prices.
Vivian, how favorable do valuations look in Chinese equity markets heading into 2022?
Vivian: Valuation risk is generally lower than a year ago, which should be positive for Chinese equities in 2022, all other things being equal. Earnings growth has been mixed in 2021, with a divergence between consumer-focused and manufacturing-focused industries; this divergence has been exacerbated by changing policies and regulations.
For example, China’s internet industries have seen both fundamental and political headwinds in 2021. As a result, China’s broader stock index, MSCI China All Shares Index, depreciated 13% in dollar terms. in 2021. China’s national A-share index, CSI 300, depreciated 3.5% in renminbi over the same period.
We expect Chinese equities as a whole to fare better in 2022, based on a recovery in earnings and less demanding valuations. The MSCI China All Shares Index was trading at a forward price-to-earnings ratio of 13.5x, comparing favorably to the S&P 500 Index, which is around 20x.
But at a sector level, we have seen valuations rise for certain segments, such as high-end manufacturing and green energy.
Clifford, what is your outlook for the Chinese bond market in 2022?
Clifford: We expect more balanced two-way flows to drive the market in 2022. Foreign inflows should remain strong as China is still one of the few major economies to show positive real interest rates. Meanwhile, investors and index providers continue to increasingly recognize Chinese government bonds as a dominant asset class, either through higher investment allocations or index inclusions. wider.
On the other hand, interest rates are rising globally amid pent-up inflationary pressures globally. This has the potential to make Chinese government bonds less attractive relative to US Treasuries and European bonds from a valuation perspective. Of course, there is still a long way to go to close the valuation gap, but investors may need to seriously re-evaluate the arbitrage trade of adopting staunchly long Chinese government bonds if the inflationary risk in China increases as in other countries.
Given these offsetting pressures, local inflation could determine the fate of the Chinese bond market in 2022. China’s CPI remains low, and I don’t expect inflation to rise much, at least in the first half 2022. So I’m cautiously bullish on Chinese government bonds, and I think current valuations are attractive both from an absolute and relative perspective.
The renminbi (RMB) is an important risk factor to watch for currency-adjusted bond returns. It is strong now – the CFETS RMB index was above 102 at the end of 2021, driven by foreign investor inflows, foreign exchange (resilience thanks to the government’s stable monetary policy) and healthy current account positioning ( which happened as travel restrictions prevented leakage of tourist outings). But the idea of a continued strengthening of the RMB will begin to be questioned amid a stronger US dollar and a possible slowdown in Chinese export growth.
Vivian, given the large-scale social and economic rebalancing in China right now, where do you see opportunities in the stock markets?
Vivian: Traditionally, the main investment opportunities in China have been in structural growth sectors, such as consumer, healthcare and technology. In our view, this has not changed, although the near-term growth prospects of these sectors such as consumer and healthcare may be affected by the resurgence of COVID variants and associated lockdowns. Some segments have faced significant political headwinds lately, but these have largely leveled off.
The internet and e-commerce industry remains a significant opportunity because the business model is so favorable; Additionally, recent policy concerns have made valuations more attractive.
We also continue to see opportunities in healthcare, particularly in areas such as contract research/manufacturing organizations, innovative medicines, specialty hospitals, non-generic traditional Chinese medicine and others. These are secular growth areas because they are under-penetrated and/or there is a big story of national substitution going on. For example, some highly innovative Chinese medical products and devices are much cheaper than their global counterparts for the same technological efficiency.
We also love technology. Digital technology was once dominant and is still important, but hardware-driven technology is now a bigger growth story. This includes high-end manufacturing, automation, semiconductors, green energy, electric vehicle batteries, and more. We think it will be even more attractive in the future, both from an industry growth perspective and government support.
Vivian Lin Thurston, CFA, Partner, is a portfolio manager and research analyst with William Blair’s Global Equities team.
Clifford Lau, CFA, is a portfolio manager in William Blair’s Emerging Markets Debt team.