Authors: Julia Wang, Timothy Fung, Yuxuan Tang, Weiheng Chen
Strategy Question: Where does China’s recovery go from here?
Since exiting strict Covid control policies, China’s economic re-opening has been quite mixed. While some areas, such as service sectors, have shown notable improvement, other areas have remained weak. Looking ahead to 2H2023, we anticipate fairly stable growth of around 4-4.5% year-over-year. While our growth assumption is below consensus, we expect a more sustainable recovery that is built on a broadening of growth drivers, rather than a narrow, stimulus-led recovery. Service sectors are over half of GDP and account for over 60% of employment, so they are key to a more sustainable recovery. While further incremental easing is likely, we expect policies to largely play a supportive role in the recovery, with a bigger focus on helping with medium to long-term growth transitions towards clean energy, domestic consumption, export diversification – and continued investment in innovation.
Why has the recovery slowed?
After an initial surge of pent-up demand in the first quarter of this year, growth eased in the second. Looking through the extreme base effect created by the Shanghai lockdown last year, compound annual growth rates point to a moderation in activities. There are a few reasons behind the slower growth trajectory, but the most important was the housing market stabilizing at low levels, rather than staging a V-shaped rebound. Given sluggish sales, investment and construction activities continue to be quite weak, impacting upstream as well as downstream industries such as materials and equipment, which are seeing a slowdown in new orders. On a related point, earlier in the year some analysts drew direct comparisons between China’s re-opening and those experienced by the developed world – and in turn reached optimistic conclusions on how much and how quickly excess savings in China could be unwound. In reality, most of the excess savings in China were due to less spending, rather than more income (due to the lack of transfer income), which means the drawdown has not been as rapid as observed in developed markets, and instead is declining more gradually. The second-round effects of the housing slowdown were underestimated by analysts and were therefore a major downside surprise for markets this year.
Apart from the household sector, corporate sector balance sheets were also in repair mode. Over the last three years many companies ran into operational difficulties. This is particularly true in the service sectors – in areas such as leisure, hospitality and restaurants – although data is also more limited given many are small businesses. Corporate balance sheets are another key differentiating factor between China’s pandemic experience and that of developed markets. Across most of the developed markets, paycheck protections and less draconian mobility restrictions have meant that most businesses did not see much damage to their balance sheets. In fact, many businesses were able to reduce leverage and increase profitability as a result of fiscal and monetary stimulus. In China, the brunt of the lockdowns were shouldered by the corporate sector – with less fiscal or monetary support. So on the whole, Chinese businesses were in relatively more stressed conditions when the economy finally reopened, and business confidence is thus likely to take more time to recover.
In the chart below we look at the manufacturing sector, as data is more limited on the services sector. Historically, profit growth tends to move together with business confidence and capex spending, so the current weak profit growth is likely a constraint on capex.
What can drive the recovery from here?
Looking ahead, some of the above factors will likely continue to weigh on the Chinese recovery. But on the whole, after the recent slip, we expect the overall growth trajectory to be more stable in the second half of 2023. The organic recovery in domestic demand continues, and the main support will come from continued improvements in the labor market. Recently we have seen signs that labor demand is improving – as indicated by PMIs. The overall unemployment rate has also come off the peak. Many analysts have pointed out that the youth unemployment rate is reaching a new high – and we think the situation reflects several issues: 1) a generally slower economy, 2) the impact of regulation on the tech and education sectors, 3) a skills mismatch – the number of new graduates will reach 11 million this fall, which is double the amount a decade ago, which deepens the imbalance between demand and supply in this part of the market, and 4) further education opportunities, which lower the cost of temporary unemployment.
Some of these issues are fairly structural in nature, and can only be addressed over time through reform. As such, we may only see limited improvement in the youth employment situation in the near term. But it is important to put this in context. As of two years ago, the share of 16-24 year olds in the labor force already fell to around 10%. Since then, its share has likely further declined due to an aging population. So while youth unemployment is a serious policy challenge, it is less important from a cyclical perspective. As labor demand picks up, we could see a more gradual rebalancing in household incomes and savings rates. This is just beginning to develop, and there are signs that income expectations are bottoming out and saving rates have peaked.
The services sector recovery will likely hold the key to further improvement in the labor market. A few years ago the services sector overtook the manufacturing sector to become the biggest in the economy. On the consumption side, spending on services was growing faster and becoming a larger part of overall consumption every year. This was interrupted by the rolling lockdowns over the last few years, but the re-opening has rebooted the sector, driving a sharp rebound. We think it could return to, or even exceed pre-Covid level trend growth in the coming years. A recovery in services demand will likely lead to improving demand for workers, which creates a virtuous cycle for more sustainable growth. The services sector accounts for over 60% of all employment, and outside of the very wealthy segment of the market, consumption is more closely linked to job security as well as income growth.
What can Chinese policymakers do?
While we expect more recovery ahead, our overall GDP growth assumption for 2023 is below consensus. We expect mostly an organic domestic demand recovery, with government policies largely playing a supportive role. After the recent series of small policy rate cuts, it is likely that further incremental monetary and fiscal support will be announced in the second half of this year. On the fiscal side, the focus will likely remain on investing for the energy transition, as well as infrastructure for an aging population. More policies to support housing sales are also possible, particularly at the local government level. Indeed, policy easing for the housing sector thus far has been quite limited – so there is room to do more. Home purchase restrictions remain quite prevalent, and were merely fine-tuned rather than relaxed in most cities. Down payments as well as mortgage rates remain quite high despite recent policy rate adjustments. In particular, mortgage rates on second homes (which constitute the bulk of buyers looking to upgrade) have not been adjusted. Some of these policies are at the discretion of local governments and may see some incremental loosening in the months ahead.
That said, recent policy actions indicate that the priority is to put a floor on growth and maintain financial stability rather than engineering a V-shaped recovery through stimulus. From this perspective, policymakers would want to avoid a downward spiral in confidence, and will do what is needed to stabilize growth. Beyond that, there is limited appetite to do more. From a short-term perspective, given the very low base from 2022, there is no heightened concern that growth is significantly under-shooting. From a longer-term perspective, there has also been a growing consensus that a property market-led economy creates a lot of imbalances, and that the economy needs to move to areas like clean energy, industrial upgrading and domestic demand. Given these considerations, policymakers will likely not want to err on the side of over-stimulating. At the local government level, the slowdown in land sales is a constraint that limits how much discretionary spending local governments can make to boost growth without relying on the central government.
What is the path for future growth?
An organic domestic demand recovery implies a more moderate pace of growth. But it is also a more sustainable one as it is built on labor market improvement, which should broaden out. From our below-consensus 2023 GDP growth assumption, we expect the recovery to become more sustainable in 2024. In the medium to long term, China’s growth will likely need to transition to domestic demand. More stable expectations for house prices is one helpful factor, as is a better social safety net. The transition to clean energy will likely remain a big policy priority in the next few years. More investment is still needed to shift the energy sources used in electricity, transportation and energy storage. The increasing penetration of electric vehicles is one part of the strategy, but there is a need to broaden progress while ensuring energy security and resilience. Export diversification continues apace, but this is also impacted by global demand as well as geopolitical factors. Innovation is another key, and we expect continued policy support in an attempt to boost future productivity growth.
We think Chinese equities look increasingly attractive following the recent correction and across-the-board downgrades on China’s macro and equity forecasts. Our expectations for a continued recovery in 2024 also sets a stage for more equity market upside in 2H2023, as share prices usually run a few months ahead of the real economy. Fundamentally, earnings upward revision momentum remains strong and is still pointing up, which is traditionally a leading indicator for more earnings upgrades. Policymakers have moved in the direction of more market-friendly practices. Recall that Chinese equity markets are still highly policy-driven, and policy is becoming more pro-growth on the margin.
We believe we are at a sweet spot for Chinese equities – where valuations are compressed to below average levels, but earnings revisions are still up, and more policy support is expected to come. China could remain a trading market in the short-to-medium term, but we are likely at the low end of the range. We therefore see limited downside risk, with much improved risk-reward in the second half. On the thematic front, we like outbound traffic beneficiaries and reasonably-priced state-owned enterprises, which are trading at single digit P/E ratios and high dividend yields (with some at around 10%). Sector-wise, we prefer oversold consumer stocks and inexpensive large-cap internet stocks that will benefit from an expected organic consumption recovery.
We are constructive on both offshore and onshore China equities, with our MSCI China/ CSI300 June 2024 outlooks at 78-82/ 4700-4900 respectively. We are positive on the onshore market’s long-term growth potential from its structural bias towards consumption recovery, industrialization, as well as A-share financial market reform. On the other hand, the recently derated offshore market offers higher near-term upside as a short-term tactical trade.
On the currency front, the RMB has weakened rapidly since April. At current levels, the currency is more reasonably-valued and better aligned with fundamentals. We expect USD-CNH to hover around 7.1-7.2, with some small depreciation risks – for example if the market gets a hawkish USD surprise. For 2H 2023, we do not see major appreciation catalysts for the RMB, given the carry disadvantage. While we do not expect a policy bazooka (as mentioned above), rate cut expectations could be in the price if the recovery continues to stay lukewarm. The current account surplus could also face increased pressure as external demand declines and outbound tourism resumes. We encourage investors to hedge their RMB exposure, and believe that a weak RMB opens the door for use as a funding currency to leverage attractive borrowing costs and take advantage of opportunities elsewhere.
All market and economic data as of June 29, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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