China was first to recover economically from Covid-19. However, its stock exchanges do not reflect this: equities have been under pressure since the Chinese New Year. That should not be a surprise since China's growth momentum has been fading. It is a consequence of Beijing's efforts to curb credit growth to limit financial risk. In addition, export growth has been slowing as the rest of the world has started producing again.
Equally, China's consumption growth has disappointed. Consumer spending has suffered from the worsening financial stress triggered by Beijing's debt reduction and structural reform policies, keeping more debt from being paid back and making consumers uncertain about their income.
However, containing credit growth is sensible. Debt reduction may hurt in the short term, but over the long term, it leads to a more robust financial system and keeps inflation under control.
Margins under pressure, but stock prices hold
Inflation has been running at two speeds. The producer price index (PPI) rose by 9% YoY in May, while the consumer price index increased by only 1.3%, with core CPI up by an even smaller 0.9%.
Companies are feeling the consequences. While production costs are rising sharply, revenue growth lags, curtailing profit margins. Still, Chinese equities have barely moved this year. However, they have also not fallen. This indicates that companies have been able to offset the effects of lower margins by improving operational efficiency.
Looking at the sectors, demand for consumer staples, healthcare and information technology has remained strong since the outbreak of the pandemic, leaving companies in these sectors with pricing power. This contrasts with carmakers and leisure companies which all suffered major disruption from the lockdowns. We believe companies with strong pricing power should continue to do better than the wider market.
China central bank has its finger on the pulse
The People's Bank of China is likely to ease monetary policy in coming months as economic growth remains uneven, with the recovery on the demand side of the economy still lagging that on the manufacturing side.
Pressure is growing for the PBoC to relax the reins. The main reason is the government's push to grow the economy by at least 6% annually. However, any central bank action is likely to be limited.
Investors should not count on a policy rate cut or a hefty cash injection since the PBoC will not want to thwart government policies. Instead, it could provide additional liquidity and permit selective credit growth to ensure a healthy balance between growth and debt reduction.
Upside scope for share prices
Analysts expect PPI inflation to peak soon on the back of, among other things, commodity prices normalising as global supply chain strains ease. Meanwhile, consumer inflation is expected to remain subdued at around 1.4% due to a weak recovery in consumer spending.
Should the PPI indeed peak this summer, then pressure on corporate earnings should ease, creating a more favourable environment for Chinese equities in the second half of 2021.
That buoyant outlook would get a boost if the PBoC did loosen policy. It would lift a lot of the uncertainty now hanging over the market.
What about regulation?
Like the EU and the US, China has begun to tackle the omnipotence of big tech companies. Action to date has been forceful in view of the unbridled growth of fintech companies in the country. Given that Chinese regulation was lagging, the authorities are now catching up.
Investors should assume further regulations that are even more stringent. This will likely affect the valuations of many tech companies. Conversely, Chinese tech companies, like many other innovative firms, should be able to benefit in coming years from policies that remain focused on strong growth and efforts to reduce any technological dependence on foreign countries as much as possible.
As a result, there should be good opportunities to invest in Chinese tech, biotech, aeronautics, artificial intelligence, electric cars and companies focusing on quality consumer products.
Declining bond risks
The outlook for Chinese bonds is also improving. International investors only fairly recently gained access to this roughly USD 15 trillion market, which is the world's second largest bond market. With the three major rating agencies now licensed to rate Chinese debt, more foreign investors could feel encouraged to buy Chinese debt.
While confidence in the bond market has been bolstered by these developments, it remains essential for investors to do their homework well. With the Chinese government allowing state-owned enterprises to fail, the risk of defaults has increased, even if over time, this greater openness to defaults should benefit the creditworthiness of Chinese debt.
No future for bitcoin
Given that most bitcoins are mined in China and that this has a significant impact on energy use, bitcoin mining directly challenges China’s sustainability goals. Accordingly, Beijing has banned bitcoin mining in China, setting an example that the rest of the world could well follow.
A further concern is the anonymous nature of trading in bitcoin and other cryptocurrencies, which could sap efforts to contain crimes such as fraud and theft.
To control financial risk, the bitcoin market must be regulated. Here, too, China is not alone. More and more central banks are planning to issue their own digital coins. This allows them to remain in charge of their policies, while allowing crypto trading to thrive.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
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