China Under Pressure

The three-week Shanghai lockdown may have slowed the spread of omicron, but China’s “Zero-Covid” policy is clearly failing. The latest road and air traffic data in and around has dropped significantly, just shy of Wuhan lockdown levels. The Purchasing Managers Index (PMI) data from auto and auto parts, computer and electronic equipment and oil refining are as bad as those reached during the Wuhan lockdown.

The speed at which Covid has surged and retreated across many geographies suggests that its impacts are temporary. Covid has forced Chinese policymakers and producers to adapt and avoid output indiscriminately. However, the near-term outlook for Covid in Greater China will worsen the lingering supply/demand imbalances of 2021.  And this will intersect with the commodity supply disruptions related to the war in Ukraine.

• Assuming a continued Covid-Zero Strategy, China’s Q2 economic activity could be materially impacted by both manufacturing shortfalls and transport slowdowns. CIO expects April monthly economic activity indicators will show even sharper declines in May.  Thus, it is now possible that China could experience a Q2 GDP contraction.
• Fears of a Q2 recession would make China’s 5.5% growth target for 2022 unachievable.  Thus, CIO expects stronger policy easing ahead. Additional fiscal stimulus focusing on maintaining household income and boosting consumption is likely. Local governments are taking action; after one week of lockdowns, the Shenzhen government has issued 30 policies, ranging from fees and tax reductions to increasing various fiscal subsidies for firms to compensate their losses and boost business confidence.
• At the recent State Council Executive Committee meeting, Premier Li announced new fiscal measures to support the national economy. New policies to support the service sectors hit by lockdowns and policies to support auto and other durable goods consumption were announced. Meanwhile, monetary policies may become far more accommodative.  

Portfolio Considerations

• Historically, the performance of Chinese equities has a strong positive correlation with the country’s monetary policies rather than its immediate economic performance. Following the outbreak of Covid-19 in 2020, the loose monetary policy, together with strict social distancing measures, helped the equity markets rebound quickly from the pandemic. Although policy makers have refrained from deploying any massive stimulus in 2021, China’s financial policy has shifted to prop up growth in 2022.  There is often a lag of a few months between the launch of significant stimulus and a rally in equities.  However, external shocks including the Ukraine war, rising delisting risks for ADRs and the possibility of sanctions against China may delay or mitigate the typical response in Chinese equities.
• The valuation of Chinese equity markets has become far more attractive after the recent correction. MSCI China is now only valued at 53% of the S&P 500, a historic low. In addition, according to a collection of five valuation metrics, Chinese equities are now at levels close to those in late 2018.
• Over time, the Covid-Zero policies may relax. Together with China’s high-tech contact-tracing capacity and effective social organization, the policy fine-tuning of CZS may allow China to refocus on its economic objectives.
• Given the expected additional fiscal policy stimulus and further monetary policy easing, Chinese asset prices will likely see support.  CIO maintains a positive view on the Chinese equity market for long-term investors.